German banks in mezzanine finance row

An unseemly row involving some of Germany's biggest banks is threatening to overshadow the development of the country's market for mezzanine finance.

According to Deutsche Bank and others, the market's leading product – HVB's Preferred Pooled Shares (Preps) – does not work as it should. HVB says that the criticism is an attempt to shake its grip on the market by rivals that are due to launch their own products this year.

"These attacks are being made for emotional reasons, not rational ones," says Thomas Göbel, HVB's Munich-based head of high-net-worth corporate customers. "We found a market segment that no-one else has."

Lars Schmidt-Ott, a managing director at Capital Efficiency Group (CEG), a Switzerland-based firm that structured the Preps platform for HVB, says that critics of Preps are making a fuss over nothing. "They're orchestrating a campaign to portray this as a bad product. It isn't. They're just frightened we're going to take their clients away."

This may sound like a petty squabble, but the stakes are high. One thing that all of the banks agree on is the huge potential of the mezzanine market, as demonstrated by the two Preps transactions completed last year. Using the platform – the first of its kind in Germany – 101 companies raised €865 million from capital markets investors, and HVB's Göbel says 20 of these companies were new customers for the bank. Now, other big German banks want a piece of the action, and the fight has turned nasty.

Companies who have already raised money via Preps, meanwhile, are furious that institutions including Deutsche Bank, HSH Nordbank and Landesbank Baden Württemberg (LBBW) are taking a negative stance towards the product. "I have a relationship with Deutsche. I'm a customer of HSH and LBBW too," says Dieter Schweininger, chief financial officer at Böwe-Systec, an Augsburg-based company that specialises in paper management systems. "I said to these guys, think about what you are doing. You can do what you want with your ratings, but if I end up with a worse rating solely because of Preps, you can forget about our relationship."

The dispute hinges on how banks regard Preps when calculating internal credit ratings for their corporate customers. HVB has marketed Preps as a form of equity – a virtuous form of financing in the eyes of credit analysts, because equity investors absorb the company's losses and have no claims in the event of default. Most German companies rely on debt finance instead, making bank analysts less likely to rate them highly. Under Basel II, that will translate into higher borrowing costs as banks use their internal ratings to work out how much capital needs to be set aside for a loan.

"German companies are coming under pressure because, relative to other countries, they have low equity ratios," says Joachim Schneegans, senior structurer at HSH Nordbank in Hamburg. A typical equity ratio for small and medium-sized enterprises (SME) is 15–20%, he says.

The new breed of mezzanine products aims to provide an alternative to bank debt by funnelling money from deep-pocketed capital markets investors to a pool of SME companies via a special-purpose vehicle (SPV). The SPV issues debt backed by the companies' cashflows and issuers get an injection of capital. To this extent, Preps and its budding rivals all look exactly the same, but different platforms use slightly different structural elements in a bid to ensure that the capital they provide to companies looks like equity – and Preps is being criticised for being too much like debt.

Stefan Boden, Deutsche Bank's Frankfurt-based head of structured finance for Germany, points out that Preps does not allow companies that run into cashflow problems to defer or delay interest payments – a feature known as a profit-dependent coupon. HSH echoes Deutsche's view. "Preps is structured like debt to a great extent. HSH, LBBW and Deutsche don't give any equity credit for corporates issuing this instrument because we think it is more like a loan than equity," says HSH's Schneegans.

This view is "complete nonsense", says CEG's Schmidt-Ott. He says that, in the event of default, Preps investors are at the end of the queue. "It is a deeply-subordinated, long-dated, unsecured claim. It was designed specifically to mitigate the risks faced by senior lenders." He argues that there's no need to incorporate features such as profit-dependent coupons. "It's like boasting that you've got five wheels on your car. You only need four."

Nevertheless, the mezzanine platforms that are in the pipeline (such as Deutsche's equiNotes, Commerzbank's CB MezzCAP, and SmartMezzanine, a partnership between HSH, LBBW and Hamburger Sparkasse) all make a concerted effort to include more equity-like structural elements.

HVB's Göbel says these tactics could backfire by making the notes less attractive to investors. "You have to answer some cashflow questions to get these transactions to the capital markets. You need a cashflow waterfall, which must be very clearly defined."

While the argument between the banks rumbles on, there is a very real danger that the market's growth will be stunted if companies believe they can't get the benefits being promised. HSH's Schneegans says: "We see a lot of confusion in the market about the equity characteristics of mezzanine products. We have some products that are regarded as equity and we have others with no equity credit at all."

Companies, meanwhile, are losing patience. "The banks are playing games," says Böwe-Systec's Schweininger. "They're basically saying if you use my product, it is equity. If you use someone else's, it is not equity."

Duncan Wood