COMMENT: Mid-market revolution coming to Europe

Wed Apr 3, 2013 12:11pm EDT

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April 3 (IFR) - I've been spending a lot of time delving into the debt financing of European mid-market corporates, and I'm increasingly in the camp of those who reckon we're at the start of a major shift in bond market activity as we move towards a more heavily disintermediated funding model.

I don't think that's overstating the case. I'm calling it The New DCM Paradigm. It will almost certainly take some years to evolve fully, but we're already on the road and things are moving pretty quickly.

The reasons for the shift are clear. Bank deleveraging, higher capital requirements, more stringent financial regulation and more value-focused client-relationship models are leading to a broad withdrawal of "free" relationship-type bank lending - not for all, of course, but banks are certainly maintaining smaller groups of core clients. That's the push factor.

Current technical conditions in the bond market are the pull factor, acting like a magnet for corporates of all sizes and types. And the advantages of diversified sources of funding are always appealing to corporate treasurers.

We're just at the beginning of this putative transformation and it's yet to be tested. One robustness test for the lending-to-DCM hypothesis will be what happens when the current phase of central bank stimulus ends and we start to see a normalisation of yield curves, higher credit spreads and (by definition) higher debt-service costs in the bond market.

Another will be when - eventually - we get some modicum of sustainable economic growth that allows confidence to return. It's anyone's guess how banks will react to that. They're maintaining tight discipline around RWA growth at this juncture because they've got their backs to the wall on capital and cost control.

But by the same token, banks have been notoriously fickle in the past around supposedly hard-held beliefs. And they may once again open the credit taps if they can see growth (read: a bigger wallet).

One thing is for sure: whatever outcome we ultimately encounter, the bond cat is out of the bag - and corporates will seek increasingly to maintain balanced bond and bank lines.

Price could be a determinant here. It seems to be a given that funding in the bond market is likely to come out more expensive than bank finance, but I wonder.

On the basis that the costs of banks' own funding is likely to stay relatively elevated - and that those costs will have to be passed on to borrowers with a premium if banks keep stringently to market-based lending models and sweat their assets to generate higher returns on capital employed - it's likely that the basis differential may be minimal, depending on what the buyside demand drivers are in the bond market.

The arrival of hordes of new mid-market borrowers into DCM has the potential to cause major upheaval, and you've got to question whether borrowers will be forced to adopt a stance that suits the status quo - or whether the status quo will need to change to suit the new borrowers. My money is on the latter.

One example of what might need to change is the current bond market attitude to (and obsession with) liquidity. Another is multiple bookrunning tickets. Investors like to demand illiquidity premia unless issue sizes are US$300m-plus, which frankly has never been anything more than price-chiselling-cum-blackmail in my view.

Mid-market issue sizes will typically be much reduced, and so won't be liquid. In that respect, they'll tend to appeal to buy-and-hold buyers, be they retail investors or private placement specialists. In this respect, I can see the development of a bifurcated horses-for-courses model, but one where investors craving diversified corporate exposure will do whatever is required to get bonds.

ENTER BOND EXCHANGES

One development that will have a major impact on the development of a European corporate bond market is the creation of bond platforms on European stock exchanges, or a re-invigoration for those have already have them.

Exchanges have made a big play to attract bond business in Europe in the past two to three years, and the signs have been encouraging. DEME, the Belgian marine engineering group, became the first issuer of bonds on NYSE Alternext in Brussels in February with a EUR200m six-year offering.

In late March, Cerved Technologies was the first issuer to list its bonds on the Borsa Italiana's new ExtraMot Pro bond platform, which is geared to professional investors. The company listed its EUR250m due 2019 and EUR300m due 2020 senior lines and its EUR230m due 2012 subordinated notes.

In a similar vein, Nasdaq OMX Group, which runs the exchanges in Copenhagen, Stockholm, Helsinki, Reykjavik and the Baltic countries, launched the First North Bond Market in December.

To provide some marketing oomph to the launch, Danish Crown, the international food producer, listed its DKr750m (US$129m) bond on the new market's first day of trading. The issue had received a positive reception; Danish Crown had initially gone out with a DKr500m-DKr750m range but sold the full amount to a group of 73 investors.

Right across Europe, exchanges are getting in on the act. As well as the initiatives I've already mentioned, Stuttgart Stock Exchange's Bond segment now has 23 corporate bonds worth an aggregate EUR1.5bn, while other exchanges are making efforts to garner mid-market business, including M:access (Munich Stock Exchange); Entry Standard for Corporate Bonds (Frankfurt); Mittelstandsboerse Deutschland (Hamburg and Hanover), mittelstandsmarkt (Duesseldorf); AIAF (benchmark corporate debt) and SEND (electronic retail trading platform) in Spain; the Nordic Alternative Bond Market in Oslo; the Third Market in Vienna; and others.

The benefits of listing and trading with transparency via organised exchanges with transparent rules are clear to both issuers and investors. So will this New DCM Paradigm take over the existing OTC market? Not in the short term. Are DCM originators taking due notice of this emerging market? Not to the extent they should. Is the DCM underwriting architecture optimally organised to deal with this market? Not at all.

I sense a revolution in the making. The mid-market is coming. Prepare for change.

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