FIXED INCOME In Focus INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME Policy FINANCING IN EMEs Notes FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs Emerging market economies (EMEs) face significant • The first note summarizes the key takeaways of the funding gaps in strategic sectors, such as infrastructure and G20 Report as to the potential of different fixed income SME financing, that if not addressed could stifle growth. instruments to mobilize institutional investors for Traditional funding sources –whether government and/or SME financing in EMEs, and the challenges for such – will not be able to meet this gap. In contrast, bank financing ­­ mobilization to take place. institutional investors in EMEs have experienced significant growth in the last decades and have a sizeable amount of • Subsequent notes go into more depth on each specific assets under management. As a result they are increasingly instrument and their potential to help address the being looked at as a potential alternative funding mechanism. SME finance gap in EMEs, including experiences and innovations in their use across advanced and emerging In this context, in 2015 the Finance and Markets (F&M) market economies. The instruments analyzed included: Global Practice led the production of a joint WBG/IMF/ OECD Report for the G20 on “Capital markets instruments • Bond issuances by SMEs, to mobilize institutional investors to infrastructure and SME • Bond issuances by SME lenders, financing in emerging market economies”.   The Report • Securitization of SME loans, focuses on fixed income instruments that can help mobilize • SME debt funds, and domestic institutional investors, in particular pension • SME covered bonds funds and insurance companies, to infrastructure and SME financing in emerging market economies (EMEs) and provide The production of the joint Report and accompanying policy recommendations to facilitate their use. The approach notes was led by Ana Fiorella Carvajal, Lead Securities taken in the Report was qualitative and conceptual, drawing Markets Specialist and involved contributions from many from our experience in the field to gauge the current use of F&M colleagues, including Ketut Ariadi Kusuma, Shanthi these instruments, the challenges that EMEs face to develop Divakaran, Catiana Garcia Kilroy, Tamuna Loladze, Michel them and potential lessons from relevant experiences in both Noel, Fiona Stewart and Simon Walley, with collaboration EMEs and AEs.   from Jeffrey Anderson, Peter Casey, James Hammersley, and Richard Kemmish, external consultants. Staff from the This Compendium of Policy Notes complements such IMF and the OECD also provided important contributions. Report in the area of capital markets and SME financing. It The Report benefitted from the peer review conducted by is composed of six notes: Anderson Silva and Jeff Chelsky, while Loic Chiquier, Matt Gamser and Alison Harwood oversaw the project. The authors also wish to thank Aichin Lim Jones for providing the design and layout of this Compendium. FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs MOBILIZING INSTITUTIONAL INVESTORS FOR SME FINANCING: KEY LESSONS Ana Fiorella Carvajal, Lead Securities Markets Specialist and Tamuna Loladze, Securities Markets Specialist, both F&M GP JANUARY 2016 INTRODUCTION Formally registered SMEs in emerging market economies (EMEs) face a significant credit gap, estimated at $0.9 to $1.1 trillion as of 2011, and access to finance is considered the biggest obstacle to SME growth. Banks have been the traditional source of SME funding but the financial crisis has led to an active debate about the importance of broadening the range of funding options available for SMEs. Institutional investors in EMEs hold a sizeable amount of assets under management (about USD $5 trillion at end 2012 for pension funds and insurance companies). As a result they are increasingly being looked at as an alternative funding mechanism that could help fill this gap. However, their potential and viability within the SME reality need to be carefully explored. This note summarizes key takeaways regarding the potential of different fixed income instruments to mobilize institutional investors for SME financing, and the challenges (and preconditions) for such mobilization to take place. The instruments analyzed included: bond issuances by SMEs, bond issuances by SME lenders, securitization of SME loans, SME debt funds and covered bonds. Tables I and II provide an overview of the main characteristics of these instruments. KEY TAKEAWAYS SMEs are inherently better suited for bank funding and asset based lending due to their particular characteristics – small size, informal nature, and limited information – which make it difficult to ascertain the quality of an SME business from a capital market investor’ perspective (arms’ length). Banks and other specialized lenders are better able to operate in this opaque environment as they rely on relationship-based finance, which provides them with personal insights into a business that would not be otherwise visible to outside investors. Asset-based lending can also more easily mitigate the information problems of SMEs, given the existence of assets to support any lending activity. As a result enhancing access to bank and asset based lending should remain a priority. The role of capital markets, and in particular institutional investors in the direct financing of SMEs via fixed income instruments is limited. In particular, bond issuances are an alternative potentially suitable only for larger, more formal SMEs. This is due to both supply-side and demand-side factors. • On the supply side, most SMEs, due to their small size and relatively informal nature, lack the capacity to prepare their businesses for an offering of securities to the public, which requires meeting a set of disclosure requirements on an initial and ongoing basis. Some avenues Mobilizing Institutional Investors for SME Financing: Key Lessons 3 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs for fund raising, such as exempt and/or private offerings to the risk-return appetite of institutional investors: higher can significantly reduce disclosure requirements vis-à- yields than government bonds; acceptable credit ratings; vis the market and the securities regulator. However, and sufficient size. Issuances by more specialized SME investors would still require some minimum level of lenders are also starting to take place across EMEs, as the information, which most SMEs would find difficult to examples from countries in Latin America and Sub-Saharan prepare. Africa demonstrate. However, they may require credit enhancements to align them with the risk-return appetite of • On the demand side, institutional investors, while institutional investors. attracted to the higher yields offered by potential SME issuances, in general, do not find it economical Over time, as markets develop, more complex to invest in individual SME bonds due to their small instruments could have the potential to integrate bank size as they would have to assemble a large number and asset based lending with capital markets, such as of SME issuances to see a meaningful impact of the securitizations and fund structures that can help SME higher yields on their portfolios. Moreover, lack of lenders offload SME loans and other credit assets, thereby easily available information on SME performance freeing up capital that could be used for generating new makes it difficult or not worthwhile for institutional lending. They could also be used by SMEs themselves to investors to select and monitor individual SME deals. offload receivables, thus allowing them to improve their Finally, many institutional investors have minimum liquidity. Investors benefit from the ability to invest in risk rating requirements, which are difficult to comply otherwise non-tradable assets at an acceptable size and with for most SMEs. For these reasons, only the larger, risk-return level and access to continuous steady cash flows more formal, and better known SMEs – i.e., the midcap at attractive yields. Most of these instruments are still at a segment –could be potentially attractive to institutional nascent stage even in developed jurisdictions. However, investors. some of these structures are starting to be tested in larger EMEs. For example, SME securitization is being used in SME bond funds, which have been launched in certain Korea and India, while funds based on factoring and reverse EME markets, such as is the case in Peru, can help factoring exist in countries such as Peru and Chile. overcome some of the demand side challenges explained above and thus increase the appetite of institutional investors for SMEs. By pooling individual bonds issued KEY CHALLENGES AND by SMEs and offering larger investment units to investors, PRECONDITIONS they overcome the size challenge; they also provide risk- return diversification by investing in a variety of SMEs For many EMEs further development of the institutional across sectors and sometimes geographies; finally, they investor base is the first precondition to enhance their role have specialized expertise to source suitable SME bond in SME financing via the mechanisms explained above investments and monitor them over time. – although there is no predetermined cut-off size that such investors should reach. However, even in EMEs where such Capital markets can play a larger –albeit indirect-- an institutional investor base already exists, their potential role in SME financing through the refinancing of SME to bridge key financing needs such as those related to SME lenders. This is the avenue that currently holds the financing has not fully materialized. To a large extent this is largest potential to mobilize institutional investors due to challenges that affect key preconditions. These relate to SME financing. The evidence from EMEs shows that to: the availability and offering of the instruments (supply institutional investors can play an important role in SME side); investment conditions for institutional investors access to finance by providing financing to SME lenders (demand side); and the broader enabling environment. (banks, microfinance institutions, factoring and leasing companies), which in turn can have a positive effect in It is important to highlight that significant innovation the availability of a steady flow of funding to SMEs, their is taking place in product design that can potentially ultimate beneficiaries. expand the role of institutional investors in SME financing. New instruments and lending mechanisms, such In the short to medium term, such financing would likely as joint SME bond issuances and electronic platforms for take place via plain vanilla instruments – corporate bond lending seem to be addressing the scale/volume problem that issuances by SME lenders. Bank issuances are already limits institutional investors’ appetite for SMEs. However, it the most common securities in EMEs, even in nascent is still too early to assess the impact that such innovations capital markets, and generally carry attributes that appeal will have. 4 Mobilizing Institutional Investors for SME Financing: Key Lessons FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs Supply side Finally, many EMEs would benefit from developing streamlined offering regimes targeted to institutional Lack of a robust pipeline of SMEs and SME related investors. Such issuance regimes reduce or eliminate assets is one of the core challenges to developing SME disclosure requirements that apply for public offerings and capital market instruments for institutional investors’ simplify or eliminate regulatory approval, which greatly investment in EMEs. This includes the lack of a facilitate the offering process and help reduce issuance costs sufficient number of midcap companies that could issue and time-to-market. For this reason, they are very attractive bonds and thereby raise funds directly from capital market to issuers and institutional investors in advanced economies. investors. It also includes the lack of a sufficient volume of “relatively standardized” SME loans, backed by robust credit information that could serve as underlying assets Demand side for instruments used to refinance SME lenders, such as SME loan securitizations and SME loan funds. The low In many EMEs rigid investment frameworks can pose volume of SME loans, in turn, has to do with the shortage a challenge to institutional investors’ ability to invest in of “quality” SMEs that would be considered bankable by SME related instruments. Proper regulation of institutional lending institutions. investors is critical given their mandates and fiduciary duties towards their beneficiaries. However in some EMEs The challenge of not enough bankable SMEs is not simply the rules-based investment frameworks in place are overly the result of a low number of quality SMEs but is often prescriptive and they significantly limit and sometimes related to challenges linked to credit infrastructure that prohibit investment in alternative assets, under which some constrain the ability to properly assess the creditworthiness of the SME instruments could fall. In addition, as EMEs of SMEs, whose businesses may in fact present attractive progress in the implementation of solvency frameworks investment opportunities. This includes underdeveloped for insurers, there would be the need to ensure that such credit bureaus and credit information tools, lack of frameworks make appropriate distinctions between different recognition of movable assets as collateral and absence of asset classes and/or tranches (i.e. high quality loans or senior collateral registries, as well as poor insolvency frameworks tranches should in principle have a better capital treatment). that do not facilitate reorganization of a business. In addition, efforts are needed to strengthen the financial skills Another challenge is the limited capacity of domestic and governance of SMEs to improve their formalization and institutional investors in many EMEs to analyze preparedness for lending and, at a later stage, potential for instruments beyond very basic products. This could capital market investment. potentially be an issue for some of the more complex structures used for SME securitizations that require stronger Also, many EMEs still need to put in place the legal and risk analysis skills. The need to develop simple, transparent regulatory framework to support the creation of fixed and comparable instruments has been highlighted as a key income instruments. In many EMEs there is already initiative to restore confidence of institutional investors in a framework in place for certain basic instruments, in certain types of instruments, such as securitization structures. particular bond issuances. There are more challenges in Efforts are underway both at the standard setting level and relation to other instruments. For example, many of the at the market level, the latter in industrialized jurisdictions. instruments to link banking and asset-based lending and EMEs will also benefit from these efforts, especially given capital markets rely on the framework for securitization, that EME investors are less experienced and more used to which, among other things, requires clear rules in relation to investing in plain vanilla instruments. the assets that can be securitized, and the requirements that such assets must meet, and robust special purpose vehicles Finally, some of the SME related instruments are likely (SPVs) that are bankruptcy remote. For covered bonds, a to require external credit enhancements to improve their dedicated legal framework with a clear definition of eligible risk-return profile and attract institutional investor assets and minimum quality standards is needed. For appetite in EMEs. Given their lower experience, regulatory fund structures, a robust framework for closed-end funds requirements and/or internal limits and policies, EME is needed which --as the framework for securitization-- investors are usually less willing to take on risks imbedded requires clear rules on asset eligibility and robust legal in non-traditional investments and prefer highly rated structures for the fund themselves. Yet, some of these more securities. For this reason, until SME instruments become specialized frameworks are not in place or are incomplete more established in a market, credit enhancements, such as in many EMEs. partial credit guarantees or insurance, will play an important role for a successful introduction of new instruments. In Mobilizing Institutional Investors for SME Financing: Key Lessons 5 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs many EMEs credit guarantee programs already exist to In addition, certain preconditions outside of the capital support SME lending. The challenge and opportunity lies market sector have an important influence on the in finding ways to optimize such programs and link them incentives of potential issuers and investors to participate to capital markets solutions as has been the case in some in the market. These include: industrialized jurisdictions (i.e. Spain). • A stable macroeconomic environment with transparent and predictable inflation, interest and exchange rate Enabling environment policies that fosters a level of certainty among market participants. The development of SME related fixed-income instruments also depends on certain important • A clear and stable tax framework, especially in preconditions being present in the broader enabling connection with the transfer of assets in a securitization environment. First and foremost, a minimum level of fixed structure, but also more generally with different types income market development, along with basic securities of investment products, ensuring that non-government market infrastructure and regulatory framework, is needed instruments are not disadvantaged due to unfavorable before the introduction of more unconventional instruments tax treatment vis-à-vis other investment options (e.g., can be considered. This entails putting in place the following government securities or banking products). key market building blocks: • A robust and reliable rule of law, judicial procedures • A deep and liquid government bond market with and insolvency frameworks which underpin the issuances covering a broad range of short-, medium- broader perception and confidence about operating in and long-term maturities to provide reliable pricing a particular market. benchmarks for non-government instruments. • Well-functioning money markets to provide reliable THE ROLE OF GOVERNMENTS AND pricing at shorter tenors (less than one year) and help DEVELOPMENT INSTITUTIONS anchor the entire yield curve; they are also important for supporting liquidity and short-term financing of EME governments must develop comprehensive policies market participants that invest in intermediate fixed- and strategies aimed at addressing the SME financing income markets. gap, along with the corresponding actions plans. These strategies should take into consideration the complementary • Key market infrastructure, including payment systems, role that capital markets can play vis-à-vis banking central securities depositories and custodians to ensure financing, and be well articulated into broader capital market that transactions are carried out safely and reliably and, development plans. The plans should aimed at strengthening hence, generate trust among market participants to the preconditions necessary for the instruments to develop, engage in capital market transactions. by ensuring that an enabling environment is in place and • Credit rating services, ideally with robust and that the supply and demand side challenges identified transparent methodologies for rating debt issuances and earlier are addressed. The Chart below summarizes key adequate mechanisms to mitigate conflicts of interest, recommendations provided in the G20 Report in the area of to support investors in determining the creditworthiness SME financing. of investments. • Strong regulation and supervision of capital markets, focused on ensuring market transparency and integrity, to build confidence among market participants to engage in market transactions. 6 Mobilizing Institutional Investors for SME Financing: Key Lessons FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs Chart 1: Key Recommendations to mobilize institutional investors for SME financing via fixed income instruments As challenges are complex and affect many stakeholders Development institutions can support EME governments (both in the public and private arena), strong leadership in the design and implementation of national strategies. is needed, as well as appropriate involvement of all This includes (i) providing advice, (ii) serving as an honest stakeholders in the definition of such a strategy and the broker to help mobilize interest and build consensus, (iii) prioritization of actions. In this context, it is recommended designing and offering risk-sharing mechanisms, structuring that the authorities: and underwriting instruments and (iv) participating in demonstration transactions with catalytic impact on market • Appoint a responsible champion that can lead and development. In this regard, as highlighted in the G20 Report, shepherd the process forward; it is critical that they be in a position to provide an integrated • Establish high-level committees to support the solution to EME governments, where all types of services are development and implementation of the strategies, aligned to achieve this common objective of enhancing SME which would be represented by key public and private financing, and designed to support and complement each sector stakeholders; and other. In this context they should also continue to reassess • Make the strategies and action plans publicly available the instruments through which they have provided support to and require periodic reporting on the progress made. SME financing, and develop strategies that integrate the use of both banking and capital markets solutions in ways that ensure the optimal use of all types of funding. Mobilizing Institutional Investors for SME Financing: Key Lessons 7 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs Table 1: Mechanisms To Provide SMEs With Direct Access To Capital Markets Type of Corporate bond issuances by SMEs SME bond instrument funds Issuances via Issuances via Issuances via public private placement private placements offerings in alternative to qualified markets investors Supply side Small and medium Larger, more formal Larger, more formal and more Pipeline of bonds size SMEs, with and more solid SMEs solid SMEs issued by SME certain level of companies formality Demand side Retail and potentially Institutional and high Mainly retail Potentially all high net worth net worth individuals investors Securities Carve out from the Carve out from the Room for proportionate Framework for markets public offering regime public offering regime regulation in the public CIS, in particular framework offering regime close-end funds Other Framework for Framework for Framework for corporations Potentially supporting legal corporations corporations framework for framework SME markets, and/or private offering Disclosure Typically none Varies from limited In general it requires the same Depending on requirements to no information type of disclosure than a whether placed requirements by public offering in the official via public offering regulation. In practice markets, but some adjustments or not. For institutional investors are made, mainly: (i) the public offering, might demand possibility to provide fewer prospectus information including years of financial information and periodic an offering circular and use of local GAAP, (ii) and ongoing and a rating for debt periodic disclosure is required information products only semi-annually and (iii) deadlines for submission of reports are usually extended. Corporate No No Yes, for equity issuers. In Governance of the governance general the requirements CIS requirements follow those of the official markets, but adjustments are made, in areas such as the number of independent directors and the type of board committees required; the thresholds for disclosure of material holdings and for take- over bids. Framework for Must allow Must allow investment This is a typical investment; In some countries, the institutional investment in in securities of private thus no need for any special investment investors securities of private offerings. treatment. funds are treated offerings. Frameworks usually Frameworks usually require separately. Thus Frameworks usually require a minimum a minimum rating for debt the framework require a minimum rating for debt securities must allow rating for debt securities this type of securities investments. Credit rating Typically no, as this Usually required by Usually required for debt Not necessary, offerings are not institutional investors but some EMEs typically addressed to require rating of institutional investors CIS Taxation Typically no tax Typically no tax Some countries provide tax Requires taxation framework incentive incentive incentives as a pass through 8 Mobilizing Institutional Investors for SME Financing: Key Lessons FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs Table 2: Mechanisms To Refinance SME Lenders Preconditions Corporate bond SME SME covered bonds SME loan and credit issuances by SME securitization funds lenders Supply side Banks, microfinance Pipeline of SME Pipeline of SME loans, Pipeline of SME related institutions, factoring loans, with quality with quality information assets, such as SME and leasing companies information loans, trade receivables, with quality credit information Demand side Potentially all Mainly institutional Mainly institutional Mainly institutional and investors, but in high net worth particular institutional Securities markets Usually nothing Framework for Framework for covered Framework for CIS, framework additional securitization bonds in particular close-end funds Other supporting Depending on Legal framework for Nothing additional Depending on legal framework the issuer, legal SPVs underlying asset, framework for banks, framework for secured factoring, leasing transactions, factoring or leasing Framework for For public offering, Depending on Depending on whether Depending on whether the offering prospectus and whether placed via placed via a public placed via a public periodic and ongoing a public or private or private offer. For or private offer. For information, including offer. For both, best both, best practice is both, best practice is at a minimum semi- practice is to provide to provide granular to provide granular annual reports with granular information information on information on audited financial on underlying pool underlying pool of underlying pool of statements and of assets required assets required. assets required. material events Corporate Not for the offering, Framework to The covered bond law Governance of the CIS governance but the respective address conflict would have provisions requirements institution might be of interest, related to the obligation subject to CG based including retention of the bank to replace on its own framework requirements non performing and prohibitions portfolio of related party transactions Framework for This would be a In some countries, No experience in EMEs In some countries, the institutional typical investment structured products with the treatment of investment funds are investors Frameworks usually are treated covered bonds. They treated separately. require a minimum separately. The would probably fall Thus the framework rating framework must under the category of must allow this type of allow investment on fixed income/corporate investment. them bonds Frameworks usually require a minimum rating Credit rating Usually required Usually required Usually required Not usual Taxation Typically no tax Require favorable Require favorable Requires taxation as a framework incentive treatment of the treatment of the transfer pass through transfer of assets of assets – when moving assets in and out of the cover pool, and in case of insolvency of the issuing entity, when the cover pool operates like a SPV Mobilizing Institutional Investors for SME Financing: Key Lessons 9 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs CORPORATE BOND ISSUANCES BY SMEs Ana Carvajal, Lead Securities Markets Specialist and Tamuna Loladze, Securities Market Specialist, both F&M GP JANUARY 2016 BACKGROUND In general, direct issuance of capital market instruments by SMEs has been limited in absolute and relative terms because of both supply- and demand-side constraints. • On the supply side, issuance requirements for public offers, such as initial and ongoing disclosure obligations, tend to be too demanding and costly for smaller inexperienced companies to comply with. For equity issuance, this process is even harder because of corporate governance requirements, which are very difficult, if not impossible, to comply with for SMEs, many of which are family owned businesses. Issuance mechanisms that provide some degree of simplification to disclosure requirements, costs, and process can help alleviate these supply-side challenges. These “alternative” issuance regimes are discussed below. • On the demand side, involvement of institutional investors in the direct purchase of SME securities has been virtually non-existent mainly because of the small size of issuances characteristic of SMEs. Institutional investors find it too costly to analyze and monitor many small issuances when they are looking to place sizeable investment assets. As a result, issuances by SMEs have primarily targeted retail investors, but this segment is small and underdeveloped in many jurisdictions, especially in EMEs. Specialized funds that invest in SME securities can help open access to the sizeable pool of institutional capital by being able to aggregate many small issuances and offer larger investment shares to institutional investors along with diversification and monitoring expertise. These fund mechanisms are discussed in detail in the note on SME Debt Funds. TYPES OF ISSUANCES REGIMES In general companies can issue bonds by way of a public or private offering regime. Each regime has different implications for SMEs. Public offers require companies to comply with a series of disclosure requirements at the moment of authorization and on an ongoing and periodic basis. Given the costs of providing this disclosure, public offers do not suit well SMEs. In an effort to facilitate SMEs access to the public markets, some countries have developed public offering regimes exclusively for SMEs, along with trading platforms that cater to them (on the exchange or as separate alternative trading platforms), which are sometimes called “alternative markets”. Private offers, in turn, allow companies to raise capital under significantly streamlined requirements, or even no requirements at all depending on the country and the exemption under which they are made. These exceptions usually include a maximum size of issuance and a limited number of investors, and in some countries also offers addressed exclusively to qualified investors. Other countries have established “hybrid” regimes for the Corporate Bond Issuances by SMEs 11 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs latter type of offers, which are then made under a streamlined In general, alternative markets are geared mainly toward regime. Theoretically the more streamlined requirements of retail investors because of the small size of issuances. In all these offers could be better suited for SMEs. fact, a WBG survey of SME exchanges indicates that the majority of investors in these markets have been retail ”because, for many institutional investors, SME issues Public offering regimes for SMEs are too small and lack the liquidity, reputation, access to information, governance, and risk profile they need.”1 Public offer regimes for small companies or issuances – typically defined by company revenue or maximum issuance A handful of SME bond exchanges are being set up with size in a given period, respectively –allow issuers to comply institutional investors in mind (e.g., Spain’s Mercado with reduced requirements while still being able to access Alternativo de Renta Fija, MARF), where only institutional the public markets based on the principle of proportionality; investors are able to access the instruments. However, these that is, the requirements are scaled down to make them platforms have been less successful so far likely because proportionate to the smaller size/issuance of the company. they continue to have the mismatch between the typically The offering regime is usually part of an alternative market, small SME issuances and institutional investor appetite for which allows SMEs to list their securities on an exchange more sizeable investments. or trading platform, typically within a special segment. The reductions vary from country to country but usually include: some rationalization in disclosure requirements Private offerings/placements (fewer years of financial information in the prospectus, less frequent periodic reporting and more time for preparing such In general, the requirements mentioned above are reports), less stringent corporate governance requirements imposed only on public offers of securities, i.e., on offers (e.g., number of independent directors, use of committees, made to the investing public at large. In practice most thresholds for mandatory tender offers, etc.) and more countries develop a series of criteria to determine when flexible performance indicators. In addition, financial a public offer has taken place. In turn, offers that do not costs of issuance (e.g., registration, listing) are usually meet such criteria are considered exemptions to the public significantly reduced as well. offering regime, and thus not subject to such requirements. The typical criteria used by the majority of countries in both Historically, alternative markets were launched with AEs and EMEs relate to the number of investors involved equity markets in mind, especially in places where and/or the (maximum) size of issuance. If an offer is too SME exchanges were the main drivers. These markets small, and/or the number of investors too limited it is have been developed in AEs and the larger EMEs. Some considered that there is no public interest in regulating such examples in AEs include Alternative Investment Market offers. Thus traditional private offerings which are open to in the UK, Alternext for Euronext which covers three equity or debt securities, lie outside the public offer domain markets in Europe (Belgium, France and Portugal), the and hence usually outside the remit of securities regulators. Mercado Alternativo Bursatil (MAB) in Spain, the Mercato Alternativo del Capitale (MAC) in Italy and TSX Venture Private offerings have potentially large advantages for Exchange in Canada. In EMEs, they can be found mainly in SMEs, as they usually completely eliminate the supply- the larger EMEs, for example, WSE NewConnect in Poland, side challenges related to disclosure, regulatory review JSE AltX in South Africa, KONEX in Korea, and ChiNext and approval. Traditional private offerings usually have in China, among others. no initial or ongoing disclosure requirements from the regulatory point of view. Information about the offer is However, more recently alternative markets dedicated provided directly to investors prospected to purchase the to debt have started to emerge. These include specialized offer. There is also no approval or monitoring of the offer bond exchanges and platforms that cater specifically to SME by the regulator; though, in rare cases, a simple information bond issuers (e.g., LSE’s Electronic Order Book in the UK, document must be filed with the regulator for information Bond platform on Stuttgart Borse in Germany, etc.). Among purposes only. EMEs, Peru has developed an alternative debt securities market, the Mercado Alternativo de Valores (MAV), which As these offerings are usually considered to be outside is open to companies with average annual revenues not the scope of the securities regulator, there is very limited exceeding $70 million. It is a public offering regime with an information available on their use by companies. associated listing platform within the Lima stock exchange. However, based on the experience in EMEs, it is possible Source: Harwood, Alison and Konidaris, Tanya. “SME Exchanges in Emerging Market Economies. A Stocktaking of Development 1 Practices,” World Bank Group, Policy Research Working Paper, Report Number WPS7160, 2015 12 Corporate Bond Issuances by SMEs FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs to conclude that, in practice, offerings that are issued under Offering regimes for sophisticated investors are an old these types of exceptions are too small to be attractive to phenomenon in places like the US, and to some extent the institutional investors. EU (although the use of this regime has significantly picked up after the crisis) and have been more recently adopted in select EMEs with others looking to follow suit. Examples Regimes for offers addressed to in EMEs include Instruction 476 Restricted Efforts regime in Brazil, Private Placement (Accredited Investor) regime sophisticated investors in Thailand, Institutional Investor Market in Peru, among others. These are examples of non-SME specific hybrid offer Many countries also rely on the type of investors to which regimes. There are a few examples of hybrid offer regimes an offer is addressed to make distinctions in the offering specifically designed for SMEs. Among them is, for instance, requirements. This condition can be imposed directly, by Italy’s so-called “minibond” regime, which has fewer and providing differentiated requirements for offers addressed simpler regulatory requirements and tax relief similar to that to sophisticated investors (professional, institutional and applicable to listed companies, along with a dedicated trading high net worth) or indirectly, by establishing a minimum platform accessible only to qualified investors.3 denomination for the securities (high), which presumes the type of investor behind such investment. In some countries Hybrid offer regimes have seen varied success in the offers addressed to sophisticated investors are considered EMEs that have adopted them when looking at their use simple exemptions to the public offering regime, with no for debt issuances. For the most part, they have attracted a requirements (see for example the EU) or private offers sizeable portion of total issuance but usually at the expense that as explained above will not be subject to regulatory of the regular public offer issuance; that is, issuance has requirements (see for example Canada and Mexico). In simply shifted from the public to the hybrid offer regime. others a hybrid regime has been developed that has some of However, in a few countries, it is possible to observe an the elements of traditional private offerings but lies closer overall increase in the value of issuance of debt securities to the regular public offering on the issuance spectrum.2 or some combination of an increase in the number of issuers These type of offering regimes can be open to equity or debt or issuances following an introduction of a hybrid offer securities, though, often they are specifically set up for debt regime. For example, in Brazil the annual issuance value in instruments, which tend to be more institutional by nature 2014 (BRL 140 bn) was nearly double that in 2008 (BRL 74 and hence, already targeting the eligible investors of this bn), the year before the hybrid offer regime was introduced, type of regime. an increase that was also accompanied by a rise in the total number of issuers. Moreover, there was a marked increase Hybrid offer regimes usually do not completely eliminate in the number of first-time issuers and number of issuances, disclosure requirements and the regulatory approval along with a decrease in the average issuance size – all of process (though, some do) but rather significantly reduce which could suggest that the hybrid offer regime might have them based on the assumption that targeted investors been helpful in encouraging smaller, less established issuers are sufficiently sophisticated to analyze risks and make to come to market.4 investment decisions. For example, initial disclosures can include a shorter and more simplified offering document and approval can be reduced to a few days or even made automatic upon submission of required information. In IMPLEMENTATION MEASURES AND general these securities are traded among institutional CHALLENGES IN EMES investors over the counter; though, some jurisdictions have specialized institutional platforms within the exchange (e.g., The above direct issuance avenues make up a set of Israel, India), where such offers can be traded without the issuance options that are useful to have alongside the risk of leaking to retail investors. regular public offer framework, to give issuers, including SMEs, choices in how they can access the market. Not every country needs to have all these options available, but more choices will offer added flexibility as potential SME issuers consider accessing capital markets. 2 From a legal standpoint, hybrid offer regimes reside either on the private or public offering side, depending on the country context. If carved out of the public offer regime, they would typically be considered exempt public offers. 3 See OECD. “New Approaches to SME and Entrepreneurship Financing: Broadening the Range of Instruments”, Report to G20 Finance Min- isters and Central Bank Governors, February 2015.4 4 This observation is not based on thorough econometric analysis and hence does not take into consideration many other factors that could influence nongovernment bond issuance (e.g., level of interest rates, banking sector liquidity, etc.). It is simply an observation based on avail- able issuance data. Source: Loladze, Tamar. “Hybrid Issuance Regimes for Corporate Bonds in Emerging Market Countries. Analysis, Impact, and Policy Choices,” World Bank Working Paper, June 2015. Corporate Bond Issuances by SMEs 13 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs Implementing successful SME public offering regimes, CONCLUSION along with an alternative market, might be a challenge for many EMEs. From a regulatory perspective, in many The above issuance avenues serve as different approaches EMEs issuance requirements for regular public offers are for mitigating supply-side constraints faced by SMEs. already too low, making it difficult to lower them further However, they do not eliminate constraints on the without undermining investor protection. And too subtle demand side. In this regard, in particular in connection reductions would likely not make a material difference to with institutional investors, issuance regimes do not address attract SME issuers. Further, there are financial challenges issues of size and risk profile, which are key determinants for the implementation of the markets themselves. In addition of the lack of interest of institutional investors in traditional to fixed costs involved in setting up necessary infrastructure SMEs. Further, in many EMEs, institutional investors can for an alternative exchange, the fees for issuers (e.g., listing, only invest in securities that meet certain minimum grade, custody) are significantly reduced by alternative exchanges. which SME bond issuances are usually not able to meet. On This coupled with a limited number of companies coming to the retail side, retail investors’ lack of knowledge about these list and small issuance sizes typically makes these exchanges companies is a key issue affecting their investment. Fund financially unviable and in need of being subsidized by the mechanisms that can aggregate small issuances of SMEs can main board. potentially help attract institutional as well as retail investors. Such challenges do not exist in the case of private There are also broader cultural challenges among SMEs offerings and hybrid regimes. In these cases, however, that serve as a bigger obstacle to SME issuance. These challenges might stem from the demand side, as will be relate to the limited knowledge that many of them have of further explained below. the options that capital markets can provide, and their ability to produce any information necessary –even if streamlined. These types of challenges limit the pool of SMEs that could be candidates for securities issuance and would need to be addressed overtime through efforts, such as business education campaigns, government programs to support SMEs, and general maturation of the corporate sector. 14 Corporate Bond Issuances by SMEs FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs CORPORATE BOND ISSUANCES BY SME LENDERS Tamuna Loladze, Securities Market Specialist, F&M GP JANUARY 2016 BACKGROUND A corporate bond issued by SME lenders—banks, microfinance institutions (MFIs), and other non- bank financial institutions (NBFIs)—is the simplest, albeit indirect, instrument for increasing access to finance for SMEs through capital markets. Simply put, the proceeds raised through bond issuance increase the lender’s available funding, allowing it to, in turn, increase its lending operations. The greater the focus of a lender on the SME segment, the greater the impact of the issuances on SME lending. In this regard, for example, the issuance of corporate bonds by banks might not have a direct impact on SME lending given that banks engage in many different activities beyond SME lending. On the other hand, issuance by an MFI or an NBFI specializing in SMEs will have a more direct link with SME beneficiaries. POTENTIAL BENEFITS In addition to augmenting the lenders’ funding base, corporate bonds offer the following possible benefits to lenders, depending on the type of lender and its particular situation: longer tenor, potentially cheaper cost of funding, and diversification of funding sources. Banks rely on deposits for funding, which are usually quite stable but are mostly short-term in nature. Access to an alternative funding source with a longer tenor increases a bank’s flexibility to expand lending to a more nonconventional, riskier customer segment like SMEs. MFIs, unlike banks, are usually not deposit-taking institutions (though, some are or have the authorization to do so) and thus have relatively more unstable funding structures. They usually rely on bank loans themselves, which tend to be relatively short-term and may not be at very attractive rates, and sometimes donor contributions in the form of grants and public sector loans, which may or may not be renewable. In the face of growing demand for their services, MFIs are constantly looking for alternative sources of private capital. Their ownership and governance structure5 oftentimes presents challenges in issuing public equity to raise capital. As a result, debt issuance is sometimes their only viable alternative for increasing their capital base. In many countries, MFIs tend to have links with local governments such as municipalities. 5 Corporate Bond Issuances by SME Lenders 15 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs USE IN EMEs Given these challenges, issuance by MFIs and other NBFI SME lenders is much rarer compared with banks but, Banks are usually the most common and one of the first nevertheless, has been happening in select EMEs around non-government issuers in capital markets, often seen the world. Often these lenders may start with issuance of as the ones that can help jumpstart nascent securities short-term securities, such as commercial paper, as a way markets outside the government debt market. They are to test the waters and become accustomed to capital market well-known, well-regarded institutions, with a risk profile financing before progressing to longer-term instruments. palatable for less experienced investors and the wherewithal Many first-time MFI issuers require credit enhancements, to go through the bond issuance process. Thus, in most which may be phased out with subsequent issuances, EMEs banks are usually the main or sometimes the only depending on investor comfort with the issuer. For example, issuers in the market. in Peru, which has one of the most developed MFI industries globally, MFIs have been accessing the bond market since MFIs and other NBFIs focusing on the SME sector, 2002, though issuance has been concentrated among the such as factoring and leasing companies or rural credit largest, so-called first-tier MFIs, such as Mi Banco and institutions, face a different set of issues and usually find Financiera Edificar, most of which also have deposit-taking it much more challenging to come to the capital market. functions. Smaller, second-tier MFIs have so far issued They are smaller, less well-known institutions, with more commercial paper, which has served as a good starting point limited resources and knowledge about bond financing, less to gain experience with market-based finance and now some stable operations and revenue flows, giving them a higher are considering tapping the market with longer-term bonds. risk profile compared to banks. For this reason, they often In Colombia, a bond issuance by Bancamia in December cannot achieve minimum credit ratings to attract sufficient 2014, which was made possible with the support of IFC, investors and require credit enhancements, especially in was one of very few MFI issuances in the country (see Box). places with underdeveloped credit cultures. Further, with Other regions have also seen MFI issuances, such as, for more limited resources and capacity, they have greater example, Sub-Saharan Africa, including Kenya, Tanzania, difficulty with meeting bond issuance requirements and and Zambia.6 taking on various issuance costs (e.g., legal, structuring, distribution, registration, etc.). BANCAMIA BOND ISSUANCE IN COLOMBIA In December 2014 Colombia saw the first bond issuance than the AA+ rating that is regularly demanded by by an MFI with a 5 year bond by Bancamia in the amount Colombian institutional investors even though their of around US$ 40 million (COP 100,000 million). regulations only require that they invest in investment Bancamia is the largest private MFI in Colombia, grade securities. However, because IFC was the sole having a 17% market share in microcredit loans, which investor, no credit enhancement was necessary. translates into a $538 million loan portfolio and about 380,000 borrowers as of June 2014. It targets exclusively Bancamia was able to take advantage of streamlined customers at the bottom of the pyramid, with an average issuance procedures of a hybrid offer regime for qualified loan size of US$ 1,310. investors, Segundo Mercado, whose framework was recently improved through a new regulation introduced While it has been a deposit-taking institution since by the Colombian authorities in 2014. Bancamia was 2008, almost 50% of its funding still depends on short- authorized for a bond program of up to COP 400,000 term bank loans. The bond will help the MFI diversify million (or around US$ 160 million) and is considering its funding structure and access longer-term funding in a follow-on bond issuance under the program in the near local currency. In addition, though the bond was fully future. subscribed by IFC with no other investors participating, it still provides the MFI visibility in the capital markets and With the increase in funding, Bancamia plans to expand serves as a stepping stone for future, more full-fledged its reach to 195,000 new micro entrepreneurs by 2018, of issuances that could attract a wider range of investors. which 117,000 are expected to be for rural micro loans. This translates into a US$ 311 million increase in the loan The Bancamia bond was rated AA at the time of issuance portfolio. and has since been downgraded to AA-. This was lower Faulu Kenya, Pride Tanzania, and Bayport Zambia. 6 16 Corporate Bond Issuances by SME Lenders FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs MEASURES TO HELP INCREASE BOND • Credit enhancement—Many MFIs are unable to ISSUANCE BY SME LENDERS achieve a credit rating that would be acceptable for domestic investors, given their riskier profile. Credit Fostering increased bond issuance by MFIs and similar enhancements by domestic or international development institutions could be an important policy area for the SME organizations or public entities, could serve as an finance agenda, given their direct link with SMEs, as important catalyst for increasing investor interest in mentioned above. Though more and more MFIs in EMEs MFI issuance. are beginning to tap capital markets for funding, greater impact could be achieved by facilitating their access to • Anchor investment by international institutions— this funding source with a number of supportive measures Similar to credit enhancement, anchor investment described below. by well-known international institutions, such as multilateral development organizations, would increase • Alternative issuance regimes7 – Most MFIs are investors’ comfort in the MFI issuance by providing a relatively small and resource-constrained first-time stamp of approval for the issuer. Bancamia in Colombia issuers, finding it challenging to comply with public provides one such example with IFC’s investment offer requirements in terms of time and costs required in its bond issuance; however, usually only a partial to prepare necessary documentation. Having in place investment by a credible institution is sufficient to help an alternative issuance regime—such as a streamlined crowd in domestic investors. This will likely be the public offering for small companies or issuances, model for Bancamia’s subsequent bond issuance. private offering based on a small number of investors or issuance size, or hybrid offer regime for offers targeted • General market development measures—as with at qualified investors—is helpful to alleviate some of the other instruments described in respective technical notes, burden related to the issuance process. These regimes measures to strengthen and deepen the overall securities reduce, simplify, or eliminate certain initial and ongoing market will also support growth in MFI issuance. disclosure requirements depending on the type of Among these, particularly beneficial to MFIs would regime, and some also lower financial costs related to be: introducing more flexible investment regulations security’s registration and listing. and eliminating minimum rating requirements for institutional investors, and building capacity and skills of investors in nongovernment bond investments, as well as raising their awareness about the MFI fixed income asset class, among others in the nongovernment bond category. See related Note on “Corporate Bond Issuances by SMEs.” 7 Corporate Bond Issuances by SME Lenders 17 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS TO SME FINANCING IN EMEs SME DEBT FUNDS Ana Carvajal, Lead Securities Markets Expert and Tamuna Loladze, Securities Markets Specialist, both F&M GP JANUARY 2016 BACKGROUND Investment vehicles that pool a variety of SME assets serve as a useful instrument in overcoming many of the challenges that complicate institutional investor involvement in SME financing. Currently, institutional investors invest in a subset of SMEs referred to as “high growth” companies (the gazelles) through growth and venture capital funds. The focus of this note is on expanding access to finance for “traditional” SMEs. Funds that hold the greatest potential in this regard and are relatively untapped to date are SME debt funds, which are discussed in the rest of this note. DEFINITION SME debt funds are collective investment schemes that pool together a variety of SME assets, from bonds issued by SMEs and SME loans to other types of credits such as trade receivables. They all have in common their goal of expanding the availability of capital for SMEs either directly (through funds specialized in SME bonds) or indirectly (through funds that package SME related assets that could have an impact on the availability of capital and/or liquidity for SMEs). As in all of them the underlying asset is a credit, investors in these funds receive as dividends the stream of income owed to the original creditor. POTENTIAL BENEFITS SME debt funds are becoming increasingly relevant instruments for mobilizing institutional investor capital for SME finance. By being able to aggregate a variety of SME assets, these funds provide several important benefits for institutional investors. First, similar to securitization, they are able to transform certain SME credit assets (e.g., loans, accounts receivable, leases), in which institutional investors are not typically allowed to invest in directly, into investable instruments. Second, by pooling together assets, funds provide institutional investors with diversification and larger size of investment, both key elements for their large holdings of capital. Finally, funds offer specialized expertise in selecting and monitoring individual investments, which institutional investors may find costly to develop in-house, especially if the overall share of allocation to the SME asset class is relatively small. SME Debt Funds 19 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs TYPES OF FUNDS SME credit funds SME debt funds cover a large variety of structures. One SME credit funds, as used in this note, are specialized way to categorize this universe of structures, as applicable funds that invest in a variety of SME credit assets other to SMEs, is according to underlying assets in which they than loans, such as accounts receivable, leases, supplier invest. This results in three main types – loan funds, credit credit, etc. Similar to specialized loan funds, SME credit funds, and bond funds – discussed in more detail below. funds also aim to fill the funding gap left by banks but, in theory, cater to even a less ‘bankable’ SME universe, i.e., smaller and riskier SMEs that banks in many EMEs are SME loan funds reluctant to lend to. As a result, the only option for obtaining credit that is available for these SMEs is through non-bank There are two main types of SME loan funds: co-origination institutions. Here too, the fund manager’s expertise in funds and specialized loan funds. identifying, selecting, and monitoring the underlying assets for the fund’s portfolio is critical. Co-origination funds pool SME bank loans into structures that are similar to the securitization mechanism and, An example of this type of funds that has started to be thus, their main benefit is to augment available bank used in some EMEs is based on the use of factoring, or financing for SMEs. This entails a type of partnership purchase of account receivables owed to SMEs, which between the fund manager and participating banks, whereby is done either directly by the fund or through specialized the fund manager relies on banks to originate SME loans and intermediaries called factors or factoring companies. The the banks typically maintain the client relationship with the proceeds provide SMEs with immediate funding instead of end-borrower, including the servicing of the loans. Similar having to wait for individual customers to pay their invoices. to the ‘originate-to-distribute’ securitization model, banks The receivables are purchased at a discount, which implies sell their loans to the fund and benefit from risk transfer and an interest rate that is typically lower than the rate SMEs can capital relief. “Skin-in-the game” arrangements are typically obtain for a bank loan (if bank funding is even an option). in place to ensure proper alignment of incentives and some In the case where the fund purchases receivables directly, it funds impose other conditions to maximize benefits for can mobilize funding from local investors by issuing equity SMEs, such as the requirement for banks to reinvest freed or debt securities, whose return (dividend/interest) is based capital into new SME loans (e.g., Spain). The fund issues on the cash flow received once these receivables are paid. In securities to be purchased by institutional investors, which the case where the purchase of receivables is done through are usually debt instruments backed by the underlying loans. specialized factoring companies, a fund may provide loans This structure also allows tranching to cater to different risk to these companies and pass on to investors the interest and profiles of institutional investors. principal payments received on the loans. Specialized loan funds originate SME loans themselves A type of fund that could be particularly useful in EMEs instead of purchasing them from a bank, whereby is based on reverse factoring8, whereby the receivables to the fund manager is involved in selecting, analyzing, be acquired by the fund correspond to large companies and monitoring individual investments. In contrast to with good credit quality, to which the SMEs provide good securitization funds, specialized funds typically cater to and services. As a result, the underlying risk of the cash flows SMEs that are not able to access bank financing or may have is of these large, creditworthy, sometimes internationally financing needs that are greater than what they can access known, companies that are SME customers rather than of the through banks. Here the fund manager plays a critical role SMEs themselves. This type of structures can be particularly in originating and monitoring the asset portfolio, requiring attractive in EMEs, where there are still significant challenges specialized expertise (e.g., credit risk analysis), as well as in credit culture, and credit information, and where there is usually servicing the underlying assets. The instrument still high risk averseness among local investors. issued to investors is usually a share participation rather than a debt security and the fund is typically structured as a closed-end fund, with dividends corresponding to the stream of income received from the interest and principal of the underlying loans. Overall the objective of both factoring and reverse factoring is to finance the supplier’s receivables, so that the supplier can obtain immediate 8 liquidity for the goods or services the supplier sold (minus an interest the factor deducts to finance the advance of money). In traditional factoring the process is originated by the supplier which selects the receivables eligible to be factored. In contrast, in reverse factoring the process is originated by the ordering party who then selects the receivables that will be eligible to be factored. As indicated above reverse factoring usually involve large companies to which the SMEs provide good and services. 20 SME Debt Funds FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs SME bond funds Examples of loan funds targeting SMEs – both already active and in development – exist in the Netherlands, UK, SME bond funds are specialized funds that invest in Germany, Ireland, and Poland, among others, some of bonds issued by SMEs. Similar to other specialized fund which include public support (see EIF 2014 for details). types, bond funds are able to address the scale problem For example, in the UK, the Business Finance Partnership is for institutional investors as well as provide them with a publicly supported initiative to invest in asset management diversification and monitoring expertise. They are also firms that lend to SMEs. The government provides funding usually structured as closed-end funds with dividends through two separate schemes, aimed at SMEs with turnover corresponding to the income received by the fund from of up to GBP 500 mn and 75 mn, respectively. Public interest and principal payments of underlying bond assets. funding is conditional on the fund mobilizing at least the same amount from private investors. To date six funds have Unlike the other fund types, they cater to the most been established under the first scheme, providing loans to sophisticated, larger SMEs that make suitable candidates 18 medium-sized and 880 small businesses amounting to for bond issuance. While this SME segment is also the GBP 877 mn. Another interesting example is “Fond Novo” most bankable, the advantage of bond funds for this subset in France, which is a EUR 1 billion fund that takes loan of SMEs would be to facilitate potentially longer term and portfolios from banks (with appropriate risk sharing in place) cheaper financing through bonds compared to bank loans. and issues a bond security backed by these loans. Unlike In addition, the more the larger SMEs can access funding securitizations, the instrument is an untranched “whole loan” through bonds, the more the banks will be encouraged to unrated debt security.13 Investors in the fund include Caisse move down market and increase funding to smaller SMEs. des depots and 17 large insurance companies. SME bond funds are also starting to be used in Germany USE IN AEs and France. For example in France GIAC, a government supported borrowing group, manages a EUR 80 million The use of SME debt funds has accelerated especially in the securitization fund, which invests in small to mid-cap bonds last few years both in Europe and the US. The majority of with issuance sizes ranging from EUR 500,000 – 2.5 million. these funds are specialized loan funds that are often established The fund itself raises financing from the market by issuing by hedge funds or private equity funds, which are able to different types of debt securities purchased by institutional leverage their expertise of sourcing attractive acquisition deals investors. The fund has a partial guarantee scheme through and extend it to debt financing.9 In general, most debt funds in a mutual fund, to which bond issuing companies contribute Europe target mid-cap companies and not the smaller SME 7% of their respective issuance amount.14 segment. Information about the size and other data related to SME debt funds is rather scarce, given their relative novelty, heterogeneous nature, and small share of available investment USE IN EMEs instruments. Many SME debt fund initiatives are also still in the process of being established. According to the Alternative SME debt funds are even a greater novelty in EMEs, Investment Management Association (AIMA) survey of US though a few interesting structures are starting to and EU fund managers, $85 billion of a total of $530 billion emerge that take advantage of local SME context and of assets under management (AUM) of the funds surveyed institutional investor appetite. SME loan funds are less accounted for private debt investments in 2014. Of this, about prevalent in EMEs in part for reasons similar to those that 30%, or roughly $26 billion, could be estimated to be directed limit the development of SME loan securitizations – lack of toward SMEs.10 According to the European Investment Fund a critical mass of SME bank loans – and in other part due (EIF),11 31 loan funds have been identified in Europe with a to risk averseness of local investors toward SME credit. As focus on SMEs, with a targeted volume of EUR 13.2 bn, out such, it appears that EMEs are starting to use debt funds with of a total of 95 active loan funds with a targeted volume of other underlying assets, such as reverse factoring, although EUR 48.3bn.12 9 Source: European Investment Fund. “Institutional Non-Bank Lending and the Role of Debt Funds”, 2014. 10 Although AIMA does not make this type of estimation, this can be deduced from the data provided in the survey on the average size of borrowers’ EBITDA. We assume that borrowers with EBITDA of less than $10 million are likely small-size SME type companies. 11 The data is based on a project carried out by the German DZ Bank to estimate the market size of loan funds in Europe, primarily through detailed screening of available databases. 12 The targeted volume for all the 95 loan funds was EUR 48.3 bn in 2013, of which about EUR 10 bn, or 20%, was estimated to be invested. 13 Source: European Investment Fund. “Institutional Non-Bank Lending and the Role of Debt Funds”, 2014. 14 Source: OECD. “New Approaches to SME and Entrepreneurship Financing: Broadening the Range of Instruments,” Report to G20 Finance Ministers and Central Bank Governors, February 2015. SME Debt Funds 21 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs there are only a handful of cases to date, mainly in Latin well-established reverse-factoring scheme facilitated by the America. development bank Nafin but it has not yet been structured in a way that can mobilize local investors through capital Interesting examples of specialized funds come from markets, though is a good candidate for doing so.15 Peru also Peru and Chile. Peru and Chile have examples of funds has recently launched a bond fund that will purchase bonds dedicated to factoring and reverse factoring. Mexico has a issued by smaller companies through the alternative market. EXPERIENCE WITH SME DEBT FUNDS: THE CASES OF PERU AND CHILE Compass Fondo de Inversión para investors are able to access the SME asset class at an attractive return – 8-10% annually– without being PYMEs16 directly exposed to the SME credit risk. Compass Fondo de Inversión para PYMEs, a closed- end investment fund established in 2004, purchases from SMEs account receivables associated with BTG Pactual Crédito y Facturas Fund in their large customers and sells participation shares Chile17 to capital market investors backed by the cash flow of these receivables. Hence, the underlying risk BTG Pactual Crédito y Facturas, is a Chilean fund of the securities is of these large, creditworthy, that provides financing to non-bank institutions, sometimes internationally known, firms rather than primarily factoring companies that, in turn, extend of the SMEs themselves. financing to SMEs. Chile has a well-developed factoring industry, supported by recent legal The fund operates with a 2-year term and has been improvements, which have made factoring renewed several times since its launch. It started transactions more reliable and secure. Industry with USD 55 mn in capital and has grown to USD participants include both bank and non-bank 100 mn, with investors comprising local pension factoring companies. The BTG fund focuses on the funds, the development bank Cofide, and the Oficina latter because they face the biggest difficulties in de Normalizacion Previsional (ONP). The fund has accessing funding, especially of longer-term. served over 2500 SMEs and around 32 registered corporations, whose receivables the fund purchases Currently, the fund has four investments: Purchase (See Boletin Empresarial). The average maturity of of receivables from a pharmaceutical company, the receivables portfolio is 60 days. whose customer base is largely comprised of SMEs; Whole-business securitization of a factoring The scheme offers important benefits to all the company; and direct loans to two factoring participants. The SMEs are essentially able to transfer companies. their credit risk to their high-quality customers and receive immediate working capital funding at more The instrument is structured as a listed closed-end fund attractive cost – the implied interest rate is around 13- that offers participation shares to investors who receive 14% through the Compass factoring scheme, whereas monthly dividends based on the income earned by the that on working capital loans ranges from 18% to fund from the different investments. It was established in 30% (See Boletin Empresarial). Participation is enticing 2008 with a fixed maturity and has been renewed several for the large buyers because the fund offers them times. The return to end-investors has fluctuated over the the opportunity to lengthen their payment schedule years but, on average, has been 350 basis points above from 30 to sometimes 120 days. And capital market the Chilean bank deposit rate. 15 Nafin facilitates an online factoring platform used by SMEs and factors, local financial institutions that purchase SMEs’ receivables. The platform is user-friendly, transparent, promotes competition among factors, and prevents fraud, which is common in factoring transactions. Nafin provides factors low-cost second-tier financing, allowing them to refinance their factoring activities and earn a spread between the rate received from SME suppliers and the rate they have to pay on Nafin loans. See Klapper, Leora. “The Role of Reverse Factoring’ in Supplier Financing of Small and Medium-Sized Enterprises”, World Bank, 2004. 16 Source: World Bank Group. “Developing New Structured Financial Products to Channel Savings towards Small and Medium Enter- prises (SMEs) Growth”, 2009 and web sources. 17 Source: Interview with BTG Pactual. 22 SME Debt Funds FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs The fund has around 200 investors, including family have chosen to issue through this channel. The issuances offices and high net worth investors, and is currently in have mainly been acquired by retail investors, with low discussions with pension funds and insurance companies, appetite from institutional investors. The HMC Capital who have shown interest to start investing in the fund. fund seeks to trigger institutional investors’ interest in these companies by pooling several small bond issues To date, the fund has facilitated financing of around $47 together. million for more than 2000 SMEs. The fund is expected to have up to US$ 100 million in HMC Capital High Yield Bond Fund in capital. It plans to make around 15 investments over 3 years with an average size of US$ 7 million per investment. Peru18 Investments will be made in both soles and dollars with two portfolios for each currency; the expected return is HMC Capital High Yield is a newly established bond 8% in soles and 6% in dollars. fund in Peru, supported by IFC investment, with plans to invest in local small and mid-size companies with Though the success of HMC Capital is yet to be seen, local credit ratings of between AA- and BBB+. Its main given its very recent launch, it provides an interesting strategy is to invest in companies issuing bonds through example from two perspectives. First, by standing ready the Alternative Securities Market (Mercado Alternativo to buy bonds issued through the MAV alternative market, de Valores, MAV), although it is not exclusively including through networking with potential companies concentrating on MAV and plans to also invest in regular considering bond issuance, it is helping to stimulate public offer bonds of smaller size and lower rating. issuance through the MAV, which otherwise has not proven to be viable. Second, by having IFC as a catalytic MAV is Peru’s alternative public offer regime for investor, the fund is able to attract additional investor companies with maximum S/.200 million (US$ 70 interest, since IFC’s presence is providing an implicit million) in average annual revenues for the last 3 years. stamp of approval for the fund’s investment strategy and It provides simplified disclosure requirements and lower expectations. costs to eligible issuers and currently focuses only on debt issues. Since its establishment in 2012, four companies PRECONDITIONS AND CHALLENGES • Legal and regulatory framework for fund structures -- All the fund types discussed require having an TO USING SME FUNDS IN EMEs appropriate legal and regulatory framework for funds, especially of the closed-end nature that allow fund Development of SME funds requires certain preconditions to vehicles to invest in a variety of assets. In some EMEs be in place, some of which may be difficult to meet in EMEs. such framework is not yet in place or is incomplete. For The main preconditions include the following: example, initially when Compass was to be established in Peru, the framework for investment funds did not • Existence of underlying assets – Two of the funds recognize trade receivables as an acceptable investment discussed above – co-origination loan funds and bond asset. Changes in regulations were needed to address funds -- require the existence of a pipeline of underlying this issue. In addition, a proper disclosure framework assets that are not easy to “produce” in many EMEs. In must be in place. many EMEs bankable SMEs are scarce and banks are reluctant to take SME risk, thus, there will likely not be • Legal and regulatory framework for underlying sufficient critical mass of SME bank loans, which could assets – In the case of bond funds, there needs to be be purchased by a co-origination loan fund. Similarly, in place a framework that allows the issuance of bonds bond issuances by SMEs are at a nascent stage, not only under more streamlined requirements than a regular in EMEs but even in many AEs, making it difficult to public offering (e.g., alternative regimes, private identify underlying bond investments for a bond fund. offerings, hybrid offers). These types of frameworks are On the other hand credit funds discussed above do not being implemented in some EMEs, though challenges face the problem of a missing underlying asset because remain for their successful implementation as explained they rely on assets (e.g., receivables) that already exist in the note on “Bond Issuances by SMEs.” For credit as part of normal business operation for SMEs. Source: IFC Financial Institutions Group. 18 SME Debt Funds 23 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs funds, such as those relying on leasing and factoring mechanisms, implementing secured transactions laws, transactions, there is also a need for an appropriate allowing for movable collateral, and establishing movable legal and regulatory framework, such as laws related to collateral registries. In larger EMEs, where there may be electronic signature, contract enforcement, and secured greater potential for having a pipeline of bankable loans, co- transactions among others. This will strengthen and origination or specialized loan funds could be a more viable increase security of factoring and leasing transactions, option. For the former, it would be important to ensure that and, as a result, provide greater comfort to end- proper incentive structures are in place, including ‘skin-in- investors in the funds. For example, the fact that the-game’ arrangements. Multi-originator structures could trade receivables constitute an “executive title” that also be explored, as a critical mass of loans is more likely can be enforced through speedier procedures in the to exist across several banks instead of a single institution. judiciary is considered one of the key reasons why the factoring industry has developed further in Chile than Reverse factoring funds are particularly relevant in other peer countries. Further, it is considered that the for EMEs, where there is high risk-averseness among implementation of electronic receivables, expected in institutional investors toward SME risk, because of the the near future, will give a further boost to the factoring relatively short-term nature of the credit assets (i.e., maturity industry and to capital market instruments that use of receivables) provided through factoring and, in the them as underlying assets, as the risk of fraud will be case of reverse factoring, no direct exposure to SME risk. materially reduced. However, ensuring safe and fraud-free factoring transactions are key to instilling investor trust. This could be achieved Investment framework for institutional investors – through appropriate laws, as mentioned above, as well as Institutional investors are sometimes precluded from technological solutions (e.g., electronic platform). investing in certain types of fund structures or underlying assets of funds. Thus, their investment regulations may need SME bond funds could play an important role in certain to be revised to ensure that targeted investors are indeed able EMEs, especially where supply-side measures to help to participate in a given fund vehicle. This was, for example, attract SME issuers have already been implemented, namely the case with the Compass fund in Peru, where a regulatory some type of an alternative issuance regime that facilitates change was needed to allow pension funds to invest in funds the issuance process for SMES. In fact, in countries with that purchase receivables. dedicated SME issuance regimes, i.e., alternative markets, but a limited retail investor base, bond funds can be instrumental in jumpstarting issuance in these markets and making them LESSONS FOR DEVELOPING SME more viable, as was seen in the case of Peru above. In other DEBT FUNDS countries, alternative markets could be developed in tandem with bond funds, that is, designed from the beginning with Collective investment schemes, or funds, bring much funds as the main target investors. value to making the SME asset class more accessible to institutional investors by pooling small SME assets into Finally, public or multilateral support may be needed, at larger investments and providing diversification, expertise, least in initial stages, to provide incentives or play a catalytic as well as usually attractive yields. Their development holds role to attract investors and bond issuers, in the case of bond significant potential in EMEs, but not all fund types may be funds. Public support may include partial guarantees for appropriate depending on the EME context. the fund’s investments, seed investment in the fund like the Co-origination loan funds do not seem a feasible option Business Finance Partnership fund in the UK, tax incentives in most EMEs because of the lack of a critical mass of for SME bond issuers or investors, and education/training SME loans. Measures to develop the necessary pipeline about bond issuance for potential SME issuers. Multilateral of loans would be similar to those discussed in the SME support would most likely be in the form of a strategic securitization note, such as improving credit information investor in the fund to help crowd in domestic investors that may feel apprehensive about investing in a new vehicle. 24 SME Debt Funds FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs SECURITIZATION OF SME LOANS Ana Carvajal, Lead Securities Markets Specialist, F&M GP; James Walter Hammersley and Jeffrey David Anderson, both consultants F&M GP JANUARY 2016 DEFINITION SME loan securitization is a financing technique that allows the transformation of SME loans which are illiquid in nature, into tradable securities that can be bought and sold in the capital markets. Securitization allows the creation of a secondary market for SME loans, whereby a bank or lender (the “originator”) extends loans to SME companies (“primary market”), bundles them in a pool (“portfolio”), and sells the portfolio to capital market investors through the issuance of securities by a special purpose vehicle (SPV). The securities are backed by the loan portfolio (Asset Backed Securities, ABS). The asset-backed securities, classified by risk categories, represent tranches of the underlying portfolio.19 POTENTIAL BENEFITS The benefits of SME securitization for banks (and specialized lenders) and investors are similar to those of securitization in general. Securitization provides banks (and specialized lenders) with an alternative source of funding in cases where they have either limited access to capital markets’ refinancing tools or unsecured bonds can only be sold at high cost. In addition, in the case of banks it potentially allows them to achieve economic and regulatory capital relief. From an institutional investor perspective, SME securitization offers investors access to assets to which would otherwise not be available. This can be attractive from a risk-return as well as from a portfolio diversification perspective. The most important benefits of SME securitization are for the SMEs themselves, and thus, potentially for economic growth. SME securitization could have a multiplier effect in the level of SME lending. As banks offload the loans, the same capital base could be used to generate additional loans. This Note focuses on true sale/funded securitizations. An alternative to them are “synthetic securitizations” 19 which combine traditional securitization techniques with credit derivatives. In this case the credit risk of a select- ed reference portfolio of loans (but not the loans themselves, which remain on the balance sheet of the originator) are transferred to a special purpose vehicle that places notes (Credit Linked Notes, CLNs), classified by risk cate- gories, in the capital market. Securitization of SME Loans 25 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs USE IN AEs The SBA securitization program has had a leading role in SME securitization in the United States. SBA issues SME loans have been securitized in the United States and securities which are backed by the guaranteed portion of Europe for many years. However, SME loan securitization loans given by lenders to small businesses. The securities remains a very small part of the overall securitization have the full faith and credit of the U.S. government. As a market, accounting for just 2 percent ($34bn) of US asset result they are very attractive to institutional investors. SBA backed securities outstanding, and 7 percent (€105 billion) volume in recent years has reached record levels in terms of of total European securitization outstanding. Furthermore, the total amount lent (loan volume exceeded US$ 19 billion partly on account of the contraction in European loan in 2014) and number of participants involved. Other SME growth, new issuance (i.e. capturing flows) has tailed off securitization is in its early stages, but is expected to further substantially in Europe since the peak of €90 billion in 2007 expand at a growing pace due to the participation of more (Figure 1). non-depository lenders in this space. Pre crisis Germany and Spain had the most active programs of SME securitization in Europe. The German Figure 1. Annual European SME SME securitization model was developed by KfW which Securitization Issuance acts as an intermediary, providing a centralized platform and defining the selection criteria of the loans. They are structured as synthetic securitizations, whereby only the credit risk is transferred. The originator retains a first loss piece while the remaining tranches are sold to investors. Securitizations in Spain are mostly true sale, and funded. SME loans are securitized via close-end funds which issued securities. The senior tranches have the guarantee of the Kingdom of Spain. In both cases pre-crisis the securities were bought by institutional investors. Post crisis Italy and peripheral countries such as Greece and Portugal became more active, although the volumes correspond to a very small number of underlying deals (BofA Merrill Lynch, 2014). The majority of deals were retained for Source: Association for Financial Markets in Europe, IMF Staff20 repo funding with the ECB. Synthetic securitization nearly disappeared, as the main motivation for structuring SME transactions was funding rather than capital enhancement needs. Data for 2014 are as at Q3, annualized. Sample includes countries in the euro area, UK, Russia and Turkey.. 18 26 Securitization of SME Loans FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs SME SECURITIZATION PROGRAMS IN AEs United States Spain The US Small Business Administration (SBA) was In 1998–1999, the Spanish government established created in 1953 to further the interests of the small the FTYMPE (Fondos de Titulizacion de Pequenas business community and to promote competition in the y Medianas Empresas), a program to facilitate SME marketplace. As part of its mission, the SBA, under securitization. The mechanics of the program are simple: Section 7(a) of the Small Business Act provides loans the Treasury commits to guarantee certain tranches of an and loan guarantees to small businesses. Based on such issuance of a securitization fund, provided that it holds authority, the SBA implemented a scheme that provides a in its portfolio a minimum percentage of bank loans to partial guarantee on almost $20 billion annually in loans SMEs. In return for the liquidity gained through the sale to small businesses. Businesses must be for-profit and of the SME loans, the originator commits to reinvest part meet the SBA’s definition of small. The maximum loan of this liquidity in SME financing. size is $5 million and the guarantee percentage ranges from 50% to 85%, averaging about 72%. Loans may The participating banks must sign an agreement with be used for machinery, equipment, working capital and the Minister of Economy and Finance; assuming certain real estate and typically have floating interest rates based commitments, in particular: (i) at least 50% of the assets on the Prime Rate or Libor. Tenors up to 25 years are transferred must be SME loans; (i) financial institutions available for real estate loans. transferring assets must reinvest at least 80% of the proceeds into new SME loans, and (iii) the reinvestment In 1985 the SBA started securitizing the guaranteed must take place within 2 years, with at least 50% portion of the loans; whereby the SBA issues securities happening in the first year. which are backed by multiple guaranteed portions of loans. In addition to the credit guarantee of the loans, For a portfolio of such characteristics, the Treasury the securities issued by SBA have a timely payment guarantees 80% of the securities with a rating of AA2 guarantee. Further, the securities have the full faith and or higher. If the funds required to repay at any point are credit of the U. S. Government. As a result, investors not available, the amount is paid by the Spanish treasury did not have to worry about payment or perform due until redemption. However, it would take at least three diligence on the creditworthiness of the borrowers or months for the government to fulfill this shortfall. As a lenders. This reduced the investor’s purchase costs and result, FTYMPE enters into an agreement with the bank encouraged more securities brokers to sell the product. for liquidity. At any given point, FTYMPE can raise As the loan scheme and securitization program grew, up to €13 million to fulfill the shortfall. The bank will many loan officers began to specialize in SBA lending. repay FTYMPE as soon as it receives the funds from the SBA continued to improve the efficiency of the program Spanish Treasury. The bank will sell its SME loans at par and delegated significant authority directly to lenders. to FTYMPE. To finance these loans, FTYMPE issues The program has continued to grow and loan volume notes in accordance with the ratings. At any point the exceeded $19 billion in 2014. originator as equity investor has to maintain a balance of 3.3% of the initial balance of the notes and 6.6% of The first securitization backed by the unguaranteed portion the notional payment or 1.5% of the outstanding balance, of SBA loans took place in 1992. It was only for loans whichever is higher. originated by non-banks, or non-depository lenders. In 1997, banks were allowed to securitize the unguaranteed As with Spanish securitization in general, multi- portion of the 7(a) loans. There is no government originators are common. Pre-crisis originating banks guarantee on these transactions. However, SBA required retained the higher risk equity tranches. Since 2008, that the lender retain some of the risk in the deal. The originating banks have retained the bulk of the senior amount of the retention was related to the performance tranches (on sharply reduced new issuance) to use as of the lenders portfolio. Overcollateralization was used collateral for refinancing from the ECB. Since 2000, as a credit enhancement. This process was mainly used €50,640 million have been issued, making it possible to as a financing tool by nonbanks lenders that did not have reinvest more than €40,512 million in new credits for a deposit base. SMEs. Though, volumes have declined since the crisis. Securitization of SME Loans 27 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs USE IN EMEs CHALLENGES TO SME SECURITIZATION IN EMEs The SME securitization market is at a nascent stage in EMEs. Securitization markets are still at a developmental SME securitization in EMEs faces a complex set of stage in most EMEs, although in the larger EMEs (such as challenges. A few challenges are more unique to EMEs, China and India) securitization has experienced considerable stemming mainly from the different state of development growth during the last decade. The SME segment is at an even of their securitization markets, and more generally earlier stage. SME securitization transactions have taken their fixed income markets compared to AEs. However, place in many EMEs, including for example Bangladesh21, some of them are directly related to the asset class and and Malaysia22, but in most cases they have been one-off therefore are common to both AEs and EMEs, although the challenges might be more pressing for EMEs. CHINA SME SECURITIZATION China’s securitization market has grown considerably Some of the loans being securitized are guaranteed over the last five years. From 2013 to 2014 securitization by a separate company under Alibaba. The additional activity grew from $3 billion to over $4 billion23. However, enhancement through the guarantee helps strengthen the the first SME securitization took place in 2013. It was credit profile of the transaction. part of Alibaba’s small business securitization program. Alibaba has been making small and micro business loans The structure is made up of 75% first senior tranche, 15% by taking advantage of its vast internet access. As of 2nd second senior tranche, and 10% of subordinated tranche. quarter 2013, it was reported that Alibaba has accumulated The subordinated tranche is retained by the financing more than 320,000 small and micro enterprises loans. subsidiary of Alibaba. The retention of the first loss piece There are a few interesting aspects of this securitization provides a strong incentive support to the transaction by program that are worth noting: the originator. Assets are replenishable over ten periods in the sense that The program was led by a securities Firm, Orient new loan assets can be purchased and securitized under Securities, which played the lead underwriter role, this same program as old ones are repaid and retired in although the program also received the collaborative each period. The expectation is to issue 200-500 mm support from a bank, insurance company and a trust yuan for each period totaling about 2-5 billion yuan for company. The structured debt is traded in the Shenzhen the entire program. Stock Exchange. Prior securitization programs in China were led by banks and listed in the interbank market. transactions. Only in a handful of the larger EMEs, such as • Challenges related to the underlying assets Korea and India, SME securitization has been used more consistently. In India, for example micro finance and SME • Lack of bankable SMEs: For many EMEs the lack securitizations reached 13% of total securitization activity in of bankable SMEs is the key challenge affecting 2013 and 16% in 2014. In China the first securitization of the development of SME securitization markets. SME loans took place just in 2013. However this transaction This stems from a complex set of issues, including is considered a milestone, both because of its revolving the level of informality and poor management of nature as well as for the interest that the Government of the companies, but also the lack of reliable and China is placing in SME securitization as a vehicle to fill the complete credit information on them. credit gap of SMEs. 21 BRAC issued a securitization backed by loans it made to micro borrowers. The transaction was completed in 2006 and, performed well. While this transaction seems successful, there does not appear to be any additional activity since then. 22 In 2007, a 600,000,000 Ringit (approx. $175Million U. S.) synthetic securitization of SME loans was closed by Maybank. Although the goal was to establish a model to finance SMEs, there was no evidence of follow on transactions. 23 Source: OECD. “SME Debt Financing beyond Bank Lending: The Role of Securitization, Bonds and Private Placements”, February 2015, pp 31-32. 28 Securitization of SME Loans FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs • Critical mass of loans at individual bank level: A • A clear definition of a retention requirement to insure second challenge, related to the first one, is the lack that the incentives driving the issuer are designed of a critical mass of SME loans at individual bank to provide optimum long term performance of the level to make the securitizations financially viable. transactions. The need for retention requirements Due to their complex nature, SME securitizations has been another key lesson from the crisis. are characterized by high costs; thus critical mass is needed to lower the costs. However, in many EMEs • A stable tax framework, which provides favorable individual banks do not possess large SME-pools. regulatory treatment to the transfer of assets, and clear guidance on the taxation of interest paid on • Heterogeneity of SME loans. SME loans are, securitized transactions. in principle, less homogenous than residential mortgages (with regard to size, legal forms, • Access to reliable trust services for payment and collateral etc.) and the underwriting criteria are less collateral handling. The trustee must have a good standardized. This makes it more difficult to assess financial standing and be extremely unlikely to default risk and potential recovery values. enter bankruptcy. • SME loan maturities. SME loans are typically • A cadre of professional accountants, auditors and short-dated and so not well suited to institutional attorneys with specialized expertise in securitization investors with long-term liabilities like pension and issues and credit rating agencies. insurance funds. • Challenges related to the legal and regulatory • Challenges related to the enabling environment for framework applicable to institutional investors: The securitization: The growth of securitization markets appetite of institutional investors for SME securitization in larger EMEs suggest that many of them might have instruments is largely influenced by the prudential managed to put in place the basic enabling environment framework applicable to them. In some EMEs, the rule- for securitization. However, in the remaining EMEs based investment frameworks applicable to pension securitization markets have experienced more limited funds are overly prescriptive and impose significant development. As a result, critical aspects of the enabling restrictions or even prohibit investment in “alternative environment which support securitization markets assets”, which depending on the country might include might not yet be fully in place or have not been fully asset backed securities. Further in many EMEs there tested. Those aspects relate to: are also minimum rating requirements that would create the need for credit enhancements. In some • A robust legal framework for securitization, with EMEs these limitations on eligible assets apply also to clear rules regarding eligible assets and robust insurance companies. Further, as EMEs progress in the special purpose vehicles that are bankruptcy remote. implementation of solvency frameworks for insurers • A stable regulatory framework that provides there would be the need to ensure that they are properly guidance to issuers and investors regarding exactly calibrated. For example, the capital charges under the how the securitization will be treated by banking EU Solvency II Directive for insurers investing in and securities regulators. This includes: securitization transactions are higher than those for other assets with comparable risks. Thus, there are concerns • whether a securitization is a true sale or a that this type of regulatory treatment might affect financing; investors’ appetite for these instruments. Initiatives • exactly how much capital is necessary to such as those in the EU to provide favorable regulatory support a lending portfolio if the assets are treatment to high quality securitizations could mitigate securitized; this type of challenge.24 • any restrictions regarding who may own a portion of the transaction or how much may be • Structural challenges: Finally there are elevated owned by one investor; upfront costs associated with securitization, which include setting up technology systems to handle data • A level of transparency that is satisfactory to issuers related to the underlying assets, and costs related to and investors. Overall, one of the key lessons from pooling, legal documentation, due diligence, credit the crisis is the need to ensure that investors are ratings and in some cases credit enhancements. given sufficiently granular information about the portfolio of assets and its performance (i.e. data at the individual loan level). See Aiyar, Shekhar et al. “Revitalizing Securitization for Small and Medium Enterprises in Europe”, International Monetary Fund Staff Discus- 24 sion Note SDN/15/07, May 2015 Securitization of SME Loans 29 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs LESSONS TO DEVELOP SME a robust framework for secured transactions is in place, as well as an appropriate insolvency regime, as detailed below. SECURITIZATION MARKETS IN EMEs In addition, experiences indicate the benefits of developing guarantee loan schemes. The SME asset class is riskier both In the majority of EMEs, but in particular the smaller due to the lack of credit information as well as the nature of ones, the development of a SME securitization market is the SME companies themselves. As a result, the existence of not a feasible proposition, at least in the short to medium a public guarantee program might become a critical element term. The lack of a sufficiently robust pipeline of bankable to align the risk appetite of banks and encourage them to SMEs prevents these markets from developing. Thus in such increase their SME lending (see box on experience of U.S.). jurisdictions the key to improving SME financing should However, it is important that those guarantee programs are focus more on measures to increase the availability of banking carefully designed to ensure their sustainability and that and asset backed lending, which in turn could have a positive proper management of contingent liabilities is in place. effect in SME securitization. Such measures mainly relate to improving the credit information available, ensuring that THE IMPORTANCE OF CREDIT INFRASTRUCTURE FOR SME FINANCING Credit information and only 20% movables. A crucial tool to better balance Credit reporting systems are an essential tool to address the assets SMEs possess with those that banks can accept the SME financing gap as they help to address the problem as collateral, is to reform the legal regime governing of asymmetry of information. While credit bureaus cover secured transactions and collateral registries. While real with a great level of granularity credit information for property is widely accepted as collateral for the extension consumers (individuals), they frequently do not provide of new loans, the use of movable collateral (such as information on SMEs. Credit insurers,  credit rating inventory, accounts receivable, IP rights, companies’ agencies, commercial credit reporting systems and credit shares, livestock, crops, equipment, and machinery) registries may serve as an alternative and provide inputs is restricted in many jurisdictions by non-existing or on SMEs to those parties that do provide financing. The outdated secured transactions laws and registries. Thus, benefits of CRS depend largely on the size of the SMEs. modernizing their secured transactions framework should For the smaller SMEs, which usually represent the bulk be a key priority for EMEs. of SMEs in a country, reform efforts should be oriented to allow non-traditional typologies of data to be shared with Reforms in this area could have transformational effects credit bureaus. These data includes for example data on in the MSME financing space, as recent examples payments to mobile telephone companies, utilities, and illustrate. In China, the introduction of the secured public data. In the past few years these data has proved transactions reform in 2007 helped to increase movable important to build a credit history for those who do not asset financing by 21 percent per year (by number) and have it (the “informal”, non-bankable, micro/SME). 24 percent per year (by volume) from 2008 to 2010, For the larger SMEs, CRS such as SME rating systems compared to no growth from 2006 to 2008. Further from would be a complementary source of information that the registry launch in 2008 to June 2011, more than could potentially be used also by capital markets as an USD $3.5 trillion was financed using movable assets additional tool to assess creditworthiness. pledges, of which over $1.09 trillion corresponded to SMEs loans. In Colombia, in less than one year more Collateral lending than 100,000 loans secured with movable collateral have The inability to use a firm’s most valuable assets as been registered in the movable collateral registry, of collateral is among the top reasons for difficulty in which 5,000 loans correspond to MSMEs, compared to a accessing finance. According to the World Bank’s few hundred loans for SMEs prior to the reform. Finally, Enterprise Surveys, assets owed by any given business developing modern secured transactions systems can be are typically 75% movables (inventory, equipment, farm cost efficient. In China, in the first three years after the products, accounts receivable and intangibles) and only reform was introduced, more than $400,000 of financing 25% are real property (land or buildings); conversely, was generated per every dollar invested into the project.25 collateral required by lenders is typically 80% real estate Source: IFC. “Small and Medium Enterprise Finance: New Findings, Trends and G/20/Global Partnership for Financial Inclusion Progress”, 25 2013. 30 Securitization of SME Loans FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs Insolvency Evidence from previous work in this area suggests that Implementing a robust insolvency system that promotes reforming an insolvency regime can help lower interest the reorganization of viable enterprises and gives honest rates, making credit more affordable especially for entrepreneurs a second chance is also critical to improve SMEs. For instance, research concluded that in Italy, SME’s access to finance. A reorganization-oriented the 2005 bankruptcy law reform that deeply reformed insolvency regime plays a crucial role in mitigating the liquidation procedure led to a decrease in interest investor and creditor risk, which in turn contributes to rates.26 In particular, firms with higher numbers of bank improved access to credit and lower cost of credit, as creditors saw the most pronounced reduction in interest well as to a more stable financial system. As a result of rates due to the enhanced coordination provided by the reorganization procedures, creditors are willing to extend bankruptcy law. In Brazil, a study of the 2005 bankruptcy more credit, debtors are provided an opportunity to stay law reform reported a statistically significant increase in in business and employees keep their jobs. the Brazilian private credit market. At the firm level, the authors reported a 10% to 17% increase in total debt and a 23% to 74% increase in long-term debt.27 For the larger EMEs, with the potential for a pipeline retention requirements. For the remaining EMEs the of SME loans, the development of SME securitization tasks ahead are broader. As a first step EMEs authorities markets is an option. should conduct an assessment of each of the elements identified above and determine the status in their The majority of EMEs did not face the reputational respective countries. problems that AEs did in connection with securitization. A key reason was the fact that securitization markets were • Guarantee programs: Guarantees can help to align at an earlier stage. Structures were simpler and business institutional investors’ appetite, in a similar fashion models such as the “originate to distribute” model had as for banks. In countries where public guarantee not yet developed. There were exceptions, particularly in programs already exist for individual loans, and where the larger EMEs, such as Mexico –which had developed a such programs have proven to be successful and housing finance model that shared some of the features of the sustainable, the key might lie in connecting existing US housing market—and Brazil. programs with capital markets (see the experiences of Spain, for example). Avoidance or at least reduction Yet there is a common concern about the need to ensure of moral hazard problem is critical. To address the that the securitization markets develop under a solid potential moral hazard problem, the roles of the public footing, with structures that are as simple, transparent, guarantee organizations should be clearly specified and and robust. In this context, EMEs that want to mobilize performance must be regularly evaluated and reported. institutional investors to invest in SME securitization, From a policy standpoint, such support should be would need to ensure that a robust framework is in place, conditional upon ensuring “additionality”, i.e. extending but also that the characteristics of the instruments are new loans to SMEs – so that SMEs effectively benefit aligned with the risk/return appetite of such investors. from the support given to the SME securitization The experience from AEs indicates that the latter will transactions. However, it is important that there be most probably require guarantees. In sum, reform efforts adequate management of contingent liabilities for the will likely need to address both supply and demand side government. To support the development of a healthy frictions if they are to mobilize capital toward the asset SME securitization market, the guarantee program class. should establish conditions for the loans themselves, the information to be given to investors and the structures • Enabling environment: The challenges and specific used, as further discussed below. steps necessary to address gaps in the enabling environment vary from country by country. In general, • Simple and transparent structures: The use of in larger EMEs any need for reforms would stem more plain vanilla structures, easy to understand should directly from the lessons from the crisis, in particular be another element of the guaranteed program (for the need to improve disclosure to investors and impose example no multiple securitizations like CDO of CDOs/CDO of ABS). Further, ongoing information, Source: Rodano, Giacomo at all. “The Causal Effect of Bankruptcy Law on the Cost of Finance”, March 2011. 26 Source: Araujo, Aloisio et all. “The Brazilian Bankruptcy Law Experience”, Journal of Corporate Finance, Elsevier, 2012. 27 Securitization of SME Loans 31 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS TO SME FINANCING IN EMEs in particular on loan performance should be given • Centralized platforms: The development of centralized to investors. The latter should be a condition for platforms and/or structures that allow the inclusion of public support, even if the securities are placed via loans from multiples originators would help address private placements. problems of critical mass at individual bank level. It is important to mention, however, that the creation of • Further standardization of SME loans: In line centralized platforms is a complex task. with existing proposals for other types of underlying assets, a healthy development of SME securitization • Capital charges: this is a task for AEs and EMEs should be accompanied by a definition of certain as well. There should be proper calibration of the minimum standards that SME loans would need prudential frameworks applicable to different types of to meet. Meeting such definition would be a key intermediaries, in particular such frameworks should element of the public guarantee program, as is the make proper distinctions between different asset classes case for the KfW. and/or tranches (i.e. high quality loans or senior tranches should in principle have a better capital treatment). This • Lengthening the duration of SME loans and thus will be key to aligning institutional investors’ appetite SME securitizations could make the asset class more for this product in EMEs. appealing for liability-driven institutional investors like defined benefit pension funds. However this might be a long-term goal. 32 Securitization of SME Loans FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs SME COVERED BONDS Simon Walley, Lead Financial Sector Expert, F&M GP with collaboration from Richard Kemmish, consultant. JANUARY 2016 DEFINITION Covered bonds are debt securities issued by a credit institution that are backed by a dynamic cover pool of high quality assets. Investors have double recourse to the issuer and to the cover pool, and thus the covered bond remains an on-balance sheet instrument. Issuers can be traditional deposit taking banks or in some cases specialized mortgage lending institutions primarily reliant on covered bonds for their funding. A key feature though is that the issuer has to be a regulated institution meeting minimum governance standards and capital adequacy requirements. In general, covered bonds are issued under a dedicated legal framework. The covered bond laws provide for minimum quality standards for the collateral, with loans in a cover pool having to be exchanged for performing assets should the original ones become impaired.28 The existence of such requirements provides investors with confidence that the bonds are issued in a uniform way and adhere to strict standards29. This in turn creates a pool of bonds which are broadly homogenous creating a deep and liquid secondary market which helps reduce overall funding costs. POTENTIAL BENEFITS Covered bonds have been a strategically important addition in the funding options available to financial institutions, in particular mortgage lenders in Europe. They have provided the market with a long term funding tool with cost efficient performance on the issuer’s side and a stable and safe long term, liquid investment on the investor’ side, contributing significantly to the creation of an efficient housing market. They also possess other advantages for investors. They usually come as bullet bonds, with less risk of adverse selection compared to securitizations. Investors usually receive bullet or simple amortizing structures, which are easier to understand and manage than securitizations. With the collateral still on the banks’ balance sheets, adverse selection and agency problems are lower than under securitization. Further, EU-based banks like their lower capital charges and preference they receive under the Liquidity Coverage Ratio (LCR). Insurance companies like the more lenient treatment that covered bonds receive under Solvency II compared to other private debt. 28 Covered bond collateral is not limited to the country of issuance. For instance, some German public sector cov- ered bonds contain Japanese public sector loans. 29 This feature has recently been taken a step further through the Covered Bond Label initiative which aims to have a broader international standard, creating a truly global pool of investable assets which investors can fund with confidence SME Covered Bonds 33 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs CURRENT USE IN AES AND EMEs managers owning about half outstanding covered bonds, with banks and broker-dealers owning another 33 percent of Covered bonds originated in Germany and Denmark, the outstanding issuance. The preferential treatment newer and have extended throughout Europe and are currently regulations (Basel III and Solvency II) afford to covered one of the key components of European capital markets. bonds should increase the share of banks and insurance firms With over EUR 2.58 Trillion outstanding at the end of 2013, in the investor base. covered bonds continue to play an essential role in bank funding strategies or the European banks, in particularly, USE FOR SMEs ASSETS from a mortgage market perspective30, the amount of outstanding mortgage covered bonds is equivalent to around There have been very few experiences with the use of 20% of outstanding residential mortgage loans in the EU. SME loans as the underlying assets for covered bonds. The EUR 695 billion issuance and arrival of 30 new issuers A key reason for this relates to the fact that SME loans are during 2011 evidence the ability of the asset class to provide not currently included as an eligible asset for purposes of essential access to long-term capital market funding. a preferential capital treatment in the corresponding EU There is growing worldwide appetite for the asset class regulations.31 Still, interesting experiences can be found in with market stakeholders having obtained, or pushing for, Germany and Italy. covered bond legislation in countries as diverse as Australia, Brazil, Canada, India, Japan, Mexico, Singapore, South In Germany, Commerzbank issued covered bonds Korea and the US. A key driver in this development is the backed by SME loans in 2013. However, the motivation fact that the asset class constitutes a long-term funding tool behind the structured SME covered bond program from which ensures lending to the real economy. Commerzbank had more to do with Commerzbank’s own situation having recently sold its pfandbrief entity, leaving The investor base of covered bonds has been dominated it with no other way to access the covered bond market. by investors who prefer ‘safe’ assets which trade with Since then Commerzbank has gained an issuing license for a positive spread to sovereign bonds. Up-to-date data mortgage pfandbrief in its own name. The rationale for the on the investor base are not available. A survey conducted issue in terms of funding was unclear given that neither the by the Association of Financial Markets in Europe of issuer nor the German mittlestand sector were struggling European covered bond investors from 2009 shows asset for liquidity at the time. This aside, the transaction provides 30 Eighty percent of covered bonds are mortgage covered bonds, the main part of the balance being public sector covered bonds 31 However the European Covered Bond Council (ECBC) has established a working group to explore the potential of Covered Bonds as a funding instrument for new collateral classes. 34 SME Covered Bonds FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs some helpful precedents for both structuring and pricing. In KEY CHALLENGES FOR THE addition, loans to SMEs are currently included in pfandbrief cover pools, in two different ways. Those that are secured DEVELOPMENT OF SME COVERED on real estate are eligible for mortgage pools, some of these BONDS IN EMEs even in residential pools, to the extent that the entrepreneur has put up their house as collateral and/or it is mixed use (flat From the structuring side above the shop) property. Secondly, some loans to SMEs are insured, in particular by KfW. As this is ultimately German • Critical mass of underlying assets: The funding government risk these loans are eligible for public sector advantage which covered bonds can offer over pfandbrief. alternative forms of long term finance is often marginal and is in part derived from the high level of liquidity in Most pragmatically, the Italians have copied their the instrument itself. This is achieved by regular issuance existing covered bond technology to create a parallel - which helps to drive an active secondary trading market. and crucially, separately branded product for SMEs. The A key challenge to the use of this instrument for SME so-called Obbligazioni Bancarie Collateralizzate (OBC) are financing in EMEs is that origination of the cover assets able to include a wide range of assets in their cover pools (SME loans) is often not sufficient to allow for large including SME loans, corporate bonds, commercial paper, volumes of issuance. This means that the liquidity shipping loans, lease and factoring receivables, as well as bonus associated with covered bonds cannot occur ABS tranches backed by the above assets. This is a work which weakens their competitive advantage versus in progress. One of the reasons for this approach may be more traditional funding methods. that Italy has a large SME sector together with an extremely sophisticated credit rating system for SMEs. With the • Capital charges: Because covered bonds are an on- right use of technology, this could potentially help create balance sheet asset, banks that raise funding this way a very transparent cover pool in terms of its risk profile. still bear the full capital charge associated with the loans However, those bonds are not subject to the same regulatory they are funding. Under the new Basel III framework, requirements and potential backing by the Italian central new capital charges will be introduced to reflect any bank as traditional covered bonds are. They also do not maturity mismatches in a bank’s balance sheet. This enjoy the same preferential rights under the EU’s banking will increase the cost of long term funding and potential and insurance regulations as bonds backed by mortgages, reduce the attractiveness of maintaining long term assets public sector, ship, or airplane debt do. on the balance sheet. Securitization which previously was a way of removing credit risk from balance sheets Turkey is one of the EMEs that has recently enacted until changes in global regulations, could again become covered bond legislation. A key feature of the Turkish a regulatory arbitrage tool used to manage liquidity covered bond framework is that it includes SME loans risk.33 as eligible assets.32 One bank has already made use of this framework and placed a few issuances in the market. The second issue worth considering is that under the Investors tended to be public sector entities and multilateral European Capital Requirements Directive covered development banks which may have a different, less bonds do benefit from a preferential capital treatment for commercial view of the ‘risk’ characteristics of the assets. the holders of the bonds. Given that a large proportion If the bonds were sold more widely on the general market of investors are banks subject to capital requirements, the fact that these covered bonds were from Turkey would it makes covered bonds an attractive investment which be the most important point in the pricing and credit analysis requires relatively low levels of regulatory capital due to making the asset class itself a secondary consideration. the low loss given default and probability of default used in the credit risk calculations. This feeds through to cost of the bonds and the margin charged over the risk free rate, making them more competitive versus other forms of funding. At present though, this treatment would not extend to bonds where the cover asset is SME loans. As Turkey is not yet bound by the EU Directives, the conformity with the ECBC definition of eligible assets has not been an issue of concern. 32 Responses to the European Commission Green Paper on Long-Term Financing of the European Economy, European Commission, January 33 2014 SME Covered Bonds 35 FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs • Cover Matching Principle: One of the core elements LESSONS: POSSIBLE AREAS FOR of a covered bond structure is the elimination of as much risk as possible by matching the cover pool FURTHER EXPLORATION characteristics to those of the bond. Housing finance • Creating a new instrument – One of the strengths of which uses long term (up to 30 year loans) on an the covered bond system is founded on the underlying amortizing basis, provides a good mirror for long term value in the ‘cover pool’. This is ensured through bonds although not a perfect one. Some systems such rigorous standards and regulations to ensure that it as the Danish Covered Bond model do aim for a perfect provides adequate cover throughout the life of the bond. mirror, but generally the bonds are issued for a shorter One of the key features of such regulations is precise period than the mortgage loans. This does create some definitions of eligible collateral. This helps to ensure mismatch issues and some refinancing risks. In terms of the heterogeneity of the cover pool, so that investors are maturity it is possible that SME loans which are unlikely comfortable with the asset quality without needing to do to be quite as long term as mortgage loans may actually extensive due diligence on the underlying asset such as offer a closer maturity match. However, SMEs loans in the case of a securitization. will have much less predictable repayment patterns and therefore difficult to mirror cash flows. This however A common argument against new asset classes being is not insurmountable and could in some cases create included in eligibility criteria for covered bonds will an advantage in terms of cash flows where on some be the quality dilution impact on the overall product. occasions traditional covered bonds can struggle. Limiting the types of assets and maintaining the utmost standards is deemed to have built a brand over centuries From the investors’ side which should be preserved. Any dilution would impact the whole covered bond family, reduce liquidity, increase • Piercing Sovereign ceiling? - In many regards the spreads, and reduce investor appetite for the product asset class is less important than the geography. The they know and trust. Therefore, including SME loans as sovereign risk would be the key determinant of pricing part of the eligible assets for covered bonds might not rather than the detailed characteristics of a particular be the right way to approach the issue. SME loan will structure. The bonds will be priced according to the have different repayment profiles, risk characteristics, local environment and risk rating almost regardless of structuring requirements to mortgage loans. the underlying portfolio, structuring, or safeguards such as cover pool monitors etc. So in that sense opening up Rather than trying to make SME fit the current template, the eligibility of cover assets to other collateral classes a more innovative approach should be considered using may not be a major issue. a new instrument which uses some of the undoubted qualities of covered bonds but also uses the benefits • Different investors’ needs – There are broadly two of SME finance loan assets to best advantage. The types of investors who might be interested in emerging Italian OBC is a good example of a new approach using market covered bonds – (i) traditional covered bond comparative advantages such as a good credit scoring investors looking for higher levels of return and (ii) system for SMEs. EMEs investors looking for returns but also managed risk. This latter group may be difficult to attract as • SME loans backed by real estate – In practice many covered bonds will not offer a substantial uptick versus loans to SMEs are actually already backed by real government debt, and in some cases may be negative. estate either in the form of the work premises or the Bank treasurers (in the EU) on the other hand will not living accommodation of a self-employed entrepreneur. invest as the bonds will not be HQLA for LCR purposes Certainly in many EMEs, any form of term financing under Basel III. has to be secured in some form. Using loans which have real estate collateral could provide suitable cover. The Local bond investors looking for alternatives to area which may require more work is on the cash flow government fixed income - In terms of developing local of the loans. Unlike a traditional amortizing mortgage, capital markets, local currency investors will not have a business may need greater flexibility in its credit with the same asset class prejudices and the government provisions for drawing down or repayment. Having can define covered bond eligibility however it likes such a credit facility backed by real estate collateral (if it chooses to put in place buy-side regulation). In could provide security for funding but will require some many EMEs, the options for institutional investors are analysis in terms of matching of cash flows of the loans really very limited. For fixed income there will be some versus payments to bond holders. government debt although it is not always traded, so having a new fixed income asset class could be very welcome, regardless of structuring issues. 36 SME Covered Bonds FIXED INCOME INSTRUMENTS TO MOBILIZE INSTITUTIONAL INVESTORS FOR SME FINANCING IN EMEs • Improved SME credit information systems – A major play a similar role to the National Housing Bank which difficulty in using SME loans as part of the cover pool acts as a mortgage liquidity facility. It is likely that some is the lack of good quality data on the credit risk for forms of public guarantee would be necessary but given the underlying loans. Improving credit scoring systems that the bonds would be backed by collateral in the form and availability of information could help remove some of loans, this may be a form of limited guarantee. of the risks reducing credit risk charges and increasing investor appetite. • SME Covered Bond Guarantee Facility – Another potential approach could be modelled on the way • SME Centralized Covered Bond Issuance Platform KfW underwrites certain bond issuances which can – Creating a pooled issuance platform can help create then be repackaged into Public Sector Covered Bonds. the necessary volume, reduce issuance costs and also This type of approach could be used for SME covered mutualize issuer counterparty risk. Issuance is no longer bonds. Such a guarantee facility could be established constrained at the institution level but is aggregated at as a partly commercial venture which would charge a the sector level. This has many benefits in terms of costs, premium for coverage, with part of the guarantee also logistics, risks and regulation. However, the creation provided by a public sector entity. This could be in the of such platforms is a complex task. As a hypothetical form of a national government or development bank, or example, an organization such as SIDBI in India could a regional/multi-lateral development institution SME Covered Bonds 37