- The European financing environment for SMEs and MidCaps has changed dramatically in recent years. One of the most striking changes is that more and more companies are now raising capital by borrowing directly from private investors. However, the future success of Europe’s growing “direct lending” segment depends not only on the regulatory environment and monetary policy framework, but also on how well these alternative investment funds perform. Their performance, in turn, is largely a function of investment strategy and accurate credit risk assessments.
- This analysis first shows that SMEs and MidCaps in general are subject to higher credit risk than global corporates. Nevertheless, up to one third of European SMEs and MidCaps have a high creditworthiness. A comparison of the credit risks of SMEs and MidCaps in Germany, France, Italy and Spain further reveals that cumulative default rates and rating distribution can vary significantly between countries. Apart from the country-specific risk structure, our analysis also identified differences in corporate credit risk within sectors, some of them considerable.
- An accurate assessment of the credit risk of European SMEs and MidCaps must be based on a wide range of factors. Assessments should consider not only the unique characteristics of SMEs and MidCaps, but also risks specific to the country and sector. Only a careful analysis of all relevant risk factors will produce an accurate assessment of corporate credit risk. Consideration of these different risks is absolutely essential for the direct lending segment, particularly as it establishes investment criteria, selects companies to invest in and manages overall risk.
Direct Lending Funds Investing Ever More in SMEs and MidCaps in Europe
The complex change processes sweeping through financial markets as a result of structural adjustments and tighter regulatory requirements for banks have visibly affected the European environment for SME and MidCap financing. One example is nonbank financing for small and MidCap companies, which political and regulatory bodies have been pushing with increasing vigour. This trend has been fuelled by an upwelling of interest among institutional investors in alternative investment funds (AIFs). One class of AIF that has gained particular significance in recent years extends loans directly to European companies. These “direct lending funds” allow institutional investors to invest directly in a loan portfolio broadly diversified across asset classes. Direct lending funds come in two types: loan participation and loan origination.
Significant Increase in Private Debt Fund Volume in Europe
Direct lending funds are growing rapidly in Europe, allowing the continent to catch up to the United States, where private debt funds have been playing an important role for some time.
The cumulative volume of fully invested private debt funds has risen dramatically in Europe over the past decade. According to a survey conducted by Preqin, a data and intelligence service, strong growth in direct lending played a big role in lifting the European private debt fund market above EUR 100 billion for the first time in 2016. By mid2017, the cumulative volume had reached EUR 144.4 billion. That means that the European private debt fund market grew faster between 2013 and mid-2017 than the US market, which nonetheless remains significantly larger at around EUR 400 billion.
The rapid growth of direct lending in Europe translates into an ever-larger market share for this segment. Direct lending funds in Europe grew by 60% on average between 2007 and mid-2017 until they held nearly half (47.7%) of the market, followed by real estate and infrastructure funds with market shares of 37.3% and 15.0%, respectively. The investment strategies of direct lending funds lean heavily toward diversified investing. According to Preqin’s analysis, 79.8% of the funds in Europe spread their capital across industries. Direct lending funds focus in particular on medium-sized companies. A survey conducted by Allen & Overy showed that the majority of investors plan to increase their investments in such companies.
We assume that private debt funds will continue to gain importance in Europe in the years to come. Our assumption is based on two facts: First, unlike banks, private debt funds operate under the public radar and are still less strictly regulated than their banking fellows. Second, institutional investors have shown growing interest in alternative investments. However, the success of Europe’s direct lending segment depends not only on the development of the regulatory environment and monetary policy framework, but also on the performance of these alternative investment funds, which is largely a function of the investment strategy and the fund manager’s ability to accurately assess the risk associated with their loan portfolios.
Risk Profile of SMEs & MidCaps Shows Strong Differences Across Countries
Assessing the credit risk of European SMEs and MidCaps is a complicated endeavour, often more challenging than evaluating multinational corporations due to the specific traits of smaller enterprises. Indeed, SMEs and MidCaps can only be assessed accurately with a methodology tailored specifically to the characteristics of these companies. Another challenge in assessing the credit risk of European SMEs and MidCaps is the need to consider unique features of the company’s country of domicile. Differences in accounting standards and tax laws do cause deviations among financial ratios used for ratings but may not necessarily affect default rates. Other national idiosyncrasies, in contrast, may have a significant impact on corporate default rates, as shown below.
Significant Differences in Default Rates of SMEs and MidCaps in Europe
Figure A shows the cumulative default rates for Germany, France, Italy and Spain as calculated from the data1 used for this analysis:
Figure A: Comparison of default rates2 of SMEs and MidCaps in Germany, France, Italy and Spain
This analysis of default rates shows that the cumulative multi-sectoral default rates of SMEs and MidCaps vary from country to country considerably. In other words, even well-diversified private debt funds of these countries may be exposed to different default risks.
For example, the cumulative default rate in Germany is higher than in Italy but lower than in France or Spain. One possible reason for Italy’s lower default rate is the fact that sectors “Manufacturing of raw materials” and “Wholesale & retail trade” have relatively low default rates but account for a comparatively large proportion of the Italian companies in this analysis. The relatively high default rates in Spain, in contrast, are driven by the international financial crisis, which had a larger economic impact on Spain than on other countries and caused a large number of Spanish companies to file for bankruptcy.
Differences in national default rates also tend to result in different risk structures, producing large differences in the multi-sector distribution of the overall corporate risk profiles.
Figure B: Distribution of ratings (global corporates) and financial profiles (SMEs and MidCaps) by rating category
As the analysis shows, SMEs and MidCaps in Germany, France, Italy and Spain have a very similar distribution of financial profiles in general. Most companies in all four countries have financial profiles in the solid “BB” range. As expected, only a tiny fraction of the companies have profiles in the “AA or higher” range while a larger, but still small group hold “A” financial profiles. More companies have “B” profiles than “BBB” in all the countries. Only a very small fraction of SMEs and MidCaps in these countries have a financial profile classified as “CCC or lower”.
When the ratings of global corporates3 are added to this comparison, the analysis shows that, as expected, global corporates have a lower credit risk than SMEs and MidCaps. Significantly more global corporates are rated “AA or higher”, “A” and “BBB” than SMEs and MidCaps. In other words, well over two-thirds of global corporates are subject to an investment-grade credit profile. While the majority of SMEs and MidCaps have “BB” financial profiles, global corporates are much less heavily represented in this category. Companies with “B” profiles are also much more common among SMEs and MidCaps whereas “CCC or lower” profiles are found less often among SMEs and MidCaps than among global corporates in all the countries under analysis. Despite these differences, the analysis also shows that up to one third of SMEs and MidCaps have a high creditworthiness.
Up to One Third of SMEs & MidCaps Have a High Creditworthiness
The distribution of financial profiles by rating range exhibits the following differences between Germany, France, Italy and Spain:
Figure C: Financial profile distribution (IG / non-IG)
When we consider how credit risk is distributed by rating range (investment grade or non-investment grade), it becomes clear that the proportion of companies with investment-grade financial profiles is much smaller among SMEs and MidCaps than among global corporates, around 78% of whom carry an investment-grade credit risk.
One reason why SMEs and MidCaps have a higher credit risk is that global corporates, being regionally diversified with a broad product range, tend to be less exposed to cyclical fluctuations in individual markets or sectors and thus are generally more stable than SMEs and MidCaps. Furthermore, global corporates can generally leverage economies of scale to improve their competitive position, especially vis-à-vis their smaller competitors. Over time, global corporates can therefore end up with better financial profiles than SMEs and MidCaps, and so generally carry lower credit risk.
Our analysis of the financial profile distribution of SMEs and MidCaps in Germany, France, Italy and Spain shows that Germany, at 32.4%, has the largest proportion of SMEs and MidCaps with investment-grade financial profiles. While the percentages for Italy and Spain are slightly lower at 30.5% and 31.1%, respectively, France presents a very different picture: Only 22.3% of its SMEs and MidCaps are in the investmentgrade range. French SMEs and MidCaps are underrepresented in the very good “AA or higher” and “A” rating categories as well; over 80% of the investment-grade companies belong to the “BBB” category. In contrast, this category constitutes far less than 70% of the total investment-grade cohort in the other countries.
Level of Sector Risk of SMEs and MidCaps Varies Significantly Across Europe
Empirical studies show that belonging to a specific sector can reveal much about a company’s credit risk, especially since it affects the company's sensitivity to cyclical changes and its ability to capitalize on its competitive advantages. Each sector responds differently to fluctuations associated with economic, market or innovation cycles. The timing and impact of these factors are industry-specific such as the type of product sold or the frequency of fluctuations in a particular market.
Volatility is also driven by the degree of competition in any given sector. Some industries have high barriers to market entry due to high changeover costs, unique selling propositions or proprietary technologies. This makes it less likely that new competitors will enter the market. Also, highly concentrated sectors such as those characterised by oligopolies tend to be more stable than heavily fragmented industries.
If we combine these two dimensions while keeping other conditions constant, a company operating in a highly volatile and fragmented sector such as construction will be more sensitive to adverse developments. It is thus more likely to default on its payment obligations than an enterprise in a highly concentrated, non-cyclical sector (e.g. public utilities).
Market developments can affect a company’s general credit risk, too. Shifts in market conditions within an industry will likely be reflected in a company’s creditworthiness and consequently impact its position relative to companies operating in other sectors. There are many factors that can change the general business environment, including regulatory changes, disruptive innovations, changes in consumer behaviour, changes in the cost of raw materials, etc.
Sector Risks of SMEs & MidCaps in Germany, France, Italy and Spain Vary Materially
The next section looks at the default rates and sector financial profile distribution of SMEs and MidCaps in Germany, France, Italy and Spain. Financial services companies are not included in this analysis.
Germany: Increased Sector Risk in “Construction”, “Other Manufacturing” and “Manufacturing of Machinery & Equipment” Sectors
In Germany, the multi-sectoral 2-year default rate is 2.59% (“All Sectors”), while default rates for specific sectors range from 1.04% to 3.40%. Sectors with below-average default rates in Germany include “Utilities”, “Public & community services” and “Real estate & rental”. Above-average default rates, by contrast, were observed in “Construction”, “Other manufacturing” and “Manufacturing of machinery & equipment” in particular.
These observations can largely be explained by volatility and market developments, as described above. “Utilities”, “Public & community services” and “Real estate & rental” usually exhibit relatively low volatility and enjoyed stable to positive performance during the period under analysis. In addition, “Utilities” and “Public & community services” are characterised by relatively little competition and high barriers to market entry. The sectors “Construction”, “Other manufacturing” and “Manufacturing of machinery & equipment”, by contrast, typically feature comparatively high volatility and fierce competition.
The analysis shows that, in Germany, companies with investment-grade financial profiles are most heavily represented in “Utilities” (38.5%), “Other manufacturing” (38.1%) and “Manufacturing of machinery & equipment” (35.5%). The sectors with the smallest investment-grade proportion are “Real estate & rental” (16.5%), “Construction” (25.9%) and “Public & community services” (26.6%).
France: Increased Sector Risk in “Construction”, “Manufacturing of Machinery & Equipment” and “Other Manufacturing” Sectors
The 2-year default rate for all sectors in France is 3.05%, slightly higher than the default rate in Germany. Rates range from 1.20% to 5.35%, depending on the sector. All Sectors Utilities Agr. & Mining Manuf. of raw material Manuf.of machinery & equipment Other manuf. Construction Wholesale & retail trade Other business activities Transportation Real Estate & rental Public & community services Germany: Financial Profile Distribution (%) AA or higher A BBB BB B CCC or lower All Sectors © Euler Hermes Rating GmbH 2018 TRIBRating CREDIT RESEARCH Up to One Third of European SMEs & MidCaps Have High Creditworthiness 9 Sectors with below-average default rates in France include “Real estate & rental”, “Public & community services” and “Other business activities”. Default rates in France were above average in “Construction”, “Manufacturing of machinery & equipment” and “Other manufacturing” in particular.
In France as in Germany, the sectors with below-average default rates typically exhibit comparatively low volatility while sectors with above-average default rates tend to be characterised by increased volatility.
As mentioned above, the proportion of SMEs and MidCaps (“All Sectors”) with investment-grade financial profiles is smaller in France at 22.3% than in the other countries under review.
An analysis of the distribution of ratings by sector in France shows that companies with investment-grade profiles are most heavily represented in “Other manufacturing” (33.3%), “Manufacturing of machinery & equipment” (28.4%) and “Manufacturers of raw material” (28.2%). The sectors with the smallest share of investment-grade profiles are “Utilities” (11.8%), “Real estate & rental” (14.7%) and “Transportation” (15.2%).
Italy: Increased Sector Risk in the “Agriculture & Mining” Sector
As mentioned earlier, Italy’s multi-sectoral 2-year default rate of 2.05% is low compared to the other countries under analysis, with sector-specific default rates ranging from 0.89% to 4.69%. Sectors with below-average default rates in Italy include “Other business activities”, “Public & community services” and “Transportation”. Above-average default rates were found in the Italian “Agriculture & mining” sector in particular.
In Italy, default rates vary by region as well as by sector. While the 2-year cumulative default rates in the northwest (1.70%) and northeast (2.06%) of Italy are relatively low, the default rates in the centre (2.57%), the south (2.44%) and on the islands (2.33%) are comparatively high. These regional deviations stem from differences in concrete conditions: infrastructure, access to skilled workers and credit supply to SMEs and MidCaps, among other things.
In Italy, companies with investment-grade financial profiles are most heavily represented in “Manufacturing of machinery & equipment” (40.8%), “Other manufacturing” (38.9%) and “Other business activities” (38.6%). The Italian sectors with the smallest share of investment-grade profiles are “Agriculture & mining” (15.8%) and “Construction” (17.8%).
Spain: Increased Sector Risk Particularly in “Real Estate & Rental” and “Construction” Sectors
As mentioned earlier, Spain’s multi-sectoral 2-year cumulative default rate of 3.67% (“All sectors”) is relatively high compared to the other countries under analysis. The sector-specific default rates range from 2.62% to 12.92%. Spain’s high overall rate is largely due to the very high default rates in “Construction” (7.70%) and “Real estate & rental” (12.92%).
After a multi-year construction boom with significant increases in building activity and property prices, the Spanish real estate bubble burst in 2008 during the global financial crisis, resulting in the very high default rates in both sectors. The default rates in the other sectors are comparable to those found in the other countries.
In Spain, companies with investment-grade financial profiles are most heavily represented in “Public & community services” (39.0%), “Other manufacturing” (38.5%) and “Manufacturing of machinery & equipment” (37.3%). The sectors with by far the smallest share of investment-grade profiles are “Real estate & rental” (18.2%) and “Construction” (19.0%).
An international comparison of sector-specific default rates reveals considerable differences among the four countries other than the very high Spanish default rates in “Construction” and “Real estate & rental” described above. “Construction” has an aboveaverage default rate in all the countries under analysis. This is particularly true in France, where the cumulative default rate is 5.25%, twice as high as the corresponding default rate in Italy (2.20%). By contrast, “Agriculture & mining” in Italy has a much higher default rate of 4.69% than in the other countries under analysis. The default rate in “Wholesale & retail trade” is slightly below the average of the other sectors in all four countries. Nonetheless, this sector’s default rate in Spain (2.82%) is more than double what it is in Italy (1.38%). It should be noted that the credit risk of companies in the “Wholesale & retail trade” sector is heavily dependent on the risk characteristics of the products being sold.
Credit Risk of SMEs & MidCaps Shows Significant Differences Across Europe
Please note that an international analysis of SME and MidCap credit risks is always based on historical data, making it impossible to apply the findings to the future unquestioned.
Trends resulting from an accumulation of risks in particular are very hard to extrapolate into the future. In contrast, sector-specific trends driven by risks inherent to the sector can generally be projected into the future. However, even this kind of projection has a few caveats because all markets are subject to constant change.
As stated above, however, it is clear that overall sector risk is significantly affected by sector volatility, sector outlook and market structure. An analysis of sector risks in each country reveals the impact of these risk factors on the default rates. Relatively low default rates tend to be found across all four countries in the rather stable sectors of “Utilities”, “Public & community services” and “Real estate & rental”. The default rates are comparatively high in traditionally more volatile sectors such as “Construction”, “Other manufacturing” and “Manufacturing of machinery & equipment”. Nonetheless, it is quite possible for default rates to vary from country to country within each individual sector.
All in all, the analysis shows that assessing the credit risk of European SMEs and MidCaps must be based on a wide range of factors. Assessments should consider not only the unique characteristics of SMEs and MidCaps, but also risks specific to the country and sector. Only a careful analysis of all relevant risk factors will produce an accurate assessment of corporate credit risk. Consideration of these different risks is absolutely essential for the growing direct lending segment, particularly as it establishes investment criteria, selects companies to invest in and manages overall risk.