KfW-Research. Economic Observer. No. 6, June 2004.

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1 KfW-Research. Economic Observer. No. 6, June 2004.

2 GERMAN MEZZANINE CAPITAL MARKET SET BETEILIGUNGSKAPITAL IN DEUTSCHLAND. FOR GIANT LEAP. Given the growing financing difficulties which many enterprises are facing, the word of mezzanine capital as an alternative financing instrument is resounding across Germany. People's expectations are high. Can mezzanine capital solve companies' financing problems? WHAT IS MEZZANINE CAPITAL? Mezzanine capital is a generic term for hybrid financing instruments situated between pure equity and pure borrowed capital. Mezzanine capital is generally subordinated to "normal" borrowed funds, that is, in the case of insolvency all first-ranking claims are satisfied first, then the mezzanine creditors and finally the owners. Mezzanine financing instruments can be structured in a similar fashion as equity ("equity mezzanine"), for instance in the form of a silent participation that participates in profits and losses, as well as in a manner resembling borrowed funds ("debt mezzanine"), for instance in the form of a subordinate loan with a fixed interest rate. So far mezzanine capital plays a substantial role as a financing instrument primarily in established venture capital markets such as those in the USA and Great Britain. In these countries it is used primarily to enable more mature enterprises to extend their financing scope with the aid of subordinate loans. Very often these are leveraged buy-out transactions, which is a complementary financing instrument in large-scale takeover transactions where the individual volume is often well above EUR 100 million. 2

3 MEZZANINE CAPITAL IS BECOMING INTERESTING FOR MANY GERMAN SMES. No reliable database on the role of mezzanine capital in Germany and other countries is yet available: Estimates of the transaction volume in Europe in 2002, for instance, range between EUR 3.3 billion and EUR 5.1 billion. What is certain, however, is that the market for mezzanine financing posted significant growth in the middle of the 1990s, both in Europe and in the USA. In Europe the volume of mezzanine capital transactions has risen roughly tenfold since The European market is still being dominated primarily by Great Britain and Ireland. The British and Irish headstart, however, is diminishing significantly. Continental Europe has been able to expand its share in the transaction volume from approximately 20% at the beginning of the 1990s to nearly 50% today, although German enterprises account for less than 15% - surprisingly little given Germany's economic strength. This also somewhat reflects the fact that for a long time it was relatively easy to obtain a bank loan in Germany - not least because of the dominant "house bank" principle in this country. But these times are over for good. Credit institutions are no longer willing to substitute the lack of equity by long-term loans at favourable rates. This is a very fundamental reason for the financing difficulties currently facing German SMEs. The traditional way of increasing the equity ratio by retaining earnings is a long-term process, so that the first alternative to be looked at is to attract private equity. But since many small and medium-sized entrepreneurs fear losing the dominant influence on business management if they assimilate external equity, equity capital is only a second choice for them. 3

4 This is where mezzanine capital suggests itself, as it usually does not grant the capital investor a right to co-determination while economically it acts in a similar way as equity and so combines the advantages of both forms of financing. In the long run the enterprise can then achieve a better equity position through the retention of earnings. Besides its positive effects on the financing structure of a company, mezzanine capital is particularly suitable for investments that are difficult to finance through a bank for lack of collateral, such as investments in research and development, investments abroad or a company takeover. This is why all of a sudden mezzanine capital is becoming very interesting for many German SMEs. MEZZANINE CAPITAL HAS BEEN AVAILABLE ACROSS GERMANY ONLY FOR A SHORT TIME. KfW Bankengruppe has recognised the importance of mezzanine capital for the financing of small and medium-sized enterprises very early. Initially it was employed primarily for specific promotional programmes in the area of innovations, participations and start-up financing. Since March 1st of this year it is being offered for the first time across Germany within the promotional programme "Unternehmerkapital" (Entrepreneur Capital) for the entire life cycle of small and medium-sized enterprises. Unternehmerkapital consists of three windows in which KfW provides start-ups, young enterprises as well as established SMEs and self-employed professionals subordinate financing at favourable terms ('debt mezzanine') in a highly standardised form. In the growth variant and in the variant for established enterprises, different interest rates 4

5 apply depending on the risk situation of the enterprise to be financed: This ensures that each borrower pays a risk premium that reflects his statistical default risk. In consequence, entrepreneurs with a good credit standing will benefit from low interest rates while weaker companies are still offered access to capital but at risk-adjusted interest rates. Subordinate loans improve the financing structure of small and medium-sized enterprises and stabilise or improve the enterprises' rating, thus improving the prerequisites and potential for further borrowing. The late start of repayment of the subordinate loan gives the enterprises the necessary scope for improving their equity situation in the meantime through the retention of earnings. Besides, it does not require any change in the shareholder structure, as would happen in the case of an equity investment. However, Unternehmerkapital is also an attractive instrument for financing enterprise growth. Small and medium-sized enterprises that used to have no access to mezzanine financing because of their size can now use this instrument for the first time. Particularly in the current economic situation in which many banks, partly under the impression of the changing financial markets, are still reluctant to make new commitments for risk considerations, the offer of an unsecured promotional loan may give an important economic incentive, because without capital there will be no investment and without investment there will be no upswing. In order to advance the development of the mezzanine capital offer across Europe for SMEs, support by the EU could be an important factor. Proposals submitted by KfW are currently being discussed also in the framework of the Community Support Programme for Entrepreneurship 5

6 and Enterprise Competitiveness (SPEC) of the European Commission, which underscores the importance of mezzanine capital as a market for the future throughout Europe. Author: Dr. Dirk Plankensteiner 6

7 CORPORATE FINANCE. TOO EARLY TO LOWER THE GUARD BUT PROGRESS IN ADJUSTING TO NEW RULES OF THE FINANCIAL MARKET. This year once again KfW, together with 24 professional and regional associations of industry, has conducted an extensive survey of enterprises of all size categories, branches of industry, legal forms and regions as to their bank connection, the borrowing conditions they obtain and their preferred financing practice. As in the previous year, the objective was to find out more about these problem complexes, but principally to find out to what extent the structural changes in the financial markets have transformed corporate finance. Additionally, this time again questions were asked about a special topic, namely about ratings. As a result of major changes on the financial markets, growing risk orientation by credit institutions and increasingly difficult access to debt capital, the issue of ratings has become tremendously important. The main results of the survey are: FINANCING CONDITIONS REMAIN DIFFICULT. The major changes on the financial markets are making rapid progress. In the past twelve months borrowing has become much more difficult for over 43 % of companies. Just under one-half of the companies that responded to the survey undertook large-scale investments during the stated period, mainly to increase their turnover. Only 12 % of the enterprises - particularly small enterprises, craftspeople and eastern German businesses - reported that their loan application was rejected. The key reason behind these rejections is the new business policy of the credit institutions. 7

8 Their growing risk awareness is having very different impacts on large and small enterprises: larger companies are particularly affected by demands of the credit institutions for greater transparency, which the latter need for comprehensive risk assessment and for calculating riskappropriate financing conditions. Meanwhile, from a business perspective an extensive risk analysis is seldom worth the effort for smaller enterprises, which usually apply for smaller loan amounts. In these cases the banks are increasingly attempting to limit their risk by demanding more collateral, and they are also rejecting applications more frequently. The fact that three-fourths of the companies affected by the rejection of their loan application would have been willing to pay more interest clearly shows that for many of them, the actual problem is not their willingness or ability to pay; rather, it is access to credit. Here the shift on financial markets has not yet brought about the expected, broad-scale improvements in credit access. Especially small companies, affected most frequently by this form of credit rationing, would benefit from a differentiation of conditions based more on risks. Although they would have to pay higher interest, it would still be better than not receiving a loan at all. Overall the survey results indicate that banks are not withdrawing from financing for small and medium-sized enterprises (SMEs) but instead that individual institutions are increasingly focusing on specific customer groups. EQUITY CAPITAL AND NEW FINANCING INSTRUMENTS ARE MAKING ADVANCES. Not least because accessing credit is becoming more difficult (and more expensive) many enterprises are trying to diversify their financing structure by tapping other sources of financing. Although internal financing out of 8

9 profits and depreciation as well as bank loans will remain the most important financing instruments by far in the foreseeable future, other sources will increasingly be playing a relatively important role as well. Here, there are huge differences depending on company size: more so than smaller enterprises, large enterprises want to increase group-internal financings, company bonds and derivatives. Medium-sized enterprises place the most emphasis on expanding their lease financings. Small enterprises mainly want to make more intensive use of internal financing and factoring. Across all size categories companies attribute the largest rise in significance to leasing and equity finance (starting, however, from a very low level). Only about 40% of the companies deem their equity capital ratio to be adequate, approx. 45% are planning an equity increase, and some 15% would like to increase their equity but do not have any realistic opportunities to do so. The most common way by far to increase equity capital is to retain more profits, followed by an augmentation of own contributions to capital. Yet, numerous enterprises also want to improve their financing structure via mezzanine capital and equity capital investments. LOW-COST LOANS ARE MOST POPULAR PROMOTIONAL INSTRUMENT. Promotional funds are of great significance when it comes to financing the enterprises' capital expenditure. Around 30% of enterprises take advantage of promotional offers that are available (grants, subsidies, promotional loans, guarantees etc.). Of these promotional offers, the promotional loans offfered by KfW Bankengruppe (KfW banking group) are by far the most in demand, followed by subsidies and grants, promotional loans offered by the Länder, and guarantees. 9

10 Those applying for promotional funds have a good chance of receiving some: on average, just under three-fourths of applicants were granted funds. RATINGS ENTER BANK-CUSTOMER RELATIONS. Most companies have since realized how important ratings are becoming for corporate finance. Over 70% of those surveyed know the criteria which their bank applies to the rating, but only half of the enterprises also find out the rating result. Three-fourths of them accept their rating or consider it adequate, and almost all others are at least discussing their classification with the bank. Despite relatively high acceptance of their rating grade, many companies (over 60%) would like to improve their result. To this end almost half of the enterprises rely on external consulting (or are planning to). Smaller enterprises frequently contact tax advisors, associations and chambers, while larger enterprises concentrate more on banks and rating agencies. In order to improve their rating the companies apply a broad range of measures. First and foremost is the improvement of their accounting and controlling, increased liquidity through more efficient management of receivables, and the augmentation of their equity capital ratio. The companies' efforts to enhance their rating are not at all futile. Despite a rather unfavourable economic environment during the survey period, just under 20% of the companies were still able to improve their rating in the past twelve months. On the other hand, however, approx. 13% of the enterprises were downgraded in the same period. 10

11 CONCLUSION: DESPITE PERSISTENT FINANCING PRO- BLEMS, THERE ARE ENCOURAGING SIGNS. In conclusion, the results indicate that the changes on the financial markets have progressed quickly. Financing problems affecting enterprises have not been relieved compared to previous years. However, significant changes in the behavior of both credit institutions and companies can be detected, indicating a rapprochement: slowly but surely the banks are able to handle the risks tied to SME lending. The companies, for their part, are learning to accept rating procedures and want to both increase their equity ratio and diversify their sources of financing. Even if the road will be long, these are encouraging signs for the future. As a promotional institution dedicated to the SME sector, KfW's task here is to accompany the enterprises along the way and to offer them support. The range of offers of KfW Mittelstandsbank now includes loan, mezzanine and equity financings as well as information and consulting services. At the same time, KfW is also working on improving the overall conditions for SME finance by applying innovative financial market instruments such as global loans and securitizations and by offering SMEs new financing alternatives. All in all this reflects a coherent and comprehensive promotional concept to new conditions on the financial markets and makes it easier for them to resolve future challenges. Authors: Dr. Dirk Plankensteiner Dr. Dankwart Plattner Dr. Volker Zimmermann 11

12 KfW Bankengruppe Economic Department Palmengartenstrasse 5 9, Frankfurt am Main Phone , Fax Infocenter KfW Förderbank Phone , Fax infocenter@kfw-foerderbank.de Infocenter KfW Mittelstandsbank Phone , Fax infocenter@kfw-mittelstandsbank.de