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Sunday, 27 April 2014

“Minding the funding gap”! Why private investment in Dutch SME companies through the capital markets is a very risky step, with an almost certainly unfavourable outcome. My reaction to Mathijs Bouman’s column in Het Financieele Dagblad.

Mathijs Bouman, the distinguished economist of RTLZ television and columnist of Het Financieele Dagblad, wrote this weekend a very interesting column: he advised owners of Small and Medium Enterprise (SME) companies to turn away from bank financing and turn to the capital markets for capital funding.

Here are the pertinent snips of Bouman’s column:

We have another transition to make, which is at least as complicated. The art of funding, for the Dutch SME companies, should go through a dramatic turnaround process.

Our SME companies are too much dependent upon bank credit. More than 80% of financing in The Netherlands is delivered by the banks. This percentage has continuously increased during decades. In the United States, on the other hand, only 30% of funding money for SME companies has come from the banks and 70% from the capital markets.

The capital markets, were money lenders can lend directly to companies or were they can even participate in auspicious companies, have been virtually taken out of the equasion in The Netherlands.

This is bad for The Netherlands, as an enormous congestion has emerged in particularly this bank funding. In a report concerning The Netherlands, which has been published last Thursday, 24 April, economists of the OECD sketch the dire situation of SME funding in The Netherlands.

Since the middle of last year, the credit supply from banks to Dutch companies has plummeted. These days, the credit supply is over €11 billion euros less. 

Over 31% of the credit applications from SME companies is refused by the banks. That is even more than in Greece. In Germany, the refusal percentage is less than 2.5%. The companies that still do receive credit, moreover pay an even higher interest rate than elsewhere. 

Summarizing: bank credit is expensive, the banks are very frugal with handing it out and the SME companies are too dependent upon it. This is a precarious situation for an economy that is yearning for growth.

The reasons for Mathijs Bouman’s plea are crystal clear and they are justified: the banks are undeniably much less generous with loans and credit to SME companies, at this very moment.

At the same time, the interest rates that the Dutch banks demand, seem to be at an substantially elevated level currently, when compared to the Euribor and Libor interest rates and even with the interest rates in other European countries. This does not seem fair at first glance.

The million dollar question remains, however: is it save to invest in SME capital and will one be able to make any profit on it?

Unfortunately, this question does not have an undividedly positive answer. 

During my long-term commitment at the Business Lending department of one of the leading banks in The Netherlands, I noticed the growing reluctance of this bank to lend money to SME companies. This reluctance was not out of misplaced shyness or exaggerated cautiousness, but based on genuine concerns about the creditworthiness of Dutch SME companies.

The spills caused by defaulted companies and the extra expenses as a consequence of the extensive risk research and evaluation, outweighed the profits coming from the loans and creditlines; even with the elevated interest rates that the bank was forced to charge to its customers.

If even this strong bank, with its extremely adequate risk department and an elevated pricing level, was not able to make a decent profit on business lending, how could the private / corporate investors at the capital markets – with their (enormous) information AND legal arrears – do this anyway?!

Wilfred Nagel, the Chief Risk Officer of ING, wrote an interesting and important article on ING’s corporate website, a few weeks ago.

Here are the pertinent snips from a reaction that I wrote upon this very article, with snippets from the original article included:

Nagel: This does not of course detract from banks, and certainly also ING, applying a prudent risk policy. Many factors determine the customers that a bank lends to within the scope of its balance sheet, including the nature and duration of the relationship with the customer, the risk profile of the proposed loan, the price the bank receives for taking on risk, the extent to which the loan contributes to the creation of concentration risk on the balance sheet and the requirements of the sustainability policy being pursued. The importance of proceeding carefully in this respect, is underlined by recent experiences with lending to SMEs. Dutch SMEs made up 5% of ING’s total credit portfolio in 2013 but contributed 22% of the total addition to the reserve for loan losses.

Against this background, the question is what actual public interest is served by loosening credit standards applied to SMEs? And how does this relate to the aim of safer banks? In fact, banks are now being told to stretch their approval criteria, which is the same as calling for more financing (often of losses) and expansion instead of reducing SMEs’ dependence on debt.

Ernst’s Comments: I fully agree with what Wilfred Nagel states here. Investing in and borrowing to SME companies is extremely risky business in the current economic conundrum and it is very hard to make this a profitable one, even for such professional and experienced organizations as banks.

No investor or customer of a bank should accept that his bank takes too much risk with his equity capital and with the money that the bank borrowed from its customers. Banks should lend to SME companies , when the risk/reward ratio and the opportunities for success are favourable; not because the politics and the general public ‘demand’ that they do so.

Nagel: On top of this, a further strengthening of the capital positions of large Dutch banks will not lead to more lending to SME’s as this only works if both the bank and potential providers of capital are convinced that the investment will be used for profitable economic activity. In other words, granting capital to creditworthy parties at a reasonable return. Gathering capital only to jeopardise it by lending to parties that do not meet the minimum requirements is not a very productive strategy.

Those calling for a relaxation of bank lending to SMEs are, therefore, promulgating a sort of industrial policy at the cost of banks’ savers and providers of capital. This is not appropriate to a market economy and is particularly unwise given the need to increase not debt but equity of SME’s.”

Ernst: Nagel is totally right with these paragraphs. It is useless for banks to increase the unweighed capital ratio, if they use it to squander money, by lending it to not creditworthy (SME) companies.

Politicians, the employer’s associations and the general public can of course say as often as they want, that the banks should borrow more money to SME companies; these people are all entitled to their opinions. Nevertheless, as long as the banks run a much more than average risk of not getting this lended money back in the end, they should not lend it at all.

At this moment, the main problem in The Netherlands is that the cautious economic growth in Europe (and beyond) is not divided evenly over the whole Dutch economy.

Especially the large corporations and export-oriented companies can really profit from this economic growth and – to a lesser degree – a number of midsize companies, which specialize in business-to-business (b2b) supplying; especially when they supply to export-oriented companies.

However, many small b2b companies and business-to-consumer (b2c) companies / retailers and stores (even the large ones) are yet hardly able to profit from this economic growth, due to consumption seriously lagging behind.

This lagging consumption is mainly caused by the fact, that many companies hardly raised wages during the last six years and some companies were even forced to drop wages, to keep their heads above water. The employees of these companies actually got poorer in purchasing power during these years.

On top of that, the Dutch  unemployment is still at elevated levels and the consumer confidence – although slightly  improving – is not yet translated in more consumption; and why would consumption rise, when the prospects at the Dutch labour market are yet unfavourable.

You could call this a ‘Catch 22’-situation:
  • For retailers and SME-companies to be more successful and profitable and the economy to grow harder, consumption and sales should dramatically increase;
  • For consumption and sales to increase, the wages of people should be raised dramatically and to accelerate this process, productivity should go up substantially;
  • For the wages of people to dramatically increase and for speeding up the process of innovation, in order to increase productivity, the Dutch economy should start to grow again. 

This is the conundrum that we are in currently in The Netherlands, and as long as nothing dramatical happens, this conundrum is here to stay. 

Although the Dutch export success helps to slightly improve this situation, it is not sufficient by a lightyear to lift the whole Dutch economy into substantial growth. In order for this to happen, the influence of the Dutch export on the Dutch economy is yet too small.

This brings me to Mathijs Bouman’s column.

Although I do sympathize with him and with his cause very much, I do not agree with him.

Financial success for the investors, is a prerequisite for lending through the capital markets: in the end they must earn more money than they invest. 

Like I stated earlier in this blog, I do not see why funding SME companies through the capital markets could and would be more successful for the investors, than it is for the banks nowadays. Banks, which have performed this kind of SME lending for years and years already:
  • The banks have the best information position, because of their vast research and risk assesment departments;
  • The banks have ample experience with creating, maintaining and preserving the conditions, legal documents, securities and pawns, which are necessary for lending money to companies;
    • Private and corporate lenders, who would operate as lenders through the capital markets, would have to reinvent the wheel with respect to this subject;
  • The banks have – in most cases – a very long and intimate relation with their customers, enabling them to have better judgment than the capital markets, which generally don’t know the companies, applying for funding, by heart;
  • The banks also have favourable legislation to their advance, which enables them to be the second creditor-in-line, only preceded by the Dutch Internal Revenue Service.
    • Private and corporate investors would never be able to gain a similar position, without turning into a bank themselves. 

One should realize that it is an awkward situation that we are in nowadays. 

Although funding SME companies is a ‘condition sine qua non’ for the Dutch banks, it is not a very profitable business at this moment: sad, but true!

Therefore I consider the chance, that it could actually become profitable for private and corporate lenders through the capital markets, very dim.

I want to finish this article, by making a small calculation, concerning a quite realistic model situation: 
  • A group of investors has €100 million to spare for investment in Small and Medium Enterprise companies;
  • They want to make an annual profit of 5% on their investments (i.e. €105 million);
  • They lend the money to 1000 SME companies, of which 10 default;
    • For reasons of simplicity, I consider this to be a loss of €1 million , although the loss could actually be much bigger.
  • I estimate that the necessary operation, for maintaining a financial relation with 1000 companies, requires at least 15-20 personnel members, including automation and an office;
  • I also believe that €1 million in legal expenses are incorporated in the process.

If we set the annual expenses for this to €2,5 million (for the operation) + € 1 million, this leads to the following calculation:

Calculation for this particular example
Table created by: Ernst's Economy
Click to enlarge
This small and simplified calculation shows, that to make this a profitable business for the investors, the required interest rate for the SME companies should already 9.5% per annum in average.

And this is in the (peculiar) situation that the lending money is ‘excess money’ and does not have to be borrowed from the banks, by the investors themselves. 

The 1% default loss, which I chose in this example, seems certainly not exaggerated in the current economic situation.

Already this simple example shows how hard it is to make SME lending, through the capital markets, a profitable business. 

I am sorry: I sympathize with Mathijs’ idea, but I simply don’t see it happen.

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