How can I finance my company? A report on an IBA Virtually Together session

Ieva Dosinaite

Ellex Valiunas, Vilnius; Vice Chair, Structured Finance Subcommittee of the IBA Banking Law Committee

ieva.dosinaite@ellex.lt

Saturday 14 November 2020

Conference Co-Chairs

Alejandro Paya Cuatrecasas, Barcelona

Andreas Kloyer Luther, Frankfurt

Panellists:

Alvaro Membrillera Paul Weiss, London

Gabriella Covino Gianni Origoni, Rome

Ieva Dosinaite Ellex Valiunas, Vilnius

Cintia Martins Costa Elvinger Hoss, Luxembourg

Jean-Gabriel Flandrois Gide, Paris

Alejandro Paya introduced the panel and the main topics of the discussion: the key means of funding available for growing and developing businesses; the pros and cons of each alternative; financing trends in different markets; and an analysis of different instruments, such as equity injections, debt instruments, banking lending, the public market and public aids as a response to Covid-19.

Debt financing

Andreas Kloyer introduced each panelist and opened the session by introducing the topic of debt financing. Kloyer invited the panellists to share their views on whether the bottom lines of debt and equity are still in place or the demarcation has ceased to exist. Gabriella Covino agreed that this a very good question, as the border between equity and debt is very thin at the moment. In particular, the choice between debt and equity depends on a number of factors (the economic climate, the  business capital structure of the company, the priorities of a company’s owners and the business life cycle stage). Typically, debt financing allows the investor to avoid taking on a level of control over a company that might then end up as an investor’s liability in case of default. Debt financing for a company is beneficial in terms of pricing. Looking back over the past few years, debt financing has provided creditors with a more aggressive influence over businesses. This trend makes debt financing similar to equity.

In the case of equity financing, investors typically take all the risk of the company’s performance. Therefore, equity investors are required to step into a company’s management and business. Coming back to the initial question, Covino pointed out that debt and equity sometimes overlap, especially nowadays and particularly in stressful situations where there is a heavy trend towards debt equity swap deals. If, for instance, the debt level of a company is too high, the company may offer conversion of debt into equity through different means, such as a capital increase dedicated to creditors only.

Discussing the trends in respect of financing instruments in the Baltics, Ieva Dosinaite emphasised that ideal scenarios and real life differ, especially in this region. In the ideal world, the main aims of the parties would be the driver for dictating the type of the instrument to be used. Banks opt for traditional banking lending but, as Covino had noted, usually such debt involves rather heavy covenants over a debtor’s business which make such debt financing more similar to equity. If we are talking about credit funds, they typically select bonds or convertibles. The latter is typically used to finance start-ups and tech companies.

In certain regions like the Baltics, companies might be forced to consider firstly the possible lenders and only afterwards to assess what the right financing instrument could be. Within the last five years, the banks – at least in the Baltics – started to treat certain industries as not bankable anymore. From Dosinaite’s point of view, this relates to the bank monopoly in the Baltics and the significantly reduced risk appetite of those two banks. Among those that are struggling to obtain bank financing are not only start-ups or small and medium-sized businesses (SMEs) but also large cap real estate developers.

Jean-Gabriel Flandrois pointed out that banks have started to reduce their involvement in the market of distressed debt and therefore debt funds started to be very active on this market. A few years ago, funds purchased debt from the banks, but the current situation is different as funds are directly investing in distressed debt.

Kloyer summarised that the border between debt and equity has indeed become closer. Gabriela mentioned that the banks can have influence over businesses, especially in case of hybrid instruments. Banks, at least in Italy, are very reluctant to get too involved in businesses which can result in banks becoming responsible for the businesses’ decisions. In recent years, the switch from banking lending to more aggressive distressed or other funds has increased. Credit funds are usually investing by subscribing to hybrid instruments that allow the investors to take over the control of business, and which provide veto rights or other corporate governance rights.

Private equity financing – actual trends

In responding to the question regarding the advantages for a company to consider private equity to raise funding, Alvaro Membrillera pointed out that equity funds offer more flexibility to the company (no maturity dates or interest payments). However, private equity may be not an attractive solution for family-style businesses who are not keen to significantly expand geographically or product-wise. If the owner has enough knowledge, the willingness to bring capital and the enthusiasm to be engaged in the business, private equity might not be the best choice. Meanwhile, if a company needs professional and effective help to change or significantly expand its business, private equity can be an attractive solution. Even an exit – which is an inseparable part of private equity funding – can be a benefit to the owners of a company. Not all founders want to be owners of the business forever, and they use private equity funds to help them exit the business for a higher valuation.

Membrillera also pointed out certain cons for a company that would result from private equity. Firstly, if the company only needs capital, private equity funds are too expensive. The target of private equity is 20-30 per cent return on assets. Compared with banking lending, a company might agree to an interest rate even lower than two-three per cent. Secondly, private equity will always require governance and certain control over business as they need to deliver capital return to investors, which means that business management and operations will be restricted to a certain extent. Of course, such actions of private equity funds can mean a company's profit increases but the actions might not be acceptable to all owners. Finally, private equity fund always must exit the target as they need to bring a high return to its investors. For the owners it means that either they need to find a new business partner or divest along with the private equity fund.

According to Cintia Martins Costa, during the last four years there has been a notable growth of alternative investment funds in Luxembourg. One of the main reasons is that Luxembourg is seen as a hub for partnerships targeting a large class of investors in the EU and the US. The majority of new debt funds are shifting into mixed equity and debt investment strategies to accommodate distressed debts. The most active investors are institutional investors. Among those, it is worth mentioning the European Investment Bank and the European Investment Fund. Such investors provide indirect equity financing by investing in alternative investment funds and co-financing in certain sectors (infrastructure, SMEs, innovations, etc) with venture capital funds. Recently we have seen large volumes of funds being raised due to the current circumstances but not properly allocated: there is a large amount of private capital yet to be invested.

When it comes to the Baltics, venture capital funds are trying to fill in the gap left by the banks. Venture capital funds are very active, not only in the tech sector but in other sectors as well, by providing funding through convertible notes or loans.

Public capital markets

Luxembourg is the financial market centre in Europe, not only from an investment fund perspective but also with respect to capital markets. Martins Costa noted that the debt markets have been affected by Covid-19 and the global recession. The biggest problem with debt markets is the downgraded ratings of issuers by rating agencies due to Covid-19. Previously highly rated borrowers lost access to the cheap funding of debt. Downgraded companies still have access to debt markets, but mainly through the issue of high-yield bonds with tightened covenants. The second trend is that convertible bonds surged in 2020, especially in healthcare and the tech sector. From an investor’s perspective, convertible bonds have the advantage of still providing fixed income revenue. Convertibles are advantageous to the issuer as such hybrid instruments allow the maintenance of control with the owners of the company over management and business, ensuring stability of share capital.

Another trend is asset purchase programmes, according to which commercial papers are issued. These instruments are crucial for large corporates to ensure liquidity funding. The issue of such papers is straightforward, and does not require extensive documentation nor extensive disclosure.

Another trend is related to green bonds and sustainability bonds which seem to be an economic response to the Covid-19 outbreak. Those bonds appeal to investors that have ESG investment rates.  

Recently pipe structures have arisen. These are privately negotiated transactions by private investors targeting distress companies. Such transactions are quicker and more cost-efficient as they do not require prospectuses and other extensive documentation. The downside for the target is that such structure is similar to private equity as investors seek control over the target.

Financing in the pandemic

Given they are living in unprecedented times due to the global Covid-19 pandemic, panellists were invited to share their experience of and how things in the financing sector have changed. Flandrois stressed that the pandemic changed everything. An extremely large part of the market needed funding for liquidity, negotiations suddenly changed due to the developing situation in the market, changing types of financing instrument, structures, covenants, etc. The pandemic increased the need to restructure companies completely. Membrillera added that, even if the pandemic is unprecedented but the market is still open, there is still money on the market and there are investors that are looking at this situation opportunistically, searching for smart deals. In general, the private equity market is really busy now.

States and governments – a new source of financing

Kloyer noted that states have become a new player in the market and invited panellists to share their views on state aids. Covino noted that, as a response to Covid-19, states have offered several measures, including loans backed with state guarantees, direct subsidiaries and grants. New state-backed entities have been established to provide support measures to businesses in Italy and France. Aid measures are addressed to both SMEs and large companies.

Dosinaite distinguished two types of measures that were taken by the Lithuanian state and the banks. First of all, the banks by their own incentive offered all their clients (corporate and individuals) ‘interest holidays’ for the coming 12 months. Secondly, as well as state-backed loans, subsidies and grants provided by state and municipality authorities, Lithuania had a quite unique special purpose fund created by the state which aims to raise funding from the state and private investors through public bond issues. The aim is to raise around €500m which would be distributed between small, medium and large corporates heavily hit by the Covid-19 crisis. The unique situation for Lithuania and the Baltics region is that this fund would invest through three possible methods – traditional loans, bonds and equity.

Martins Costa added that the governments’ intervention in the capital market was obviously needed to calm down the market. On the other hand, it must be well balanced as not all benefit from such public aid. The problem actually resides in the future – whether the market will be able to repay debt upon maturity. Therefore, such state aid brings mixed feelings in relation to sustainability in the future.

To sum up, Membrillera agreed that in exceptional circumstances, exceptional measures must be used. However, he raised concerns that governments are aiming to control private equity funds in a discriminatory and unacceptable manner. Therefore, some discipline would be very much welcome.

Final round of remarks and comments

In wrapping up the session discussion, Martins Costa concluded that companies must diversify and not rely on one source of funding, especially in capital markets. Covino advised care with state-backed loans as these are not grants: once the maturity is reached, they might be converted from unsecured to secured debt if the situation does not become better. Meanwhile, Flandrois stressed that a company must be realistic and assess what it can realistically get from the market and state. Adding to this, Dosinaite noted that a company needs to assess the options available in general, then identify the main aims of the financing in order to understand which instrument would be the most suitable. A company should also clarify its own plans for three or five years to assess if the proposed financing option hinders those plans.