Financing the Mittelstand – whose role is it anyway?

Germany has the highest banking density in Europe. Over centuries, banks have played a crucial part in servicing the German economy, characterised by its vibrant and entrepreneurial Mittelstand. Deeply interconnected, the banks and the Mittelstand have therefore formed strong relationships, based on mutual trust and understanding.

Yet, recent data suggests that Germany is one of the markets that has experienced the fastest growth in private debt financing in recent years. In financing leveraged buyouts supported by financial sponsors, private debt funds’ market share rose to 30 percent in 2017.

How can that be in a country populated by more than 1,000 local banks? Or when a large number of foreign banks are desperate to give credit to the coveted, successful and solid German Mittelstand?

Growing familiarity, a highly competitive offer, and a competitive advantage for banks through partnership are three clear reasons.

Greater acceptance

All our experience suggests Mittelstand companies are increasingly open to private debt funds as financing partners. For many, seeking a financing partner can simply come down to relationships. We have found that as we spend time with entrepreneurs and management teams to understand their challenges and appreciate the lifecycle of their business, opportunities to form new partnerships are increasingly ripe.

Naturally, non-bank lenders must work harder to build the trust and long-standing relationships that banks have spent years building. This is especially true in Germany, where it is not unusual for a company to use the same bank over several generations. It is taking time, but with capable and trusted boots ‘on-the-ground’, we have started to see a shift in attitudes.

Competitive financing solutions

The competitive nature of private debt financing is becoming increasingly well understood and appreciated as well. The owners and executives of these mid-market companies understand that the investors in credit funds are often large, stable institutional investors such as insurers and pensions funds, which have long-term, patient capital. Credit funds can provide bullet loans with maturities of seven years, in comparison to banks, which seldom go beyond five years in corporate finance. The ability of credit funds to provide sustainable and reliable financing that works over the long term can prove very valuable as they are making long-term investment decisions or evaluating options for expansion.

But the longevity of financing alone is often not enough, particularly in situations where companies want to grow inorganically, through new markets or acquisitions. The flexible nature of credit offered by private debt funds can be tailored to the specific needs of entrepreneurs, providing them with greater room to manoeuvre than they could receive from banks. This is particularly true in the case of committed and callable acquisition facilities. These require a more entrepreneurial approach to lending. The credit analysis of the initial borrower needs to be supplemented by a thorough understanding of its medium-term strategy and the rationale of the acquisitions it seeks to undertake, without concrete knowledge of what they are going to be. With their targeted business model and flexible decision-making processes, credit funds are in a better position to evaluate such complicated financing solutions. In a fast-paced and ever changing environment, this can be key.

A partnership model

The banks have not faded in significance though. In an increasing number of cases, we find that corporates’ existing bank partners in Germany are keen to work with private lenders, as it offers many benefits.

Most prominent amongst these is the chance for the bank to cover the entire credit requirements of a corporate customer in a more flexible manner, without the need for third-party banking partners. By combining the financing capacity of the bank and the credit fund the bank would thus not only secure a permanent role in the financing of the customer, but can to a larger extent dominate the other “day-to-day business” with the company.

Similarly, the ability of credit funds to provide more risk-intensive senior loans as well as subordinated loans can be applied to the benefit of the bank. For example, by using these financing instruments banks can continue to serve long-standing clients that perhaps have had to navigate some rough waters and help to accompany them back on track, while not losing the relationship.

One recent transaction exemplifies these mutually beneficial partnerships well. It involved financing a food producer that is operating very profitably and growing solidly, but primarily supplies some of the major supermarket chains and therefore has high customer dependencies. Our due diligence revealed that this dependency is ultimately mutual as our borrower is the key supplier to some of these chains for a very important product category. Nevertheless, the addressed bank was not comfortable providing the company with the desired financing volume. It signalled, however, willingness to provide some of the financing against security over certain assets that it perceived as particularly valuable. We therefore structured a solution in which the bank received just those assets as senior security, with Pemberton receiving senior collateral over all other assets.  Based on this comfortable piece of security, the bank was able to offer its part of the financing at a rather low margin, while Pemberton agreed a correspondingly higher risk premium for its part.  The bank alone would not have offered the financing.  Pemberton would have done that, but at significantly higher than the weighted cost of funding from both sub-elements. A classic win-win situation.

Work with banks, not around them

We strongly believe in the benefit of long-standing relationships and don’t see the fundamentals of the German market changing anytime soon. However, we do think that the shifts taking place will continue and perhaps even accelerate.

As part of this, we look forward to continuing to work with German borrowers and forming mutually beneficial partnerships with their partner banks, in order to ensure that the German Mittelstand is provided with sufficient, long-term, flexibly designed and adequately priced debt capital.

Jürgen Breuer is head of origination for Austria, Germany and Switzerland at Pemberton Asset Management.