Advancing credit: alternative investment sources for Mittelstand firms are growing

Germany’s mid-market firms – the world-famous Mittelstand businesses –are hugely important to its economy, contributing around one third of total GDP. Like their peers across Europe, these companies will gradually tap alternative sources of funding to finance investments necessary for growth. Yet the development of diversified funding markets will likely be slow.

So far, the German banking system remains a very liquid and competitive lender, so the pace of disintermediation will likely be slower there than in many other European markets. Nevertheless, smaller mid-market companies will encounter greater hurdles to accessing bank funding over time as the disintermediation process takes effect, making access to alternative lending more important.

To support the development of new lending markets, investors will seek greater transparency about the credit risk of mid-market debt issuers. In general, the increased transparency will lead to better capital allocation and more accurate and efficient pricing, which will strengthen the trust of market participants to re-invest in turn.

More difficult economic prospects for mid-market companies

Current more difficult economic conditions should favour Germany’s export-oriented mid-market corporate sector. In general, the German mid-market employs more than 9 million people, representing approximately 30 per cent of the workforce. Around 65 per cent of those mid-market companies show some sort of link to international markets including exports. The financial crisis encouraged many companies to pursue a more conservative financial policy, as the increase in German companies’ equity to total assets since 2007 indicates. EBIT margins since 2007 indicate that German mid-market companies’ profitability is lower but less volatile than larger peers.

However, we find that smaller mid-market companies tend to be more vulnerable than larger and more diversified peers to cyclicality and volatility in general. There are a variety of reasons for this: the scale of their operations is more limited, their activities less diversified and their operating margins more volatile. Nevertheless, “hidden champions” (market leaders in their respective industries that are not necessarily visible to the wider public) benefit from a good competitive advantage and strong margins because they hold dominant market positions in their relative niche.

Mid-market firms are in a strong position to tap funding markets

The generally solid credit characteristics should put German mid-market companies in a position of strength when they tap various debt investors for additional funds. The benefits of traditional bank loans for mid-market companies are obvious – they have far fewer investors to deal with than a public instrument, and management and owners can keep their commercial and financial information confidential. However, privacy has its cost. Bank debt is a much less liquid instrument and typically requires some liquidity premium in pricing.

At present, access to bank debt financing is especially important for medium to small companies because of their relatively higher credit risk profile. In general, they require a higher level of credit analysis and monitoring by investors than large corporates or upper mid-market companies, and extensive due diligence and credit analysis is necessary. However, investors often do not have sufficient important credit information when a company is held privately. Should mid-market firms decide to access alternative funding sources, they will first need to provide greater transparency into their creditworthiness.

One alternative to bank funding for mid-market companies is the private placement market. So far, these markets have mainly been tapped by larger companies with relatively good credit risk profiles. Yet the number of mid-market firms accessing these markets – which include the well-established U.S. private placement market and the private “Schuldschein” market in Germany – is growing.

Alternative funding markets are growing

The Schuldschein market is a long-standing private placement market widely used by the federal states, banks and corporations. The market for managed and arranged corporate deals had a total estimated size of about €12bn in 2014 –an increase of 50 per cent from €8bn in 2013 – with mid-market companies making up approximately 40 per cent of total deal volume. Current market estimates expect a further increase of total managed and arranged corporate deal volume to €14bn in 2015.

Likewise, the U.S. private placement market (USPP) is a well-developed and efficient market that mid-market companies can use to access funding. It remains the most important private placement market by volume size for European companies, although its share declined slightly after a peak in 2012.

But both the German Schuldschein and the USPP market offer only limited potential at this stage for funding medium to small German mid-market companies with lower credit quality. Institutional investors active in those markets currently have only limited regulatory leeway to invest in noninvestment-grade companies. Their main domain is still investing in issuers with a rating of ‘BBB-’ and better, even though some insurance companies use their flexibility to investin certain crossover issuers to realise higher returns.

Evolving markets will favour smaller firms

However, direct lending and mid-market bond platforms have started to become accessible to a broader range of mid-market companies. Direct lending, for example, is becoming more attractive for German issuers in non-typical standard refinancing situations, such as M&As that require fast execution and incremental leverage above standard bank leverage targets, or in distressed situations.

And some mid-market companies appear to be using the currently positive financing environment strategically to build up a reputation with alternative lenders so as to diversify their funding sources beyond plain bank debt. The current market environment of willing investors and favourable pricing is supporting this strategy. Should the environment change in the future, for example through more difficult access to bank loans or a rise in interest rates, these companies will be in a stronger position to use this competitive advantage to gain access to more flexible and competitively priced debt.

We also believe that direct lending and mid-market bond financing would increase the financial flexibility of mid-market companies with lower credit quality should bank disintermediation start to limit their bank borrowing. Yet, to ultimately close the likely funding gap, additional institutional and other funding sources still need to be further developed. In our view, credible transparency about a company’s credit risk will be key to unlocking the internal and external capital allocation decisions of this class of investors, as access to comparable information is fundamental for investment decisions.

Mark Waehrisch and Alexandra Krief are directors, and Claire Mauduit-Le Clercq an associate director at Standard & Poor’s Ratings Services