As the EU decides where to take the Capital Markets Union (CMU) project, following the UK’s vote to leave the European Union and the resignation of Commissioner Jonathan Hill), it is a good time to reconsider the EU’s quest to develop a European private placement (PP) market and ask whether a different approach is needed.
European capital markets professional have always looked to the US for a lead on how to disintermediate banks and build deeper capital markets. On the face of it, the US PP market, which pairs medium sized and unrated companies with institutional investors, is a shiny example of this success — so much so that plenty of European borrowers are regular visitors.
One secret to its success is the National Association of Insurance Commissioners (NAIC), which grades borrowers with a rating from one to six. Those products with a rating of ‘1’ are considered the safest investments (on par with a triple-A credit rating) on a scale down to ‘6’ (a D rating).
Regulated investors in the US have an AVR (Asset Valuation Reserve) requirement telling them how much capital to set aside for each deal. A PP rated ‘1’ by the NAIC must have 0.4% capital backing the investment; for a rating of ‘2 ’ the ratio is 1.3%.
But the requirements leap up for a grade ‘3’ investment, to 4.6%, and up to 30% for level ‘6’.
While NAIC is planning more finely calibrated asset classes, for the moment most US PP investors operate in the comfort zone of assets rated ‘1’ or ‘2’ (equivalent to at least a triple-B rating).
This keeps the market mostly in investment grade territory and deters investors from moving down the credit spectrum.
If Europe wants a PP market that connects its small and mediu sized enterprises (SMEs) with its institutional lenders, it will have to go further than assigning convenient ratings, like the NAIC’s.
The responsibility for the credit research has to lie with the investor, which has to be capable of ascertaining the value of any investment to have the confidence to make a riskier investment.
Even in the developing European PP markets, banks will not be entirely pushed out of the picture. While the CMU wants to provide alternatives to bank lending, the banks are still expected to play a role in the new PP landscape.
The plan is for banks to arrange the deals, connecting investors and borrowers and act as the gatekeepers of the market — placing some responsibility for assessing a borrower’s credit worthiness with the bank arranging the PP.
But bank representations and reputations are not a firm enough credit foundation to grow a new market. It is, after all, in the banks’ interest to earn fees arranging the largest possible amount of these deals and making a return for their shareholders. There is always the risk of contamination, where the arrangers allow weaker credits into the market in boom time.
Since banks can also invest in PP, there is also the risk that they will keep their favourites for themselves and leave institutional investors out of the best deals.
Any truly sustainable and useful market needs institutional investors to step away from banks and rating agencies, and go ahead and invest in startups and unlisted companies. It is expensive and it is time consuming , but it is the right way to build a market.