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Western EuropeNovember 4 2004

Structured finance lifts credit clouds over SMEs

Germany’s small and medium-sized enterprises are turning to structured finance products to provide the credit they sometimes struggle to find, says Jan F Wagner.German bankers may not like to admit it, but for the first time in post-war German history, the country’s small and medium-sized enterprises (SMEs), known collectively as the Mittelstand, face a credit crunch.According to a new survey by KfW, the government-owned development bank, nearly half the Mittelstand say that obtaining a bank loan – its main means of finance – has become “considerably more difficult”. KfW also found that three-quarters of the SMEs turned down for a loan would have paid a higher interest rate to get it.
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“This fact shows clearly that, for many German SMEs, the problem is access to credit rather than their ability or willingness to pay,” wrote Dirk Plankensteiner, a KfW expert on Mittelstand finance who helped to compile the survey.

KfW’s findings pose a real problem for the German economy, as the loan-dependent Mittelstand accounts for 99.5% of the corporate sector and employs 70% of the workforce.

Not surprisingly, the findings have also put German banks, especially big commercial ones, under pressure. Though neither the government in Berlin nor KfW, for whom Mittelstand finance is a chief priority, has criticised the banks for cutting lending to the sector, they continually urge that more is done to help SMEs.

Now, two of Germany’s biggest banks, Deutsche Bank and Dresdner Bank, have stepped forward with what they believe is a solution: structured finance (SF) products: syndicated loans, mezzanine financing, asset securitisation, private placement of bonds and private equity.

Berthold Bonanni, head of structured finance at Dresdner, says: “The paradigm for Mittelstand finance is changing, as the Mittelstand increasingly looks for alternatives to bank loans. There is no doubt in my mind that structured finance will be an important part of the new paradigm.”

Deutsche’s rhetoric goes even further. In a new brochure about its SF product line, it says the products help “close the funding gap” for the Mittelstand.

Deutsche and Dresdner think that SF products are the way forward for the sector because, as well as offering considerable flexibility and capital, some products – particularly mezzanine financing and private equity – can raise the Mittelstand’s deplorably low level of equity capital, which stems from a historic over-dependence on bank loans.

Such a boost in the Mittelstand’s equity capital, in turn, improves the sector’s creditworthiness, which experts currently put at below investment grade (‘BB’). By improving its creditworthiness, the Mittelstand can gain access to cheaper financing, in the form of bank loans or – and this is where SF comes in again – bond flotations. And this makes SF an ideal alternative to bank loans for the Mittelstand, say Deutsche and Dresdner.

New initiative

SF products are not a new concept in Germany, having been first introduced there in the late 1980s. And Deutsche and Dresdner are not alone in offering them. Their rivals Commerzbank and HypoVereinsbank (HVB) have them, as do publicly owned Landesbanken and KfW itself.

What is new is that Deutsche and Dresdner have recently created teams of specialists dedicated to actively promoting SF among the banks’ existing Mittelstand clients. At Deutsche, a team of no less than 64 specialists is overseen by Werner Steinmüller, chief operating officer at Deutsche’s global banking division. At Dresdner, Mr Bonanni is in charge of around 50 specialists. Both teams act as an interface between the banks’ investment banking and corporate banking arms.

So far, Deutsche has had more success in promoting SF products. According to Mr Steinmüller: “Deutsche has a portfolio of €30bn in credit facilities with the German Mittelstand. This includes everything from overdrafts to structured finance. We have 12,000 clients covered by the global banking division and another 100,000 clients covered by the private and business clients division. We have done about €6bn in structured finance business in 2004 so far, including syndicated loans.

Such volumes may not sound like very much, but then the credit crunch facing German SMEs has only emerged in the last year. Their access to bank loans will, moreover, become even more difficult once the new Basel II lending requirements take effect in Germany.

Mr Steinmüller and Mr Bonanni are right when they say that SF is a growth market. Indeed, SF’s prospects in Germany have prompted numerous international banks to go after business there. German banks find themselves competing for SF with the likes of Royal Bank of Scotland (RBS), Citigroup, Fortis, Barclays Capital and ING, which already has an extensive Mittelstand client base via its ownership of BHF-Bank. Mr Bonanni tips his hat to the foreign competition, saying that it is particularly formidable in private equity.

Broad base

Still, the importance of SF for Germany’s Mittelstand can not be overemphasised, as a broad base of companies fall into this category. The sector ranges from large, mature companies traded on German stock exchanges to the so-called “Ma and Pa” stores found in small towns.

Deutsche and Dresdner are making inroads with SF products, but they are typically only selling SF to the larger and more established members of the Mittelstand who have a need for large sums of money. Deutsche requires a volume of at least €50m to do an asset securitisation deal or a private placement of a corporate bond. Syndicated loan arrangements also begin at a volume of €200m.

Unlike their smaller brethren, large and well-established SME clients can better comprehend sophisticated finance and will pay a higher price for it. As Deutsche and Dresdner themselves admit, their SF strategy involves targeting their products at their existing SME client base and not going after other (smaller) SMEs.

Regarding those other SMEs, which make up the lion’s share of the Mittelstand, experts say bank loans will continue to be their chief means of finance in the foreseeable future. Hence, these SMEs will have to become far more transparent as credit conditions continue to stiffen. Mr Plankensteiner at KfW says: “The days of cheap and easy credit in Germany are over, and that means SMEs will have to open their books more to banks so that they can obtain a credit rating.”

However, Mr Plankensteiner does not expect a huge number of German SMEs to abandon what he calls a “master of their house” mentality. Typically, these SMEs are family-owned and their proud owners are utterly convinced that such an attitude is best for their business. To support this view, they can point to a long tradition of success for family-owned SMEs in Germany. The internationally known food retailer Aldi, which is owned by two brothers, is a prime example

Mezzanine financing

The “master of their house” mentality has, however, been a huge barrier to private equity investment, a main pillar of SF, and Mr Plankensteiner thinks that, of all the SF products currently on offer, mezzanine financing holds the most promise for the broad base of the Mittelstand.

In basic terms, mezzanine financing enables a client, in this case an SME, to borrow money from investors. The money borrowed represents a “dormant” equity stake, which the investors acquire in the SME. The equity stake is dormant because, while the investors own a piece of the SME, they are given no say in the operation of its business. To German SMEs, such a situation might be very compelling.

According to Mr Plankensteiner, another big attraction for German SMEs is that, if they require capital for research and development, to launch foreign operations or even to take over a competitor, obtaining mezzanine financing is far easier to do than getting a bank loan.

Mezzanine financing has now caught on with Germany’s Mittelstand. At the beginning of this year, KfW unveiled its own version of the SF product, which enables small SMEs to borrow up to €2m. It says it has lent an impressive €200m since then.

The popularity of mezzanine financing was confirmed by Mr Steinmüller at Deutsche. “Among our Mittelstand clients, we are seeing big demand for equity-type mezzanine financing to strengthen the equity ratio of the Mittelstand. I also expect strong demand for loan-type financing in the future,” he says. “As I understand it, the reason is that many of these clients insist on maintaining complete control of their companies. Maintaining complete control is fine, however companies are now more prepared to open their books.”

Beyond mezzanine financing, Mr Steinmüller says there is strong demand among SME clients for two other SF products: high-yield bonds and the issuance of corporate bonds via private placement. The former product has generated a volume of €600m, while the volume for the latter is close to €1bn.

As one might expect, though, SME demand for private equity solutions from Deutsche is weak, raising doubts about recent comments from the investment bank Rothschild that the German private equity industry has become increasingly robust. According to Rothschild, private equity accounted for 40% of German M&A deals last year, compared with just 12% in 2000.

Culture of change

In any event, Mr Steinmüller believes German SMEs have to end their guarded culture if they want to maintain a high level of financial access: “In the past, it was relatively easy for German companies to obtain a loan from us or any other bank. Personal ties with the Mittelstand mattered more than the low margins or risks associated with lending to it,” he says.

“German banks have, however, learned their lesson and they are now pricing risk appropriately. Credit ratings are standard. Therefore, the Mittelstand has to become more transparent, whether it is to obtain a loan or even more equity capital.”

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