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New options emerging as non-traditional credit grows share of Irish market
With credit availability expected to increase in 2016 Peter O’Brien and Grace Kelly analyse the growth of non-bank credit in Ireland, the European Union’s moves in the area and the new borrowing options emerging for corporates from both private and public sources as non-traditional lenders enter the market.
The general outlook for the Irish market is that credit availability (and particularly real estate credit availability) will continue to increase in 2016. The source of this credit, however, is shifting away from solely traditional lenders to a mixture of banks, mezzanine lenders and non-bank lenders.
Internationally, global political and economic tension could influence the global lending market but the outlook for real estate finance in Europe is perceived to be bright. Prime property, often in so called “safe haven” cities, is still considered to have potential for growth in 2016 and a shortage of suitable assets together with over heated competition is generally identified as the greatest challenge to the European real estate market for the year ahead.
While we expect more traditional credit to become available in Ireland this year than in recent years, banks can still be reluctant to finance the entirety of a project (often preferring to part-finance an acquisition or to lend in conjunction with others) and corporate borrowers are becoming increasingly aware of non-bank borrowing options. Critics sometimes refer to this non-bank lending market as “shadow banking”. Non-bank lenders are typically investors and institutions which are willing to lend and can include hedge funds, pension funds and insurance companies.
Non-bank lenders seeking to diversify their investments can provide an important alternative source of credit for borrowers in sectors which require long term debt and which are able to provide appropriate levels of security, such as borrowers investing in prime real estate.
At the European Financial Forum in Dublin Castle in January this year, the new Governor of the Central Bank, Professor Philip Lane, expressed the view that Europe is overly dependent on the banking sector and that that the policy regime should support a greater role for non-bank providers of debt and equity financing. The Bank for International Settlements has previously released data showing that over the last decade, European businesses have relied on traditional bank credit for approximately 80% of their funding requirements. Irish SMEs were arguably too reliant on bank lending and as a result, were disproportionately affected by our banking sector difficulties in terms of their ability to access or renew credit.
Corporate finance in Europe and Ireland is not likely to mirror the US lending market, where non-bank financing (including non-bank lending) accounts for an estimated 80% to 90% of corporate funding. However, despite renewed lending in Ireland, increased regulatory pressure on banks as a whole to deleverage and reduce their loan books could leave a gap in the market which non-bank lenders can take advantage of.
Of course, such lenders are also limited by applicable regulation. For example, only certain types of investment funds are authorised by the Central Bank of Ireland to originate loans. Pension funds and insurance companies are subject to their own regulation and investment limitations.
Increased supervision of non-bank lending is also probably imminent. The European Central Bank has noted that the push towards market based financing could lead to systemic risk building up in parts of the financial system which are seen as opaque and less regulated. Recent reports put Ireland in third place (alongside China) and behind the US and UK in terms of shadow banking activity, on the basis that there is €2.3 trillion of assets in the Irish shadow banking system. However, as Michael Noonan pointed out in Dáil debates on the matter, about 85% of that amount is subject to other forms of regulation and the majority of the assets and liabilities of the entities involved are located outside of Ireland.
At present, the European Commission is working towards the creation of the Capital Markets Union (CMU). The CMU is a collection of ideas and initiatives aimed at (among other things) boosting non-bank lending for businesses in Europe. This includes cultivating more financing from investment funds and encouraging public investment through initiatives such as the European Fund for Strategic Investment.
The CMU aims to make access to finance more harmonised in Europe so that borrowers have a wider pool of investors from whom to seek credit.
Peer to peer lending
Interestingly, the CMU includes peer to peer lending as a growth area for alternative funding. This area is completely unregulated in Ireland (as the Central Bank of Ireland pointed out to Irish consumers in 2014) but the European Commission has identified it as a method of involving households in financing the real economy while reducing reliance on traditional banks. Candidates in the General Election were alive to the potential for growth in this area. As part of its election manifesto, for example, Renua had promised to establish a new peer to peer lending platform for Irish businesses which would operate independently from banks. Fine Gael promised to boost alternative sources of credit by €1 billion per year if re-elected, including through peer to peer lending. In the UK, peer to peer lending has become more mainstream and is no longer considered to be alternative lending. Some banks are reported to be partnering with peer to peer lenders and referring borrowers to them where the bank cannot provide the required funding. However, the risks of such an unregulated activity are very real, as highlighted by a recent peer to peer lending scandal in China, where social lending platform Ezubo is under investigation for conducting a Ponzi scheme which lost $7.6 billion of investors’ money.
While we are aware of borrowers in the market having chosen non-bank lenders (in one case an insurance company) over traditional banks for credit, there may be an argument that if a borrower suffers financial difficulty and needs to re-negotiate with its creditor, a traditional banking relationship between a borrower and its bank could be more robust than the relationship between that borrower and a new non-bank lender. Cultural factors also play a part, as Irish borrowers may believe that a historic relationship between the lender and borrower can assist in these circumstances.
Documents and structure
Non-bank lenders often prefer a fixed rate of return and the interest rates on non-bank lending are typically higher than those for traditional bank loans. This could reflect the higher risk to return requirements for non-bank lenders or their internal rate of return. However, some non-bank lending can be more flexible in other respects. In the US and UK for example, non-bank lending (particularly from private equity firms) is sometimes described as “covenant-lite” meaning that the usual covenants relied on by lenders for protection in case financial circumstances change are waived or are more borrower friendly.
The loan structure in non-bank lending can differ from traditional club or syndicated loans. Non-bank lenders may not have access to the same administrative functions as a traditional lender so loans are often on a bilateral basis or from a small pre-agreed group of lenders. They are typically straightforward term loans with one drawdown and often sit alongside a borrower’s other financings. For example a borrower may also have revolving facilities from a traditional bank for working capital purposes. Interest or exchange rate hedging, if required, would also typically be provided by a traditional bank.
From the lawyers’ perspective, this impacts on the type of documentation used to document the facilities. The UK and US have seen an increase in “covenant-lite” loans and there has been an increase in unitranche loan facilities in the UK and US markets when non-bank lending occurs. These are usually simplified single tranche facilities combining senior and junior risk and having a single interest rate (sometimes comprising a blended senior and junior rate) which simplifies the layers in a borrower’s capital structure.
Public initiatives in the non-bank lending sphere also offer an alternative source of credit for borrowers. The Strategic Banking Corporation of Ireland (SBCI) is a non-bank lender although it partners with other (often traditional) lenders for on-lending purposes. It was incorporated in September 2014 to offer lower cost funding for Irish SMEs and started its lending programme in March 2015 through its initial on-lending partners, AIB and Bank of Ireland. SBCI is funded by the European Investment Bank, KfW Group (the development bank owned by the Federal Republic of Germany and its states) and the Ireland Strategic Investment Fund, a new fund to which the assets of the National Pensions Reserve Fund were transferred, and which focuses on investment designed to support the Irish economy.
It is estimated that up to the third quarter of 2015, approximately €110 million in SME loans from the SBCI were drawn down by about 3,200 SMEs engaged in a variety of businesses. Last year the SBCI announced on-lending agreements with two non-bank lenders as well as an additional €200 million facility available to Irish businesses seeking lower cost working capital, business investment, agriculture and refinancing loans. The SBCI is in discussions with a number of other bank and non-bank lenders in relation to further on-lending arrangements, giving borrowers further credit options. Fianna Fáil, in its election documentation, proposed converting the SCBI into a fully licenced state bank so it may not technically be categorised as a non-bank lender in future.
Enthusiasm for lending to Irish businesses is picking up, particularly for businesses engaged in commercial real estate. We expect this to continue based on market predictions for Ireland and notwithstanding global uncertainty and its potential impact on the lending market in the coming year.
However, new borrowing options are emerging for Irish businesses, whether Irish public initiatives aimed at SMEs, sector specific infrastructure projects funded by the European Fund for Strategic Investment or general corporate lending from institutional and other alternative lenders. In light of the European Commission’s push to broaden the lending base across Europe through the establishment of the CMU, it will be interesting to see if in Ireland we experience a shift towards a wider lending marketplace with a variety of non-traditional lenders and what the resulting changes in the transaction documentation and structures will be.
This article first appeared in Finance Dublin March 2016.