The Schuldschein instrument has become significantly more popular in recent years as European corporates search for less heavily-regulated products in an increasingly burdensome market.
What is Schuldschein?
A Schuldschein is a privately-placed, medium to long-term, unsecured debt governed by German law. In recent years, it has become an increasingly popular option for those beyond the Dach region (Germany, Austria and Switzerland).
“Originally, a Schuldschein was a very German, domestic instrument, typically used by German banks only,” says White & Case partner Karsten Wöckener. But corporates are increasingly taking an interest in the product.
For example, the German supermarket group Rewe entered the Schuldschein market in 2019, seeking €300 million ($330 million) to fund its acquisition of wholesaler Lekkerland.
As Wöckener says, Schuldschein has gradually become useful for a more diversified funding portfolio for corporates with a high credit quality.
“It’s nothing but a loan under German law,” he adds. “However, the more unique reasoning for its popularity is that the look and feel is very much that of a eurobond. If we look at it, aside from the fact that it’s a loan, it has hybrid elements.”
The product is somewhere between a syndicated loan, a privately-placed bond and a loan participation note. This status between bond and loan means that it draws the benefits of each, enjoying the flexibility of a loan with the lower cost of capital of a bond.
What makes it trustworthy to the financial community is that it is over 100 years old and enshrined in the German Civic Code Bürgerliches Gesetzbuch. The product comprises a loan agreement (a Schuldscheindarlehen or SSD) and a certificate of indebtedness: the actual Schuldschein.
“Schuldschein is a bilateral loan agreement with the potential for a large number of lenders,” says Sebastian Zank, corporate ratings executive director at Scope Ratings. He’s clear that it’s not a financial market instrument, adding: “I think it’s more comparable to a normal loan. A great advantage of it is that you do not have to book it on a mark-to-market basis. It remains on the loan book until maturity.”
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While there are structural similarities with securitisation, a Schuldschein is not considered a securitisation under local nor EU law. This means borrowers do not need to offer a prospectus.
In addition, while under the jurisdiction of German law, this has not stood in the way of international engagement. Typically, the Schuldschein agreement is drafted in German and English; sometimes even in a third local language of the borrower if required – meaning that unfamiliarity with the local language does not create a barrier to use.
What are the main benefits?
As Katie Kelly, senior director of market practice and regulatory policy at the International Capital Market Association (ICMA) points out, private placements such as Schuldschein are not subject to the same regulatory and market scrutiny as public offers.
“Listing is not always required, so it takes private placement out of the scope of the requirements of the EU’s Prospectus Regulation, which could be extremely onerous for the target issuers,” she says.
The documentation needed for Schuldschein is also significantly lighter and typically negotiated on a much smaller scale, often between the issuer and a handful of investors, rather than hundreds.
Because of this, the conditions and covenants are more bespoke and easier for the investors to monitor. Meanwhile, in the event of something going wrong – such as a covenant breach – there is an easier channel for communicating with the investors to address the situation, rather than automatic default. As a rating is not essential for private placement, issuers do not have to go through this process, which can be difficult.
“An SSD offers borrowers a new and diverse investor group, largely made up of international banks, who are asset-takers and not looking for relationships and ancillary business,” says Richard Waddington, head of syndication and sales at Commerzbank.
Waddington pointed out that it is often used as a first approach to the international capital markets for borrowers who have traditionally been reliant on loans and are looking to diversify their funding sources, but perhaps isn't yet ready to issue a bond.
“Volumes can be below bond benchmark requirements, although we also see some sizeable deals now and no rating is needed,” he continues. An SSD means a borrower can raise funding in one issue via a range of different tenors, interest structures and currencies. Deals can really be tailormade.
Waddington also pointed out that a big plus for borrowers is that a floating rate SSD can be prepaid if required. “The product is not listed, has no formal prospectus, and is generally a lower cost product to issue than a regulated bond with all the associated costs,” he says.
His thoughts on costs were echoed by others in the banking community.
"Regardless of an issuer’s rating, the costs for third parties are much lower in the Schuldschein market," said Michael Bures, head of DCM corporates at Raiffeisen Bank International. "As there is no prospectus requirement, lawyer costs and legal opinion are much cheaper. Moreover, there is no comfort letter required."
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What are the risks?
“The biggest risk for the market at the moment is the fact it has grown so quickly out of the DACH region,” says Martin Strohmeier, fixed income analyst German bank NORD L/B. “Since the shift into eastern Europe and then elsewhere, companies beyond the DACH region are now using it as a financing diversification, shifting from the traditional issuer and investor base. We’ve seen recently that it has come out of the investment space, migrating more and more into high yield.”
As Strohmeier indicates, newfound reach also delivers newfound problems.
“The instrument’s growing popularity means more issuers – such as non-rated and often rather small companies where investors have limited transparency on the issuer – are realising that they can take advantage,” says Zank. “We have observed a few defaults and selective defaults with debt restructurings over the past few years.”
British firm Carillion, for instance, went bankrupt less than a year after raising around $155 million on the Schuldschein market.
“If this continues, we could end up with the reputation of the product declining,” he says.
Wöckener adds: “Warnings have been issued due to insolvent companies who have entered into transactions. I don’t follow these views. It’s a debt instrument. The credit risk of a borrower or issuer applies to all debt instruments. The ways of restructuring a debt instrument might be very different though.”
Zank says that while there have been issues, he thinks the market is still able to regulate itself, and that the underlying regulatory framework is sufficient.
“In the end, it’s the investors who invest consciously,” he says. “If they’ve not undertaken analysis properly, or monitored, they have to justify the investment. In addition, arrangers who usually seriously take their responsibility as gatekeepers to the market simply have to stick to very general rules, and there is lots of experience in the market.”
Regardless, Zank raises the issue that loan documentation often doesn’t address how to move forward in the case of a debt restructuring.
“For Schuldschein, you need 100% lender agreement on restructurings,” he continues. “If there are excessive lenders, and everyone’s opinions differ about how a loan should be restructured, it risks being the case that it can’t be restructured anymore and goes into default.”
This is a peculiarity of the instrument, and it’s important because of defaults and selective defaults. “However, due to the increase in these instances, it has also become well known to investors who are engaging,” he says.
What’s currently happening in the market?
“Over the past five years, the main development of the product we have seen has been the material growth in the use of the product outside of Germany as it has been adopted by a broad range of non-German issuers and investors,” says Penny Smith, head of private debt origination, western Europe at Commerzbank. “It’s fair to say that SSD has become the pan-European private placement product of choice for investment grade and crossover companies.”
The changing face of Schuldschein
However, while SSD has grown significantly beyond its traditional German base and is now pan-European with circa €30 billion of issuance in 2019, Smith and Waddington do not think it will ever be viewed as a global product.
The instrument has however been celebrated in the digital space. “Digitisation has allowed SMEs into the market and they are able to use digital platforms, which are quicker and more efficient than the traditional route,” says Strohmeier. “Due to digitisation, we observed that SMEs are using the market in an opportunistic manner, such as issuing Schuldschein more than once per year, which is new.”
This had not been anticipated. “We expect that this must be happening due to increased SME experience with digital platforms, which they feel more comfortable tapping,” he continues. “This has been a remarkable turning point for the Schuldschein market that has contributed, among other factors, to the increase in issuance volume and deals per year.”
The Schuldschein market has also been of benefit to sustainable finance.
“It’s a very flexible product and can be adapted for both green and ESG issuances,” says Smith. “Similar to the growth of green and sustainable loans, we saw a material increase in green and ESG SSD issuance in 2019, and we expect that to continue this year.”
Last year, Spanish bank BBVA negotiated a €220 million sustainable Schuldschein for the Madrid government, using blockchain and ICMA’s green bond principles for the debt structuring.
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“Lean documentation makes it easy to include another paragraph that refers to ESG KPIs,” says Zank. While 2020 has only just begun, he has already seen deals with ESG elements, such as a new issues from Faber-Castell, Verbundnetz Gas and Voith.
“When looking at the progress made in the last few years, I think it is likely we will see plenty more sustainability-linked Schuldschein deals coming to the market,” he summarised.