Viewpoint: Andy Stewart, Consultant, JCRA
Tell us about JCRA?
We are independent hedging advisors, focused on interest rate and FX risk. We are a complement to the debt advisor and part of our role is making other advisors in the transaction aware of the impact of any hedging, preferably well in advance of the deal completion. Too often, we find that the hedging is considered a peripheral issue, and at worse, an afterthought which can lead to suboptimal outcomes further down the road.
What has been the impact of regulatory change?
The post financial crisis world is all about creating transparency in what are very opaque financial markets. This desire for transparency increases the documentation companies must complete, and can lead to significant delays in executing a derivative. For example, under EMIR (European Market Infrastructure Regulation), all counterparties (companies and financial institutions) have to report their derivatives transactions to the trade repository regardless of size and declare their counterparty classification, which can be arduous to say the least.
What has been the effect of continued low interest rates?
The low interest rate environment has meant swap rates (fixed rates) have continued to fall in the UK over the past few months, allowing borrowers to fix their cost of debt at a lower rate than current floating LIBOR. Of course, many would take the view that they don’t need to hedge now as rates are so low. However, it actually makes a lot of sense to hedge at the point where it is ‘cheap’ to do so such as when the market is expecting a low probability of the event which you are hedging against (i.e. rising rates). It seems odd that businesses were hedging their interest rate risk at rates of 4.5% only a few years ago, but are cautious about hedging at 0.40% because they think they might get a better deal if they wait.
Are there risks from low interest rates?
Yes, definitely. A bank’s profitability is determined by net interest margins and these are incredibly tight when rates are low, further adding to the pressure of increasing capital requirements. For a borrower, paradoxically, the risk is rates moving into negative territory (as they have done already in other European markets). Lenders hedge against this by putting in place interest rate floors (minimum rates of interest). In putting a debt facility together, debt advisors need to be aware that these floors are not benign. It is effectively a sold option by the borrower and can have material repercussions for accounting as well as any hedging strategy.
What has been the impact of Brexit so far?
I am fairly bullish on the long term economic outlook, although the shortmedium term impacts are still to be fully felt. The uncertainty will definitely mean more volatility, particularly in the currency markets. We have had a large increase in clients looking to hedge GBP currency risk (particularly versus USD), and this looks set to continue as they try and pin down as much certainty as possible for the months ahead.
Viewpoint: Colin Wright, Director, European Capital
Tell us about European Capital?
Founded in 2005, European Capital has teams in London and Paris and provides flexible debt products, mostly in the form of unitranche and mezzanine loans to midmarket companies. In recent years we have made the transition from investing balance sheet capital to investing funds raised with external investors.
We are currently deploying our first two funds raised with third party investors. One is a £100m UK SME fund set up in partnership with the government-backed British Business Bank, and the other is a circa ¤475m pan-European mid-market direct lending fund. Over the last year we have invested in nine companies across the UK, France, Netherlands and Spain.
What do you look for in a deal?
Companies which have market leading positions that are defensible and with high quality ambitious management teams. Understanding their business models and thinking how we can tailor solutions appropriately is one of the most interesting parts of our job. We’ve invested in a wide variety of sectors over the last year, including: housebuilding for housing associations (Westleigh); consultancy services for pharmaceutical companies (Xendo); herbal extracts (Euromed); educational services (Inseec); and food products (Poult).
What do you see as the main advantages of debt funds over banks?
Debt funds can offer greater flexibility, in particular on structure and with covenants, and can put together loans that are bespoke to a company’s needs. A good example is Westleigh where we were able to structure a loan that was more flexible than a conventional bank approach to the housebuilding sector and which gave the business room for growth but retained asset cover protection for us as a lender.
Another advantage is that debt funds operate with small teams and this can bring benefits of speed of execution with direct access to decision makers and short credit processes. Furthermore, the team making the investment will be the same as that looking after the investment throughout its life, irrespective of how well or not the business performs.
Do you see debt funds continuing to grow?
Definitely. Debt funds have now taken a big share of the lending market following a growing understanding of the benefits by advisors and PE sponsors. On the supply side there has been strong appetite from investors and significant long-term capital raised in recent years which looks set to continue.
What has been the impact of Brexit so far?
For new investments it is still early days, but we think Brexit will present an opportunity for direct lending funds like us with long-term capital to invest. Bank lenders are likely to be more risk adverse and selective on which opportunities they pursue. For portfolio businesses we have not had any material impact to date on the movement in exchange rates post Brexit. The more significant question will be how consumer spending develops over the coming months and the impact on the broader economy.