Who wouldn’t want to invest in the Mittelstand, Germany’s economic backbone of mostly family-owned businesses? With their strong balance sheets, stable ownership and deep expertise they are among the best businesses in the world. So when stock exchanges started issuing Mittelstand bonds back in 2010, investors were understandably excited.
Between January 2010 and September 2014 there were 126 private placements by German SMEs with a total value of €8.7 billion, according to German rating agency Scope. However, things have not gone to plan: 26 bonds have defaulted, and there have been four selective bond defaults. Scope predicts more refinancing risk, especially in 2017 and 2018 when €1.6 billion and €2.4 billion of debt is due to mature.
Mittelstand bonds have clearly not been the easy win that many hoped. So is this the end for them? Not at all.
There has long been an appetite among Mittelstand companies for alternative funding. A decade ago there was a spate of mezzanine funding, but this was not as effective as hoped. Then came the idea of using the capital markets. Stuttgart’s stock exchange was the first to issue Mittelstand bonds, and those in Frankfurt and Dusseldorf soon followed.
What went wrong? Initially, some good businesses were involved, such as Dürr AG, an engineering firm with 8,000 employees and a turnover of €2 billion, and DIC Asset AG, a large commercial real estate business. This boosted the bonds’ reputation, but the quality of the firms involved soon dropped and there were several high-profile defaults. A number of renewable energy firms got involved, which were not really Mittelstand firms at all. The word “Mittelstand” was being used as a marketing term, and customers were misled.
So the bonds were over-hyped and over-sold. But they aren't dead yet. There were 10 Mittelstand private placements with a value of €430 in the first nine months of 2014, the most recent period Scope has data for.
The fundamental reason for creating Mittelstand bonds has not disappeared: that these companies are no longer willing to rely on bank financing alone. “You would never accept having one or very few customers, you would always try to get a broad range to spread your risk,” says Rolf Kobabe, a partner and investments expert at German law firm Luther who has worked on several Mittelstand bond issuances.
“This applies to the right-hand side of the balance sheet as well. If you only have one lending partner, a bank, and not capital markets partners, you don’t have sufficient risk diversification on the finance side.”
There are several other reasons, too: stricter banks rules mean that lenders have to give more information if they want to borrow, and family-owned firms often find the less-onerous private placement rules more palatable; structuring and issuance costs are also lower for private placements; and the low-yield environment means that institutional investors have a greater appetite for alternative assets. Mittelstand bonds are here to stay.
That should improve Germany's economy, and be a boon for investors. And it could have some interesting unintended consequences. “When you use capital markets you need good structures in the company and good quality information,” says Kobabe.
“Many Mittelstand companies still have problems being transparent and communicative, and banks can only handle that to a point.” Using capital markets could force them to get better at this. And then, Kobabe says: “They might even find that their banks loans get cheaper.”