This article appeared recently in German also. Please click here.
"Le roi est mort, vive le roi" (French for "The king is dead, long live the king") is the heraldic formula used in France to announce the death of the old king and at the same time proclaim the new one.
In fact, after the first quarter of this year, market observers had already tried to pronounce the previously very successful form of financing of the promissory note dead - above all because the primary market volume had fallen to around EUR 4.5 billion. This was as little as the volume in January 2017, and a certain disillusionment spread to the first half of 2018: While more than EUR 20 billion in new issues had already been placed in the market in the middle of last year, the 1H18 brought it to just over EUR 9 billion - and this despite the fact that the market also recorded jumbo transactions in this period (e.g. the REWE transaction alone for EUR 1.0 billion), which boosted the total volume.
The decrease - or should we better call it decay already? - has its reasons. Until the financial crisis (2007/2008), this product was used almost exclusively by large companies with sales in the billion Euro range, but was then increasingly sold by banks to smaller companies and SMEs. On the one hand, because it was a rather manageable product with limited structuring effort and lean documentation, and on the other hand, because it enabled companies with lower sales and generally poorer credit ratings to gain additional access to debt financing. Traditionally, investors for this product are mainly co-operative banks (“Volksbanken”, “Raiffeisenbanken”) and savings banks (“Sparkassen”). Over the past ten years, the volume of loans sold via Schuldschein has therefore also grown steadily and massively. While in 2013 it amounted to only EUR 8.1 billion, it had already grown to over EUR 27 billion by 2017. 2018 is now the first year in which the steeply upward curve has clearly broken, and it is not to be expected that the second half of the year could even come close to making up for the volume losses of the first half of the year.
But the problems are probably homemade. The Schuldschein boom initially began at a time when German medium-sized companies were not sufficiently supplied with bank loans as a result of the financial crisis. At that time – and no different from today-, access to the bond market was only open to large corporations, issue volumes of EUR 500 million and upwards are the norm and are expected by investors. While some companies, therefore, chose the newly emerging market of so-called SME bonds (“Mittelstandsanleihen”), others increasingly took advantage of the obvious advantages of the borrower's note, as this also enabled them to attract investors beyond their own house banks. For this asset class, however, this also meant that the criteria applied to the creditworthiness of a certain address were significantly softened over time. More and more banks sold this simple product to more and more customers. Structuring and distribution fees eroded in line with the covenants to which a company was subject for the term of the loan. At the same time, margins also fell by and large: "On average, the risk premiums on new German companies' promissory notes last year were only about one percentage point above interbank rates" The Schuldschein has thus become a commodity and me-too product over the years.
This development shows clear parallels to other products of recent years. Best examples: ship loans and so-called SME bonds. Here, too, a very similar development took place, the effects of which ran counter to the risk reward principle, namely that an increasing risk must be accompanied by rising risk premiums (margins) in order to be able to compensate for the more probable defaults. But the opposite was the case: An ever-increasing number of investors (not infrequently banks, but often also retail savers in the case of SME bonds) plunged onto issuers with ever worse credit ratings. Margins, structuring and distribution fees eroded almost faster than the requirements for the creditworthiness of borrowers, and the gap between risk and earnings continued to widen. The end is known: Some banks didn’t survive the risks of their shipping portfolios, others still have a massive "digestive problem" with them today. And from 2010/2011, the bankruptcies of issuers of SME bonds began to rise rapidly, which hit small investors of the retail market particularly hard.
If the banks are not careful, the same fate threatens the promissory note. There have been clear warning signs in the past. In recent years, foreign issuers have increasingly used the successful German product Schuldschein, and it is precisely of these that the first really bad news recently hit the markets.
Example 1: South African furniture manufacturer Steinhoff. BayernLB, together with other banks, placed a EUR 730 million note in June 2015. Towards the end of 2017, however, the Steinhoff group, which also includes the German furniture chain Poco, experienced a massive financing problem that could only be countered by means of fire sales of assets and renegotiation of loans. BayernLB, for its part, sold loans in the secondary market at below par.
Example 2: the British construction giant Carillion. Together with HSBC, BayernLB had also placed a promissory note for the latter, for an amount equivalent to approximately EUR 126 million (GBP 112 million). After the construction group had recorded massive write-downs in July 2017, it finally had to file for insolvency in January 2018 - with a mountain of debt of around EUR 1.8 billion.
These are very clear warning signals, the interpretation of which is actually not difficult. If the requirements for the creditworthiness of issuers deteriorate, the default risk increases. And as more and more banks jump on the Schuldschein bandwagon all at the same time, with fees and margins falling, there is going too little left to cope with the defaults.
But it is not too late and there is hope. On the one hand, there has for some time been the intention to standardize the loan documentation in a similar form to the clauses used for syndicated loans (on the lending side, several banks act as so-called syndicates), namely in accordance with the so-called LMA standard. LMA stands for London Market Association. As early as 2012, a group of banks and lawyers in Germany had already addressed the topic and started writing an LMA guide. This is currently available in the 2016 version, but is still rather descriptive. Nevertheless, it is to be expected that the end result will be a higher density of regulations for the promissory note which banks are likely to voluntarily commit themselves to in their own interest. On the other hand, the currently emerging sales platforms for promissory notes are also moving in the direction of standardizing contract clauses, which can be combined as needed according to a modular principle. The first transactions were already reported by Value Concepts in the first half of the year: The bank-independent Fintech had provided Austrian Verbund AG, a utility based in Vienna, with promissory note capital via its platform www.vc-trade.de in cooperation with Helaba. LBBW and the Stuttgart Stock Exchange also tapped the borrower's note market for BayWa AG via their new platform www.debtvision.de.
The hopes placed in standardization are manifold: On the one hand, the transaction costs of an issue are to be reduced considerably, because the remunerations for the banks are already hardly covering costs any more. Investors' confidence is also to be strengthened. If there is a high degree of standardization, transparency also increases, and that is paramount in today's Schuldschein market. On the other hand, it is expected that relevant platforms will be equipped with artificial intelligence in the future. According to generally accepted principles, translated into algorithms, the creditworthiness of issuers should be determined and priced independently of banks and therefore will be close to incorruptible (i.e. free of individual interests).
Of course, for the banks this will be a bit of a sour lemon. As soon as both the sales platform and the credit rating are no longer under their control, they are superfluous as brokers between borrower and investor. And then they too must limit themselves to the role of the investor and rely entirely on a robot's rating. Something banks will have to get used to. But this is also the biggest advantage and the future of this product, because it is about to become the first fully digitized credit product, and it will not be long before the promising Blockchain technology comes into its own here. All in all, a viable vision of the future for a product whose completely analog origin dates back to the beginning of the 20th century.
And so, despite all the current prophecies of doom: The Schuldschein is alive (and kicking)!
 DZ BANK Corporate DCM Update Juni 2018
Image credit: Sascha C. Roeber