Ignacio de la Torre. Professor. IE Business School
8 June 2010
The credit crunch could go on for years. That’s why alternative funding is on the rise, and it looks like it is here to stay.
In 2009 more European companies financed their businesses using bonds rather than banks. This has never happened before, so what’s going on? The current situation means that banks are having to clean up their balance sheets, build up equity and write off toxic assets, which makes it difficult for them to offer companies competitive interest rates. Plus, Basel III will penalize bank loans to companies, which further exacerbates the current liquidity crunch. This scenario has forced companies to do their homework and to seek alternative sources of funding for expansion.
What is alternative financing? It’s the kind that does not depend on the banks. Traditionally, risk capital has played a major role in financing companies undergoing growth. It is normally broken down into two types: venture capital, which finances startups (often technology-related businesses) and private equity, which is generally used by more mature companies with a lower growth rate and a higher debt volume.
Nevertheless, demand for alternative financing is gaining speed in the capital markets. Investors in capital markets demand coherent and attractive business plans, a tolerable risk level, reasonable corporate governance measures, sound strategy and a solid management team.
More specifically, there are different ways in which alternative financing may be obtained, for example through bonds with a credit rating, known as “investment grade”, awarded by one of the three agencies that make up the rating oligopoly, or through “high yield” bonds, with a rating below the investment grade previously called “junk”. Also, companies may issue not-yet rated bonds that will be rated within an established time frame, or issue bonds that are convertible into stock. Alternatively, they may seek funding through the stock market, either in the continuous market through a capital increase, or in the alternative equity trading market. In my opinion, using the continuous market for funding is efficient for companies with a size (market cap) of at least 400 million Euros. Smaller companies should opt for the alternative equity markets, such as the MAB in Spain. Currently, the European IPO rate is growing annually by 400%, with 63% of that activity taking place in alternative markets, such as the MAB in Spain, Alternext in France, AIM in the UK and First North in Sweden.
This kind of financing is feasible because there are both attractive entrepreneurial projects as well as the capital to finance them. This year, more than 50,000 million Euros have flowed into European equity funds, and investors’ appetite for risk as measured in terms of volatility has peaked. The VIX volatility index has reached 16%-17%, down from 80%. (The lower the index, the higher the risk appetite.)
We have recently witnessed truly original forms of alternative financing, such as the breakthrough of Islamic financing, with assets totaling more than 800,000 million Dollars, making it ideal for projects in fields like renewable energy or infrastructure. Islamic bonds called “sukuks”, which gave us the word “check”, have made financing possible for a number of projects in Malaysia and the Gulf region, and are now slowly expanding into new geographic regions. General Electric, for example, has recently issued a sukuk of 200 million Dollars.
Is this science fiction? Apparently not. In recent months we have seen companies like Abengoa issuing unrated bonds, Pescanova announcing the issuance of convertibles, Imaginarium raising capital in alternative markets, and Renovalia trying to do the same in the continuous market.
Alternative financing is here to stay.