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Western EuropeJune 3 2013

Making the money flow: Can Europe's SME financing woes be solved?

SMEs are often cited as the backbone of any given developed economy. However, in Europe in particular, a lack of financing from banks is stunting the growth of these businesses. Alternative lending models are rising in prominence, and some banks are looking to up their game in this sector, but is this too little, too late?
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Making the money flow: Can Europe's SME financing woes be solved?

Marc S Tenbieg seems luckier than most of his peers. The executive director of Deutscher Mittelstandsbund, the association of German small and medium-sized enterprises (SMEs), represents a thriving sector that elsewhere in Europe is stifled by reduced bank lending, bleak investment opportunities and weak demand.

In Germany, he says, there are few complaints about access to finance from SMEs. In the same breath, however, he admits that what some SMEs suffer from, especially those exporting to southern Europe, are late payments.

“European issues are fast becoming German issues,” says Mr Tenbieg. This view highlights two concerns. One, the breakdown of the supply chain of SME financing and payments may have a domino effect on Germany, eventually dragging down its SME sector. Two, how will the German model, mostly supported by the decentralised savings and co-operative banks and a global case study for success, function in the future?

Wider concerns

Such liquidity concerns are not limited to Europe. Among Organisation for Economic Co-operation and Development (OECD) countries, only a handful grew their SME lending in the year to the end of 2011. The share of SME loans in overall business loans reduced or stagnated in most OECD countries – even if total business loans increased.

This suggests that larger corporates have better access to finance than SMEs, and this is a matter of concern to economists, politicians and banks who laud SMEs as the engine of any given country's economy, crucial to boosting employment and creating innovation.

SMEs face huge challenges on many fronts. Excessive bureaucracy can smother the growth of SMEs, just as the lack of access to finance from banks or alternative sources can. Banks say they want to lend to SMEs, but restructuring their balance sheets to comply with Basel III requirements necessitates stricter lending standards. As it is difficult to assess an SME’s creditworthiness, and as they are perceived as more risky than larger firms, banks in general curb lending to this sector.

In a region such as Europe, where between 75% and 80% of SME financing is dependent on banks, such restraints can have serious consequences. In contrast, banks in the US account for just 25% of SME finance. The dynamism of the US economy is often put down to a vigorous SME sector sustained by various capital sources such as bonds, private equity and venture capital.

In Europe, there are big differences between countries. Germany’s famous 'mittelstand' (SMEs) are served by decentralised savings and co-operative banks – and now commercial lenders have discovered the sector’s appeal, too. In the UK, by contrast, banks are often chastised for failing to supply SMEs with sufficient lending. But slowly, concerns over SME financing are being addressed. Financiers are generating alternative sources of funding while banks are proclaiming a new appetite for lending.

However, time is of the essence, and Stefano Manzocchi, professor of international economics at LUISS Guido Carli University in Italy, warns that many SMEs will have gone bankrupt by the time these industry efforts are established. “We need to distinguish between a short-term solution and a long-term one," he says. "A short-term solution is needed to help the SMEs right now and this solution has to be connected to the banking system. Then you need a long-term solution based on innovative funding vehicles and institutions.” 

A varied picture

When looking at SME financing on a global scale, or even just in Europe, the differences from country to country are striking. The OECD, in its report Financing SMEs and Entrepreneurs 2013, found, for instance, that only Chile, France, Russia, Serbia, Slovenia, South Korea and Turkey reported a continuous growth in SME lending in the year to the end of 2011. However, between 2007 and 2011, the share of SME loans in overall business loans decreased or stagnated in most countries – even in South Korea, Russia and Turkey.

According to the European Central Bank's (ECB's) latest survey covering October 2012 to March 2013, in Europe access to finance was a concern for 38% of SMEs in Greece, 25% in Spain, 24% in Ireland and 21% in Italy. This is in sharp contrast to SMEs in Germany and Austria, where only 8% of SMEs cited a lack of access to finance as their main concern.

Banks in Europe are under pressure when it comes to funding and the continent's economic outlook is bleak, hence they have tightened lending standards for both short-term and long-term loans to SMEs. But it is unclear whether the low level of bank lending is only due to banks’ unwillingness to lend, or whether it is also a result of the private sector’s unwillingness to borrow. Some SMEs have stopped applying for loans out of fear of rejection, others have delayed investments, while others still have raised their own capital. This has been particularly prominent in Germany, where many SMEs did not require so much lending because they increased their own capital, says Mr Tenbieg.

Diverse funding

To cut dependence on bank financing, politicians are emphasising the need for more alternative sources of funding. “One solution would be to bundle up SME loans and sell their risk on the capital markets. You could do that with asset-backed securities [ABS] or covered bonds,” says Gerhard Huemer, director of economic policy at the European Association of Craft, Small and Medium-sized Enterprises.

Although ABSs attracted controversy for their role in the financial crisis, the ECB has started discussing them as a possible solution to revive the SME finance market. Such bundled portfolios could be very attractive for investors as it gives them diversification, according to the European Investment Fund (EIF).

There is also a benefit for banks, the EIF argues, because those that securitise their loan books can offload their risk while accessing the different SME risks of other banks. This way, banks too would be able to diversify their assets.

The standard way for companies to raise capital is by listing on a stock exchange. But for family-owned companies this is often an unattractive proposition as they lose control of their businesses. Raising capital by issuing bonds may be more attractive, but many SMEs cannot afford the cost of bond issuance, lack the resources and expertise required, and find that the minimum issuance amounts demanded by investors are too high for them. Also, there is a lack of credible financial information about many SMEs, which raises the costs of evaluating their creditworthiness.

To explore ways to help SMEs better access the capital markets, the Association for Financial Markets in Europe (AFME) set up the Agency for Business Lending last year. “Anything that works should be considered – it might be securitisation, covered bonds, sponsored funds, retail and investment, synthetic credit risk transfer or existing schemes,” said Richard Hopkins, managing director in the securities division of AFME at an April roundtable on the role of securitisation and capital markets for SMEs in Europe.

There could also be opportunities for institutional investors, especially pension funds and insurance companies, to invest in SME bonds. As the ECB puts it in its October 2012 to March 2013 survey, insurers and pension funds can “match the part of the lending market from which banks are retreating”.

Trends in loans to small and medium-sized enterprises

Germany leads the way

It is early days in the search for alternatives to replace bank funding, although some headway is being made, especially in Germany. There, SME high-yield bonds have become important. Four of the country's eight exchanges have been trading so-called 'mittelstand bonds', with issuances ranging from €25m to €225m, for the past few years. Institutional investors hold 60% to 75% of these bonds, which return attractive yields of 7% to 9%.

In some cases, banks are not involved at all in SME funding, as is the case in Stuttgart where the BondM platform enables mid-cap companies and SMEs to issue bonds and sell directly to retail investors without any underwriting from an investment bank, with costs kept to a minimum. However, the total volume of corporate bonds for medium-sized companies is small throughout Europe.

Giovanni Sabatini, general manager of Italy's banking association, hopes SMEs will be able to access markets directly in future. “The bank-firm relationship could improve and banks would be engaged in more value-added services that don’t absorb Basel III capital,” he says.

This is the kind of marketplace that Germany’s Commerzbank wants to enter. Markus Beumer, a member of Commerzbank's board of directors who is responsible for mittelstand, confirms the bank is competing with the country's sparkassen (savings banks) for the business of SMEs. “We want to give SMEs access to the capital markets,” he says.

Mr Beumer states that Commerzbank will use credit as its anchor product and cross-sell services and products as the client grows. This requires a long-term commitment from the bank, he admits. “A return on investment is only seen after a few years. This sustainability enables us to build strong partnerships with SMEs, however,” he adds. 

“The majority of smaller SMEs are clients of the savings banks. Now we want to be the bank for this segment as well," says Mr Beumer. "Our anchor product is credit – but as our relationships develop with SMEs and they continue to grow, we can cross-sell other products, such as supply chain finance/trade finance, hedging and foreign exchange. We can also offer a variety of deposit and investment opportunities. This development will take a few years, but we are keen to see it through. Family-run businesses do not usually publish their financial results. In their view this is frequently time-consuming and expensive. So listing on the stock exchange is not an option that is considered by many SMEs."

Exchange action

Stock exchanges, on the other hand, are keen to see high-growth companies list. Roadshows are common to entice companies to go public, with the Central Eastern European Stock Exchange Group and the Istanbul Stock Exchange being particularly active in this area.

In the US, NYSE Euronext created a platform called NYSE Corporate Connections, a matching platform that enables start-ups and corporates to interact with each other to promote investment and mergers, in a similar manner to an online dating website.  

In the UK, the London Stock Exchange (LSE) has introduced a new platform for the equity shares of UK and European trading businesses for smaller technology companies that have aspirations to move into the main market but are still in the early stages of development. As such, the LSE considers its High Growth Segment (HGS) platform to be a stepping stone to help SMEs on the way to becoming listed companies. Part of the rationale of the HGS is that the usual 25% minimum requirement of a free float in the UK acts as a barrier for some smaller companies. Instead, the HGS requires a minimum standard of a 10% free float valued at at least £30m ($45.5m) and for the company to have a compound annual growth rate of 20% over three years.

The HGS does have its limitations, however. It is only targeted at technology companies and some critics consider the upside as too limited, arguing that a 10% float may not bring the capital and other benefits needed to grow. As the HGS features less disclosure and governance requirements – an LSE spokesperson says companies have to disclose not all but “significant” transactions, for instance – it may not appeal to as broad a range of investors as originally hoped for.

A quick fix

But such alternatives – while important – are still accessible for only a limited number of SMEs; those that can offer high returns and grow fast. For the bulk of SMEs in Europe, borrowing from banks will remain their main source of funds for the foreseeable future. One key area where banks may be able to assist is in late payments, a problem for many SMEs and one that hinders their cash flow.  

For Royal Bank of Scotland (RBS), the solution could be in combining discount financing and e-invoicing. Manoj Menon, global head of trade services at RBS, says the main concern for SMEs is whether they can receive guaranteed and early payments. Discount financing, coupled with e-invoicing, which is paperless and therefore faster and cheaper, is set to grow in Germany and the UK, he says. This involves the bank paying companies at a discount against their invoices and taking on the payment risk.

Some help for SMEs should also come from the EU's Late Payment Directive, which came into force in March. The directive stipulates public bodies must pay their suppliers within 30 days and comes with stringent measures regarding late payments. SMEs are entitled to claim interest on late payments and can be reimbursed for reasonable recovery, which will help unlock working capital, according to Mr Menon. “This is good for the mitigation of risk in the financial supply chain of SMEs,” he says.

But not everyone agrees that the regulation will be a panacea. Mr Huemer says: “We always advocated this. But I’m not too optimistic that SMEs will apply the late payment fees to buyers, because they may worry that they won’t get new orders in again. The directive will have some advantages, but [won’t] eliminate late payments.” 

Emulating success

Some banks are trying to emulate the success of Germany’s sparkassen. Stephen Pegge, the director of SME and corporate communications at the UK's Lloyds Banking Group, says business relationship managers in 500 locations can decide on loans of up to £500,000 at his bank. This covers 90% of lending applications at Lloyds, he says.

“This works well for us because managers get to understand and know their customers. It is a similar model to the sparkassen in Germany in terms of relationship management. Our managers specialise in certain sectors, such as agriculture, franchising, property, healthcare, legal and, more recently, manufacturing,” Mr Pegge explains. And it seems to be working. “On a net basis, lending to this segment grew 4% year on year to the end of March,” he adds.

Banks may publicise their engagement in SME finance in different ways, but the reality is that this is still a tough environment in which to operate. The combination of a poor economic outlook and new regulations is making life difficult in the short term, while a changing market structure, with increasing globalisation, is presenting longer-term challenges. Getting money flowing in the direction of SMEs will require a resurgence in bank lending as well as alternative forms of finance. Happily, work is being done on both, but for some it may not be done fast enough. 

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