Mittelstand-bonds

An alternative for bank financing in the Netherlands

Mittelstand-bonds

The Dutch and German economies are similar in many ways. Could the German Mittelstand bond (M-bond) be an alternative for financing Dutch corporates?

M-bonds are bonds with principals between EUR 10 million and approximately EUR 50 million (with exceptions that go up to EUR 100 million). They are mostly issued by companies that are not listed and are traded via an electronic platform. Looking at the similarities with the German economy, it is interesting to see if products like M-bonds could fi ll the gap that has been created for many corporates in the Netherlands, by the disappearance – or limited availability – of bank financing.

The first M-bond was introduced in 2010 at the Stuttgart exchange – one of Germany’s local exchanges. The banks at that time had a strong internal focus and were busy improving their balance sheets. On the one hand because they had incurred losses as a consequence of the financial crisis, on the other hand because of new regulations such as Basel III.
At the moment M-bonds can be traded at five local exchanges in Germany (Stuttgart, Düsseldorf, Frankfurt, München and Hamburg-Hannover). At the end of 2011 the volume of M-bonds was EUR1.8 billion and 36 different bonds were listed on local German exchanges.

Individual and institutional

M-bonds were originally intended for the individual investor, the so-called retail investors. These investors are attracted by the relatively high coupon of, on average, 7%-9%. Furthermore, the returns on the stock exchanges are low and uncertain, regarding the economic situation causing high volatility at the exchanges. Also, investors regard bonds as a safer investment than shares; in a bankruptcy, bondholders take precedence over shareholders. Furthermore, the choice of high-yield bonds is now much more diverse than in previous years, so investors can better diversify their risks. The nominations of the M-bonds are on average EUR1,000, which is low in comparison with standard corporate bonds. They are therefore more easily accessible for individual investors.

Last year there was a shift and the role of the institutional investor was extended – in part because brokers wanted to increase their chances of a successful issue. One of the larger brokers (Close Brothers Seydler) has even decided that M-bonds should only be issued if a minimum of 50% is taken by institutional investors. These investors are often small savings banks, insurance companies and pension funds. They add the M-bonds to their portfolios of funds, in which private investors can then participate.

Sector-wide

Most companies that issue M-bonds are not listed, they typically have revenues between EUR25 million and EUR 400 million, with the occasional exception of revenues above EUR 1 billion.
They are often financed with high levels of debt capital, even before the M-bond issue. Interest cover ratios – which indicate to what extent a company is capable of meeting its interest obligations – are in general low, less than 3x EBIT. This is a clear sign that the companies have had difficulties in obtaining bank financing and are looking for other means of financing.

Companies that have issued M-bonds are active in different sectors, but with larger concentrations in the energy sector (primarily sustainable energy), real estate and the automotive industry. These are sectors in which banks had little interest; energy companies are often innovative starters and the other two have been hit hard by the economic recession. This creates a risk in the long run in that the moment one or more companies that have issued M-bonds defaults, this can undermine the success of the product. Most M-bonds have a credit rating from one of the three credit rating agencies approved by BaFin, the German regulator. The cost of this kind of rating is considerably lower than for example a rating by Standard & Poors, Moody’s or Fitch. The credit rating of almost 80% of German M-bonds is BB (acceptable) or BBB rating (sufficient).

M-bonds can be an attractive alternative form of financing for family business

Family businesses

The key question is if M-bonds could also be a financing alternative for the Netherlands? The answer is yes. Firstly because there is a great need for alternative financing. The long term of the bond of five years is also an attractive feature for companies. An additional advantage of M-bonds is the fact that the notionals are low – from EUR10 million – and therefore within reach of many medium-sized companies. They constitute an important segment of the Dutch economy that encompasses many family businesses. According to a recent research of Nyenrode Business University and auditor Baker, Tilly and Berk, 53% of the Dutch gross domestic product is generated by family businesses. These companies often have revenues between EUR10 million and EUR450 million. The same research shows that most family businesses are coming out of the crisis in a better condition than listed companies, mostly because of their long-term vision and strategy, the close involvement of their shareholders and their strong solvency.

Sharing company information

Often family businesses are reluctant to obtain external financing because they want to avoid becoming too dependent on a bank. They do need capital, however, to grow. Increasing the company’s equity capital is not always feasible or desirable and attracting debt capital has distinct advantages. Debt capital is much cheaper and the risks for the provider of the capital are lower. In addition interest payments on debt capital often create tax advantages while dividend does not.

In the Netherlands, M-bonds can be an attractive alternative form of financing for family businesses, but also for medium sized companies in general. Companies should, however, realize that a bond issue is something entirely different to bank financing. Instead of sharing company information with one or more banks, they will have to communicate with the market. To generate interest from investors for the bonds but also to comply with requirements regarding the publication of the (semi) annual report and other information that is relevant for the market.

Smaller intstitutional investors are important as front runners

Front-runners

Success in the Dutch market depends on the degree of confidence in the product. This needs to be built fi rst by working with low risk companies. Due to their normally strong balance sheets, family-owned businesses are well positioned for this purpose.

Prerequisites for listing

Each of the local exchanges in Germany has its own set of requirements but, in general, companies that want to list M-bonds will have to comply with the following requirements:

  • Prospectus approved by BaFin (the German regulator)
  • Annual financial statement, approved by the auditor
  • Semi-annual financial reporting
  • Corporate financial calendar published
  • Company profile
  • Relevant intermediate announcements
  • Credit rating by a local BaFin certified credit rating agency. (The exception here is the Hamburg-Hannover exchange, which does not require a rating).

In order to attract investors it is also important that the return is attractive and higher than that of government bonds, corporate bonds, deposits or savings accounts. From the perspective of the capital markets, the size of these issuing companies is small, raising their risk profile. This has to be reflected in the expected return.

Liquidity is another concern to investors. Local exchanges in Germany have an important role in this respect. They provide an online trading platform for the efficient processing of transactions, a service that is also for the individual investor. In the Dutch market such an exchange platform will first have to be developed. Alternatively the trading platform BondMatch, launched by NYSE Euronext in 2011, could be expanded.

Lastly, it will be important for all investors, and in particular for retail investors, that M-bonds obtain a credit rating. This allows for an easy assessment of the credit risk. Given the smaller size and higher risk profi les large institutional investors will be more reluctant to invest in M-bonds. M-bonds might be attractive for smaller institutional investors as they promise higher returns and provide an opportunity to diversify risk in the portfolios of these investors. Smaller institutional investors are therefore important as front runners to kick-start M-bonds in the Netherlands and to generate liquidity in the market.