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The credit gap and the emergence of alternative lenders

Since 2008 the European and Irish Banking systems have experienced a period of unprecedented change. Many of the events during this period have been well documented and will remain topical for some time to come.

What has emerged is a smaller banking sector containing fewer active players with a reduced capacity to lend and a reduced (and arguably appropriate) appetite for risk.

Unlike in the US where companies are predominantly funded through institutional investors, European companies (and particularly Irish Small and Medium Enterprises (SMEs)) are highly dependent on banks for capital. 

These changes to the Irish banking sector, coupled with the high level of dependence on banks for funding, has resulted in the emergence of a credit gap that the existing banking system is unable to service. Governments are now trying to encourage institutional investors to provide funding solutions to fill this credit gap.

The key drivers of the credit gap and the emergence of alternative lenders are discussed below.

Reduced competition

Since 2008, we have seen Irish banks being nationalised, merged, deleveraged and liquidated. We have also seen the partial or full withdrawal of foreign banks from the Irish market, a trend that looks likely to continue for the foreseeable future. As the table below demonstrates, this has led to a significant decrease in the number of players in the market with only two banks remaining that could be considered “fully active”:

 

Fully active

Restricted activity*

Exiting

Irish lenders

  • BoI
  • AIB
  • Irish Permanent
  • IBRC (in liquidation)
  • EBS (merged with AIB)
  • INBS (merged with IBRC)

Foreign owned lenders

  • None
  • Ulster Bank
  • Barclays
  • HSBC
  • BNP
  • Danske Bank
  • Close Brothers
  • ACC
  • BOSIZurich

* Activity is restricted to certain sectors

However, the table above does not give the full picture. Competition varies greatly by sector, with a strong level of competition remaining in the low risk large corporate/institutional sector and very little competition in the mid corporate, SME and property sectors:  

Large corporate / institutional sector

Mid corporates (c. €20m - €250m turnover)

SME’s

Property

  • Competitively banked.
  • BoI, AIB, UB/RBS, Barclays, Rabo, BNP, HSBC and Danske are all actively looking for new business.
  • Private placement bond market becoming increasingly popular.
  • Category seen as low risk with most businesses cashflows heavily weighted towards exports
  • Currently under banked.
  • BoI, AIB and to a lesser extent UB, are the only active lenders. Badly hit by the withdrawal of BoSI and Anglo.
  • Due to the lack of scale, the overseas Capital Markets are not accessible as a source of funding.
  • National Pension Reserve Fund (NPRF) sponsored funds will help to provide an alternative source of funding to this sector.
  • Under banked and politically sensitive. Difficult sector to lend into, particularly in a recession.
  • Significant Government pressure on the “Pillar Banks” to lend into the sector and some recent indication that this is happening.
  • NPRF sponsored funds will help to provide an alternative source of funding to this sector.
  • Issue remains that a lot of companies in this category are under capitalised.
  • All Irish banks remain overweight in this sector.
  • Will lend against well let income generating assets but focus is on cash generation rather than market value.
  • Banks are not willing to write any new business in this sector above 65% loan to value (“LTV”), unless it is part of a debt recovery strategy.
  • Property development funding remains very restricted and limited to low risk projects.

Over reliance on bank lending as a source of capital

Small and Medium Enterprise (SME) businesses are an extremely important component of the Irish economy, making up over 99% of businesses in Ireland and accounting for almost 70% of people employed in the State.

Despite this level of significance to the economy, new bank lending to SMEs has decreased significantly across all sectors since 2010 as illustrated in Figure 1 below.

However, this decrease in bank lending should also be viewed through the backdrop of Irish SMEs being over reliant on banks for funding and therefore overly exposed to difficulties in the banking sector. Figure 2 below illustrates that Irish SMEs are overly reliant on bank borrowing relative to other countries in Europe, particularly overdrafts where Ireland has the highest share of firms using bank overdrafts while for bank loans it is the third highest in the Euro area. This is based on a study on “The importance of banks in SME financing: Ireland in a European Context” by the Central Bank of Ireland, November 2013.


This suggest that’s Irish SME’s are under capitalised and must look to other forms of capital to de-risk their balance sheets and fund growth. 

 

 

Changes to lending criteria

During the credit “boom” years of 2000 – 2007, banks were able to access cheap short term funding through the interbank lending markets. This availability of cheap credit for banks resulted in banks becoming predominantly asset focussed i.e. focussed on building up their loan books. When the interbank market froze in 2007 the banks’ focus changed to the liability side of their balance sheets resulting in banks engaging in large deleveraging exercises and assessing all new lending on a best use of capital basis.

On a micro level, banks took a lot of comfort from the value of fixed assets held in a personal capacity and/or on a company’s balance sheet during the credit boom years. Loan to Value (LTV) and interest cover were the key lending criteria for most banks (especially the property focussed banks operating in the Irish market), with less emphasis on cashflow generation and repayment capacity.

However since 2007, a combination of the lack of availability of longer term funding for Banks and the introduction of Basel III and its implications for how Banks allocate their capital has resulted in Banks shortening the period of committed facilities to under five years. This has resulted in a focus on repayment capacity and refinance risk i.e. emphasis has moved to sustainability of cashflows.

The table below summarises the key changes in the bank lending environment:

 

2000 – 2007

New environment

Banks’ focus

 

 

 

 

  • Asset Focused i.e. build up loan book
  • Funding was easily accessed  and cheap
  • Liability led, funding is hard to access and expensive
  • Selective use of capital

 

Lending criteria

 

 

 

 

 

  • Strong focus on borrower’s balance sheet
  • Particularly fixed assets i.e. buildings
  • Key criteria included interest cover and Loan to Value
  • Capital repayment was not seen as essential once the Loan to Value was acceptable (<80%)
  • Unsecured personal recourse gave banks comfort to increase leverage even further
  • Focus is now on operating cash flows
  • To assess operating cash flow and forecast with any level of certainty banks need to assess and understand the business and its management
  • Ability to service interest AND repay capital within a reasonable timeframe is key
  • Assets on the balance sheet give comfort around refinance risk but are no longer a substitute for capital repayments

Other factors

 

 

 

  • Capital allowances made it tax efficient to borrow in a personal capacity rather than through a corporate structure
  • Capital allowances have mostly been rescinded, no longer as tax efficient to borrow in a personal capacity.

 

 

Emergence of alternative lenders

Most of the issues raised above are also being faced to varying degrees by the UK and other Eurozone economies. Common to all has been government led initiatives to encourage alternative lenders to provide solutions for the credit gap in their respective markets.

In the UK, the Government has set up the Business Finance Partnership to invest £1.2bn in lending to SME’s from sources other than banks. This money is being matched with at least an equal amount from private sector investors and will be invested on fully commercial terms.

In Ireland, the Government has opted for Direct Lending Funds and Private Equity Funds sponsored by the National Pension Reserve Fund (“NPRF”). The impact of these funds has already been a positive one and we would expect them to become increasingly active over the medium term.  A summary of the three existing NPRF sponsored funds is set out below:

Fund

Manager

Capital available

Size

Target market

SME Direct Lending Fund

Bluebay Asset Management

Senior and Junior Debt including Unitranche

€500m Larger SME’s and mid-sized corporates

SME Equity Fund

 

 

Cardinal Carlyle Equity €300m

Healthy businesses with debt that need equity to grow

 

SME Turnaround Fund

 

 

Better Capital Equity €150m

Underperforming businesses – at point of insolvency but have the potential for financial and operational restructuring

We have also seen increased activity from non NPRF funds such as QED Equity and MML Growth Capital Partners Ireland (Enterprise Ireland are an investor in MML’s fund) and portfolio acquirers such as Lone Star, Sankaty and Kennedy Wilson.

Although we do not expect Ireland or Europe to adopt the US funding model where Bank debt only accounts for approximately 10% of corporate funding, we do expect non-bank funding to play a greater role. This will result in companies having to adopt more complex capital structures as they use a number of sources to fund themselves, however this should also lead to lower refinance risk in companies as corporate and commercial Ireland will be less exposed to changes in the banking sector.  

Contact John Doddy (01 417 2594) for further information. 

 

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