June 6, 2013 6:48 pm
Finance: Forced into the shadows
With Europe’s banks reluctant to lend, private equity groups are stepping in with loans to struggling companies
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After five years battling its most severe downturn since the Spanish civil war, Uralita felt that it was running out of options.
The building materials supplier faced debt repayments this year and next. And with no recovery in sight, Uralita’s banks were not in a lending mood.
In 2007, the family-owned company boasted healthy profits and more than €1bn in sales. But it lost money in 2012, with revenues down 40 per cent, due to the collapse in the Spanish construction market.
Its banks, including Santander, the country’s largest, and Bankia, which was bailed out last year, indicated that they would push back the payments for another year – but only if Uralita sold assets, recalls Javier González, Uralita’s general counsel.
Uralita’s tale highlights the struggles of cash-starved companies in Spain and across Europe to find credit, as banks, under pressure from regulators to meet more stringent capital requirements, cut assets and curb lending.
“The Spanish banks are just not ready to take on any more risk,” Mr González says. “They were pushing us to look elsewhere.”
Left with the unpalatable prospect of selling profitable operations to satisfy its lenders, Uralita looked for alternative sources of funds. To its surprise, it found plenty. Four private equity groups, including New York-based KKR and Blackstone, competed to offer a loan. In April the company borrowed €320m over seven years from KKR to repay all existing creditors. The loan will also help fund new investments at its pan-European thermal insulation business.
Uralita’s loan from private equity is a sign of how “shadow banking” – long a feature of US finance – is beginning to take hold in Europe. Across Europe, ailing companies are scrambling for credit, only to discover that their bankers are not picking up the phone – except to demand repayment. So funds such as KKR and Blackstone are seeking to fill the void.
For Uralita and other crisis-hit European companies, the shadow banks – financial groups that do not have to meet the capital requirements that traditional banks do – are offering a valued service at a tough time. But the rise of the new private equity-funded lending raises questions about whether struggling borrowers will be able to bear the cost.
“We are going through a seismic shift in Europe,” says Mubashir Mukadam, the head of KKR’s special situations business in Europe.
“European banks have been amending and extending loans provided before the crisis. But now the liquidity needs of the companies and changing regulation are forcing companies and banks to look for other solutions.”
Last year the US-based Giant subsidiary of Spanish cement producer Cementos Portland Valderrivas found itself in a similar bind to Uralita. It was unable to repay its loans as demand for cement in Spain fell 70 per cent.
With banks reluctant to extend a helping hand, Giant turned to GSO, the $58bn credit management arm of Blackstone. GSO ended up lending the cash-strapped company €325m, charging a high rate of interest and taking a 20 per cent cut of its cash flows. It also took collateral in the form of its three US cement plants in the process.
Still, despite such onerous requirements, GSO has enjoyed huge demand for its money – so much that it finances just 5 per cent of the requests it receives for credit. Traditional banks cannot structure a loan in the flexible, lucrative way GSO does. It is protected from downside risk, but enjoys upside potential in the form of equity warrants or a cut of cash flows.
“A combination of regulation and the markets have raised the cost of capital for European banks,” says Mike Whitman, who is responsible for the lending business in Europe at GSO’s London office. “As banks shrink their balance sheets, the knock-on effect is companies must diversify their sources of funding away from their historical relationship with lending banks.”
To make the banks safer, regulators in the US and Europe require them to hold more capital. This has made them more risk-averse and reluctant to lend to smaller companies, and they charge more for the money when they do.
In the US, where capital markets and non-bank institutions have long played a central role in financing, banks typically account for about 20 per cent of lending. This explains why companies have been able to offset the reduction in bank lending.
But the funding gap left by retrenching European lenders, which have historically accounted for 80 per cent of lending in Europe, is potentially huge.
Alberto Gallo, an analyst at Royal Bank of Scotland, estimates that European banks have cut €2tn from their balance sheets over the past year, including €850bn of loans, of which €200bn was in corporate loans. He expects lenders to slash another €3tn off their balance sheets and says the lending shortage will continue to affect the periphery more than the rest of Europe.
Société Générale analyst Alain Bokobza estimates that in the French market, small and medium-sized companies need an average $100bn in loans every year. The lending deficit is also affecting European real estate and infrastructure projects, which rely on about $400bn of loans each year, he says.
Adding to the difficulties, about $100bn of European collateralised loan funds – a big source of credit for leveraged buyouts – will expire by 2015, and only a fraction will be replaced, according to Standard & Poor’s.
Moreover, European banks are saddled with bad loans from the credit binge. Those bad debts make European banks doubly risk-averse while reducing their lending capacity.
“Addressing the [non-performing loan] problem is likely necessary to unlock bank lending to small and medium enterprises,” notes Nikolaos Panigirtzoglou from JPMorgan in London. In the eurozone’s periphery, these bad debts have surpassed €500bn, he estimates, adding that Germany is the only country where such loans are not rising.
The unintended consequence of all this is that it has become possible for groups such as GSO and KKR to offer capital to the capital-starved. For borrowers, this money is far more expensive than they have paid in the past.
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In the good times that ended with the global financial crisis, banks in Europe funded themselves from cheap deposits and from the wholesale market – generally US money market funds. They could borrow for a rate that was just below the Libor benchmark and then charge their corporate clients at a generous margin above that – sometimes as much as 3 percentage points.
The banks did not seem concerned by the fact that they were borrowing for anywhere between one and three years and then lending money to their customers for five years. This lasted until the global financial crisis hit and the wholesale market disappeared.
The debt binge on both sides of the Atlantic peaked in 2007. Since most corporate loans are for five years, the number of borrowers seeking to repay and refinance has been rising in recent months. In Europe, some of the smaller borrowers, such as Uralita, are getting closer to the so-called maturity wall, a mountain of debt inherited from the credit bubble that has to be repaid in the next few years.
Credit funds such as GSO are happy to help – at a price. For a long time, GSO was the only player of scale in this segment of the business. Its portfolio of non-investment grade loans is larger than that of JPMorgan.
The group provided the first leveraged buyout “rescue loan” in Europe in 2010 when it gave $550m to Almatis, an aluminium maker that is part of Dubai Investment Corp’s portfolio. That enabled DIC to fend off Oaktree Capital Management, which had bought a big part of the debt and hoped to buy the company at a significant discount.
“We were faced with two choices: lose control to a vulture fund or partner with GSO, which developed a solution that enabled DIC to retain control while providing capital for the company to prosper,” says David Smoot, chief executive of DIC.
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Other private equity groups are rushing in, flush with money from pension funds hungry for yield amid record low interest rates.
KKR, which manages about $18bn in credit funds, plans to use its $7bn balance sheet to fund deals. It can also use its capital market operations to syndicate a portion of its deals. “We speak for more than we hold in some cases,” says Scott Nuttall, the KKR partner who oversees many of the credit activities there.
Other groups, including Los Angeles-based Ares Management, London-based Intermediate Capital Group and Stockholm-based EQT Partners, are seeking more than $32bn in total for European-dedicated credit funds, according to data compiled by Private Debt Investors.
New teams are being set up, and more and more buyout fund managers, including London-based CVC Capital Partners and 3i, are diversifying into this emerging asset class.
“It feels like the private equity industry in the late 80s and early 90s. There are a lot of teams raising new funds,” says Jeremy Ghose, head of debt management at 3i. “It is there to stay, there’s no turning back.”
Still, private equity groups are not renowned for their munificence. And the fear is that many desperate companies will not be able to pay off this expensive debt.
In the case of Uralita, KKR’s interest rates are higher than what a bank would have offered, says Mr González. But the interest payments are structured so the company can save cash in the short term. This technique, known as “payments in kind”, was widely used during the credit boom and is risky because it increases the company’s debt load.
Moreover, unlike most of the banks, private equity groups will not be scared to take the keys if the companies default, rather than “extending and pretending”.
“If the coupon is too high, they could see the debt drown both their capital structure and their business,” says one lender. “Some of the deals being done today are just bridges to future restructurings. There is a high probability that many of these deals will end badly.”
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Europe: Lending plays second fiddle to safety
Europe’s banks rather than capital markets are the overriding source of credit for companies, a fact that is weighing ever more heavily on policy makers as the EU works through its post-2008 regulatory overhaul, writes Alex Barker.
Michel Barnier, the EU commissioner overseeing financial services, has made unblocking credit flows to the real economy one of his policy mantras over the past year.
The trouble for Europe’s banks is that well-meaning efforts to encourage lending seem secondary to the welter of measures designed to make the financial system safer – ranging from higher capital requirements for banks and insurers to tighter rules for market operators.
Added to this are the strains of the eurozone crisis, multiple national initiatives, looming reforms to bank structures, stress tests and policy initiatives such as the financial transaction tax, which the financial industry fears will gum up markets and choke off access to capital.
“They are asking us to do contradictory and at times impossible things,” says the head of regulation at a big eurozone bank.
This has left the door open for private equity groups, many of them from the US, to step in and fill the lending gap.
So far, the European Commission and European parliament’s main policy moves aimed at supporting lending – or at least industry concerns – have appeared at the margins of bigger prudential reforms.
Bank capital rules were eased, for instance, to reflect the “diversity” of European banking models and improve incentives to lend to small businesses.
New proposals in the pipeline – notably covering money market funds and shadow banking – are also being tempered to heed warnings that too much regulation will undermine credit flows and liquidity.
Mr Barnier recently shelved plans to propose tougher solvency rules for pension funds, citing the “fragile economic situation”.
More proactive initiatives are also being considered to diversify financing for the corporate sector and improve incentives for institutional investors to join banks in long-term investment projects.
Brussels is also exploring ways to reset the tax system to promote long-term investment.
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Copyright The Financial Times Limited 2013
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