UK: FUNDING FEAST. - The staple diet of corporate borrowers is no longer the bank loan. The world of finance is now a wonderland where products can be mixed and matched to suit all tastes.

by Richard Thomson.
Last Updated: 31 Aug 2010

The staple diet of corporate borrowers is no longer the bank loan. The world of finance is now a wonderland where products can be mixed and matched to suit all tastes.

Consider, for a moment, this remarkable statement by the corporate treasurer of a leading British multinational. 'Around 10 years ago, I would say that roughly 90% of our funding was through bank loans. Within five years that had completely changed. Around 90% of our funding now comes from sources other than banks.'

Is this the raving of some maverick out to prove his own crazy theories of corporate funding, some maniac trying to undermine his company's stability by cutting it off from its bankers? Hardly. The speaker is Richard Desmond, group treasurer of BAT Industries, as sober and responsible a member of the business community as you could wish to meet. So when Desmond says that since the 1980s he has turned BAT's funding policy on its head, it is wise to sit up and take note. You can, moreover, take it as read that if BAT - a relatively conservative company when it comes to looking after its balance sheet - has radically changed its sources of finance, then much of the rest of corporate UK has done so too. What is going on here?

The answer is disintermediation - a long word for a fairly simple process. Companies needing money are bypassing the traditional source - bank loans. Banks, in other words, cease to intermediate between borrowers and lenders. Investors with surplus cash, and borrowers with a need for cash, meet face to face in the capital markets. Banks with their loan portfolios, meanwhile, are sidelined.

Each company, of course, has its own reasons for participating in this trend but there are several general benefits enjoyed by most borrowers. Disintermediated funding is usually cheaper than an ordinary bank loan - often substantially so. Funding can be for a much longer term than the five or seven years maximum that banks are prepared to lend. And disintermediated funding enables companies to diversify their sources of borrowing so that they are not reliant merely on the goodwill of two or three bankers.

Companies can now raise money from commercial paper markets in Europe and the US, from mid-term and long-term bond markets, the Euromarkets, from swaps, leasing, securitisation, short-term trade finance, not to mention equities and the increasingly complex instruments that mix and match different funding elements to give even cheaper and more flexible options. These days, the financial world is a veritable wonderland of different borrowing products, none of which require a single penny in loans from a bank. It was not always thus.

Disintermediation took off in the early 1980s under the impact of the Third World debt crisis. The crisis followed a period of unprecedented intermediation during the 1970s when the world's banks recycled hundreds of billions of petrodollars by lending them to Latin America and other needy borrowers. Just as the bankers were congratulating themselves on a job well done, it all went horribly wrong. The loans turned out to be more permanent than anyone expected. Many borrowers could not repay them. Capital markets that did not rely on bank lending had, of course, existed in the US and Europe for years. The Eurobond market, for example, was founded in 1963, while various corporate debt markets had started in the US even earlier than that. But they received an unprecedented boost with the banking crisis caused by Latin American loans in the early 1980s. Faced with vast potential losses, the banks' creditworthiness plunged. They found it harder to borrow capital - which made their own lending scarcer and more expensive.

Meanwhile, in the early 1980s, corporate liquidity soared and companies found that their credit-ratings were actually higher than those of their bankers. Like sensible people, they began lending to each other as a safer bet than lending to banks. As the capital markets grew fast, they became more liquid and therefore even more attractive to borrowers and investors. For corporate borrowers they provided greater security by offering a way of diversifying their funding. And, crucially, they offered cheaper ways of raising money than bank lending. By about 1986, however, the banks were back on an even keel and in a frenzy of competition they cut their rates until bank borrowing was again cheaper for companies than issuing a bond or using the commercial paper market. According to the British Bankers Association, corporate borrowing from banks was rising by 25 to 30% a year by 1989.

Then came the recession, the banks were hit once more by huge bad debt losses and the cycle began again. Their lending plunged in 1992 and was still relatively low last year. Disintermediation, meanwhile, was back in vogue.

The range of options is startling. At the short maturity end the most popular for larger corporates is commercial paper, effectively a corporate certificate of deposit. The CP market has existed for many years in the US where it is worth some $300 billion. It is very short-term, typically with a maturity of seven days to about three months, although it can be as much as one year.

'We use CP the most of the new instruments,' says Anthony Stern, director of treasury at Bass. 'It effectively cuts out the middleman so the investor gets a higher return, and the borrower's cost of funding is lower.' Credit rating is crucial in this market. Last year a high 'A' rated corporation, for example, could raise CP money very cheaply - including advisory fees, it would probably pay a sixteenth or an eighth percentage point below the London Inter-bank Offered Rate (LIBOR). The same company borrowing from a bank, in the conventional way, on the other hand, would pay the same margin above LIBOR. The saving with CP therefore would be a hefty eighth to a quarter per cent.

Liquidity is, of course, an important consideration. 'In the US market you can usually get what you want up to two or three months,' says Stern. The much newer Euro CP market, however, is still only worth around £100 billion, although it is growing steadily. Bass, for example, launched a Euro CP programme last year and has found its liquidity less reliable.

There are further problems with CP. Companies are under strong pressure to keep borrowing all the time whether they need to or not because investors forget them very fast if they disappear from the market. Moreover, they are still obliged to have an overdraft facility with their banks because credit-rating agencies demand it. This costs a tiny amount to maintain and is usually never called upon, but it shows that bank lending is not completely a thing of the past. Banks are there, in effect, as lenders of last resort if the securities markets cannot deliver.

For longer period borrowing there is the medium-term note market, usually of three to four years maturity, where the price advantage is similar to the CP market. The full-scale bond market, meanwhile, goes up to 20 years or more, providing funds that the banks would not even consider lending. Again, credit-rating is crucial in deciding the exact cost of funds in these markets.

But what of smaller or less highly rated companies which either cannot tap the public markets or do not want to raise, say, the £150 million or £300 million that a bond issue usually demands? For them there is the private medium-term note market, largely based in the US. Ron Lis, capital markets director of Schroder's, has successfully persuaded many UK companies to take advantage of this. 'The market is worth about $150 billion in the US, of which about $3 to $4 billion is lent to UK companies. US investors like the UK because they feel they understand it better than other places.' A relatively small amount of bonds, perhaps no more than £30 million but with a maturity of up to 20 years, can be placed privately with a small number of investors. US investors, such as some insurance companies, are used to this kind of investment. It is relatively illiquid because it isn't quoted on any stock exchange and the risk is greater because the company may not even have a credit rating. The yield, though, is correspondingly higher. This type of funding is not easily available in Britain or Europe. The fact that it is in dollars is no problem. They can easily be switched into sterling at low cost.

Having weighed up the possibilities of the debt markets most companies will also consider equity. There is nothing new-fangled about a share issue, of course, but with so many funding options, the balance has now changed. Traditionally, equity was about the cheapest kind of funding there was. No longer. 'Any UK company should go for as much debt as possible before opting for equity because it is cheaper, particularly after tax,' says BAT's Desmond.

One senior corporate treasurer confesses to be daunted by the tax on dividends and the demands of shareholders for constantly rising share payments, the compound effect of which can be astonishingly high. He reckons that it makes the overall cost of share capital roughly twice as high as debt capital. He calculates that if the after-tax cost of debt is around 6% at the moment, the cost of equity, allowing for the dividend rises over the next five years or so, should be around 12%. Moreover, shares are relatively inflexible because, while many forms of debt can be re-deemed at the convenience of the borrower, shares cannot.

There are, however, times when equity cannot be avoided. 'When borrowing gets up to 100% of equity it starts to become expensive and then issuing shares is an option that needs to be seriously considered,' says Stern. As a compromise, one of the more popular methods of disintermediation is the convertible equity bond - which is both loan and shares. Typically, these are used to raise 10-to 15-year money in the form of a bond which gives the investor the option of changing it into equity at a specified price. In return for the equity option, the interest on the bond is lower than normal - pitched between an ordinary bond rate and the dividend yield of the shares. This 'contingent' equity (because it is assumed that all the debt will one day be converted into shares) is often used in acquisition financing.

For smaller companies and those engaged in management buy-outs, for example, conventional equity funding is often difficult or impossible - which is where the venture capitalists come in. A company such as 3i plays a crucial role in supplying long-term debt (up to 10 years or more) and equity finance to small companies that either find it difficult to find finance elsewhere or simply want to diversify their funding sources and maturities. In many cases, the cost is less important than the fact that the funding is available at all. 'Many of our clients only come to us for equity in unusual transactions like buy-outs or acquisitions,' says 3i's Charles Richardson, 'otherwise they borrow from banks. In a management buy-out worth £6 million, for instance, we might put up equity of £3 million.' The size of its contributions is likely to depend on the level of earnings to proposed debt. The debt must be serviced comfortably by earnings, otherwise, as in the 1980s, companies that are overgeared are likely to run into trouble.

Smaller British companies do not, however, like offering equity to outsiders if they can possibly avoid it. An increasingly popular method of raising money without doing so and without resorting to ordinary bank lending is leasing - which has the added advantage of tax incentives. This, of course, helps to make it a relatively cheap method of finance.

Yet another way of raising money is to sell future cash flow for immediate cash. Smaller companies increasingly do this when they use a factoring agent. They are selling future income (unpaid invoices, for example) at a discount in return for immediate cash flow. The discount may be substantial but the benefit of getting instant cash flow may be far greater.

Finance companies and even clearing banks do a more sophisticated form of this when they securitise loans. For example, the Household Mortgage Corporation packages groups of mortgages into a security and sells them on the bond market. This was a technique pioneered in the US, with homes loans, car loans and local authority debt during the early 1980s, which gradually found its way over to the UK. There is often no cost advantage in doing this at all - indeed, borrowing from a bank might well be cheaper. 'We looked at it but it was too expensive,' said one corporate treasurer. The real advantage, however, is in moving the loans off the balance sheet so that new loans can be made using the proceeds of the bond issue. The assets being sold not only have to produce a secure future cash flow but need, preferably, to be of high quality - which is why so few companies are able to use securitisation.

Inevitably, all of these different forms of disintermediation have eaten into the traditional lending business of the banks. Yet, ironically, it is those same banks who now embrace disintermediation with open arms. The simple truth is that for much of the 1980s and over the last year or so, there have been few less profitable ways of making money than lending to large companies.

'I would rather not do any corporate lending at all,' says one corporate banker. 'The margins are too wafer thin to produce a decent profit.' Although about a quarter of UK bank assets are in corporate loans, only a tiny proportion of their revenue comes from there. Loans are often just the key to the door to selling other fee and commission-earning services to companies. Lending, in other words, is a kind of loss leader while disintermediation is often far more profitable to banks than their basic lending business.

Predictably, the merchant bankers have been quick to seize the opportunities. Schroder's success in persuading UK companies to enter the US medium-term note market is only one example. And even the clearing banks have got into the act. Barclays and NatWest have reorganised their corporate business so that the lending and merchant banking operations are one and the same, and feed off each other. The financial engineering packages they now offer have become a crucial part of the disintermediation scene. A typical package might include some form of securities fund-raising linked to a derivative, those controversial but now essential financial instruments that have developed since the early '80s. The aim, as always, is to reduce costs. For example, a company might raise fixed rate money through a bond issue or a private placement, then swap it into a floating rate at a lower rate of interest and, very probably, in a different currency. The cost of a swap is minimal these days, while the saving on the funding costs might amount to a quarter percentage point or more.

A few years ago, some companies spotted that there were huge profits to be made from actively dealing in derivatives. Unfortunately, it quickly became clear that there were huge losses to be made, too. Allied Lyons (now Domecq) lost more than £50 million this way. Glaxo last year also lost a small fortune taking a punt on the bond markets. It now takes a cautious approach, like most other companies, only investing its £2.5 billion cash pile in gilts and high-quality bonds. 'Derivatives are not for making dealing profits,' says Stern. 'They are for controlling risk and the cost of raising money.' Desmond agrees: 'We only use them in limited ways to control our interest rate risk.'

But having reached this degree of complexity, where does corporate funding go from here? It seems inevitable that sources of finance will continue to proliferate and grow in sophistication. We can, moreover, probably expect that more of these products will filter down to smaller companies as their cost falls and company treasurers become more expert about what is on offer.

But it would be rash to assume that bank lending is dead. 'Bank lending is back in vogue,' declares Robert Law, banking analyst at Lehman Brothers in London. 'You'll always have a place for bank lending beside the securities markets.' Large and small companies alike continue to rely on overdrafts. 'It is impossible to do without them because they are crucial to funding daily cash flow,' says Stern. Banks also remain the lender of last resort for most companies - as the loan facilities required on CP illustrates. Bank loans are flexible - they can, for instance, be repaid early whereas a 10-year bond usually cannot. And if a company wants to raise money in, say, Malaysian ringgits, it would have great difficulty in doing it any other way than through a bank loan.

There is no reason why bank lending should not continue to rise and fall in sympathy with the banking cycle. Disintermediation took off in the early '80s when banks were unwilling to lend. Lending returned towards the end of the decade when the cycle turned up and the cost of loans plummeted, then faded away again in the recession which encouraged a return to disintermediation.

What companies want is the cheapest form of funding that suits their circumstances. 'Today you don't just go to your corner sweet shop,' says Lis of Schroder's. 'You go to the market of greatest efficiency and switch it around to get the best and cheapest deal.'.

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