Hungary: All change?

Author: | Published: 1 Jun 2011
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Hungarian companies, and in particular smaller businesses, have been heavily dependent on bank financing, partly because of the undercapitalisation that has generally characterised Hungarian business enterprises and partly stemming from the structure and practice of the Hungarian financial markets. The over-reliance of Hungarian businesses on bank loans appears to have been supported by a pre-crisis trend of unreasonably extensive use of bank financing even amongst those companies, which would otherwise have had the necessary financial resources for their business operations or projects.

At the same time, as a consequence of the global financial crisis, combined with the effects of a special transitional bank tax levied on the Hungarian banking sector, the past year has seen Hungarian banks adopting significantly more stringent lending policies. They are expected to further tighten lending standards, particularly in the corporate segment. This has in turn reduced the availability of credit and/or has resulted in extended collateral requirements and covenant packages, including increased loan-to-cost ratios. In addition, the implementation of the Basel III capital and liquidity standards might exert further constraints on lending volumes in the near future.

As the vast majority of Hungarian enterprises tend not to have sufficient (unencumbered) assets, liquid funds and/or financial resources to meet such tightened lending standards, or are not willing to assume the increased costs of bank financing, the resulting credit gap may drive them to seek funds directly from the capital markets. This could take the form of debt offerings, as an alternative to syndicated loan facilities (but without excessive collateral requirements), equity financing or the issuance of hybrid instruments.

A natural precondition for a move towards equity financing would be sufficient interest in equity investment and risk appetite on the part of investors.

Historically, equity investments were considered as significantly riskier assets than debt securities. The recent global financial crisis has, however, shed light on a pronounced increase in the risks of holding debt investments and exposed a considerable convergence between the risks associated with debt securities, particularly in the case of more structured instruments, and those attached to equity investments. The convergence between the risks associated with debt instruments and equity investments may make them interchangeable in the future, at least for a large group of institutional investors, who have the ability and are more willing to assume greater risks in the hope of higher return. This might particularly be the case with the Hungarian capital markets, as a growing body of research suggests that the central and eastern European region will lead the way to recovery and expansion among European economies and therefore has the potential for offering significant return on equity investments channelled to its financial markets.

Challenges and opportunities in the debt markets

Although the Hungarian debt capital market is sufficiently well-integrated into the global financial arena, Hungarian market practice is still not fully compatible with international market standards, in particular with respect to the documentation and the holding system of publicly-offered debt securities.

This primarily arises from the peculiarities of the Hungarian legislation on the primary capital market and the creation of securities issued for public circulation as set out in Act CXX of 2001 on capital markets (the Capital Markets Act), which lays down the legal framework for the Hungarian securities infrastructure and securities issuances.

As with the relevant legislative acts of a number of other jurisdictions, the Capital Markets Act has introduced certain requirements as to the form in which publicly-offered securities may be issued, primarily with a view to facilitating the issuance of book-entry securities and electronic settlement.

It should be noted, however, that the vast majority of the jurisdictions where such requirements apply have adopted the notion of book-entry securities within a wider meaning and do not distinguish between its two broad models, namely immobilisation and dematerialisation. In the case of book-entry securities, investors are not provided with, and do not hold, paper certificates. Securities and/or interests in securities are evidenced by way of book-entries in securities accounts held with intermediaries. The overwhelming majority of such holding systems are multi-tiered with the top tier consisting of national central securities depositaries (CSDs) or Euroclear and Clearstream, Luxembourg acting as international central securities depositaries (ICSDs). The next tier comprises entities that hold securities accounts with CSDs or ICSDs, commonly referred to as participants. These participants in turn provide securities accounts for a number of lower-tier intermediaries down to the lowest-tier intermediaries with which investors hold their securities accounts.

With immobilisation, securities, represented by paper certificates, still exist, but they do not move in the secondary market and are immobilised within the relevant settlement system. In most immobilisation systems, paper certificates, typically in the form of a single global certificate that represents or evidences all securities of the relevant issue, are held, at all times, on the top-tier by the relevant CSD or, as the case may be, ICSDs or a custodian acting for that CSD or the ICSDs. The CSD/ICSD in turn holds its interests in securities for participants. Participants hold their interests either for their own account or for the account of their own customers for which they maintain a securities account and so on down to investors.

Moreover, market practice in the international and in the most developed national capital markets (such as those in the US, Germany or Switzerland) is based on the concept of immobilisation rather than dematerialisation. In the eurobond markets, issues of eurobonds are, at least initially (and more frequently, throughout until maturity), represented by a bearer global note, which is held by a common depositary, acting for the two ICSDs, Euroclear and Clearstream, Luxembourg (in the case of the Classical Global Note structure, or by one of the ICSDs, in its capacity as common safekeeper (where the New Global Note arrangement is used).

The relevant provisos of the Hungarian Capital Markets Act, on the other hand, impose mandatory dematerialisation in respect of securities issued through public offerings in Hungary.

As a result, the current Hungarian market practice (before the Capital Markets Act came into force, immobilisation of securities was a recognised practice in the case of government debt securities) cannot accommodate international market standards with respect to the documentation and holding system of debt securities offered to the public, particularly in the retail segment.

All these necessitate Hungarian issuers, which intend to access the investor base of the international debt capital markets, conducting their public debt offerings separately in the domestic (primarily retail) capital markets and in the international capital markets (to institutional investors), which in turn significantly increases transaction costs. Apart from credit institutions, the Hungarian state and large companies (often subsidiaries of multinational groups), smaller corporate entities are not able to incur such high transaction costs, and therefore tend to be locked into the domestic debt capital markets.

At the same time, the relatively small size of the domestic debt capital market imposes significant constraints on the demand for bonds and plain vanilla debt securities, which tends to be fully soaked up by offerings of the Hungarian state, municipalities and credit institutions. As regards the market for corporate bonds, the past few years have seen this market segment being predominated by state-owned enterprises (such as the state railway company, MÁV) and a small group of big companies (the Hungarian oil company, MOL, for example), which suggests that there exists no sufficient demand to absorb the offerings of straight bonds by smaller corporations.

Hybrid securities: the way forward?

Size constraints and the lack of sufficient demand in the market for straight bonds could drive smaller companies towards the issuance of hybrid instruments, particularly convertible bonds. The use of such instruments may also enable synergies to be realised from combining the benefits of debt and equity financing.

Convertible bonds have a number of features that may make them favourable to issuers.

As the rate of interest payable on convertible bonds is usually lower than that payable on straight bonds with comparable terms and conditions, the issuance of such instruments offers the issuers an opportunity of raising funds at lower costs than through the use of traditional debt securities.

As with other bonds, the terms and conditions of convertible bonds can also confer a call option on the issuer and thereby the right to redeem such instruments before maturity if prevailing interest rates have moved considerably below the rate of interest payable on the convertible bonds. In the case of convertible bonds, such a call option may also give flexibility in the sense that it can provide a possibility of preventing stock dilution if the maintenance of the existing shareholding structure in the issuer becomes important in the light of future developments of the company or market conditions.

To the extent that the relevant issuer is interested in raising equity capital in circumstances where the prevailing market price for its shares is, or would be, too low, the issuance of convertible bonds, as a form of deferred equity financing, with a higher conversion price may enable the issuer to place its shares at a premium above the current market price.

As the conversion period normally falls on or around maturity under Hungarian convertible bonds, such deferred equity financing can also provide the possibility of preserving the status quo in respect of voting rights until a particular business strategy or project is implemented.

Convertible bonds may be attractive also to investors through the advantages of a debt security, which guarantees regular payments of interests, while providing investors with the opportunity to benefit from a rise in the price of the issuer's shares. This feature might be particularly appealing in the current circumstances, where recovery of the equity markets (and promising outlook) comes with uncertainties as to the performance of the real economy. If the outlook continues to be positive and stock prices rise further, investing in convertible bonds can offer the chance to reap, potentially, considerable benefits from their equity-component. Should things go wrong, convertibles may still, to a significant extent, provide protection against volatility in stock prices thanks to their debt component.

Subordinated bank debt

The recent financial crisis has led to a significant reduction in disposable income and thereby a significant decrease in savings levels and in the demand raised by retail investors in the domestic debt capital market. In addition, Hungary has transposed the latest amendment to the Capital Requirements Directive (CRD3) into national law, and now Hungarian banks face an even more stringent capital adequacy regime, which is expected to be further tightened as the implementation of Basel III goes ahead and in the light of the EC's proposal package (known as CRD 4) for new amendments to the EU capital adequacy framework.

The combined effects of these developments may push also credit institutions towards hybrid securities, primarily in the form of Tier 1 or Upper Tier 2 subordinated debt instruments.

Recent trends suggest that the European subordinated bank bond market is bouncing back and investors are increasingly interested in investing in such instruments. Further, the issuance of subordinated debt instruments might be an attractive alternative source of fund-raising also for insurance companies as the market has seen pick up in the demand for subordinated issuances from insurance companies.

As the Hungarian market for money market instruments is rather poorly developed and demand tends to be fully soaked up by treasury bills, direct fund-raising from the financial markets may still not be viable for those companies which primarily need short-term financing (such as retail gas provider companies, which look for funds mainly for financing short-term liabilities from supplies). For such companies, bank financing will likely remain an essential source of fund raising. A recent survey published by the National Bank of Hungary in respect of the lending practices of Hungarian banks in Q1 2011 finds an increase in the demand for short-term loans (see Senior loan officer survey on bank lending practices – Summary of the aggregate results of the survey for 2011 Q1 – May 2011). For larger corporations with predominantly short-term funding needs which are able to incur higher transaction costs, the establishment of a Euro Commercial Paper Programme in the international financial markets may nevertheless offer an alternative solution.

Private equity to take the lead

The Hungarian equity market has been dominated by large companies over the past decade. The low number of IPOs and the moderate levels of share public offerings by listed companies indicate that the domestic equity market is still not sufficiently liquid and therefore fund-raising through IPOs will remain a less significant source of alternative financing, at least for smaller corporations.

On the other hand, in terms of equity financing, the most important source for such companies with high growth potential or competitive products or services will likely be private equity. The scope for private equity financing might be further widened in the medium term in the light of the forthcoming adoption of the Alternative Investment Fund Managers Directive (final publication of which is expected during 2011, while EU member states will be expected to have transposed it into national law by mid 2013). The passporting regime envisaged under the Directive will enable fund managers (including managers of private equity funds) authorised in a member state to passport into any other member state to establish a branch or provide their services on a cross-border basis and, possibly, to have access to a deep pool of EU investors. The increased number of providers and private equity funds in the market and the (potentially) extended underlying investor base might facilitate a growth in the capital flows that are channelled to Hungary in the form of private equity.

Paradigm shift

In summary, recent trends in the Hungarian financial sector indicate that insufficient levels of available credit may make bank financing a less dominant source of funding in the future and may push business enterprises towards the capital markets. Indeed, the National Bank of Hungary survey found a decline in the demand for long-term loans in Q1 2011. The peculiarities of the Hungarian financial markets and infrastructure may also prompt a shift from debt to equity financing, primarily in the form of private equity, or to fundraising through the issuance of hybrid securities.

The conditions for this move seem to be present also on the investor side as the significant convergence between the risks associated with debt instruments and equity investments may drive institutional investors and, possibly, a considerable proportion of retail investors to choose stock, shares in investment funds or other forms of equity investments over debt securities.

All these may trigger a change in deep-rooted Hungarian fund-raising patterns towards more diversified practices and suggest that the Hungarian capital markets may offer a viable alternative solution for even smaller businesses to ease their credit starvation.

About the author

Dr Zoltán Martonyi is the managing partner of Martonyi Law Firm. Martonyi was a partner at Martonyi és Kajtár Baker & McKenzie, heading the banking, finance and securities practice group, before founding Martonyi Law Firm in 2008. He worked for Linklaters in London and Budapest from 2000 until 2004, and before that was an associate with Moquet Borde Szecskay in Budapest.

Martonyi exhibits solid expertise in both the Hungarian and the international banking and capital markets. His extensive practice includes project finance, capital markets (debt as well as equity), structured finance, syndicated lending, corporate restructuring, derivatives and securitisation. He is listed as one of the world’s leading capital markets, project finance and banking lawyers by IFLR.

He has been a lecturer in the Financial Law Department of ELTE since 2001, and lectured in European Post Graduate Studies at Pázmány Péter Tudományegyetem in 2005. He is a member of the board of directors of AEDBF Europe and an external member of the board of KDB Bank (Magyarország) since 2010.

Martonyi holds an LLM from Cornell Law School, New York, and a JD from Eötvös Lóránd University. He was admitted to the Bar in 2002. He speaks English, French and Hungarian.
Contact information

Dr Zoltán Martonyi
Martonyi Law Firm

Október 6.u.4.
1051 Budapest
Hungary

t: +36 1 999 0140
f: +36 1 267 6390
e:zoltan.martonyi@boltonmay.com
w:www.boltonmay.com


About the author

Dr Alexandra Papp is a partner at Martonyi Law Firm. Papp was a senior associate in the banking, finance and securities group of Baker & McKenzie in Budapest from 2004 to 2008. She now handles mainly capital markets matters and is involved in all sorts of debt/equity and hybrid securities issues, IPOs, structured finance transactions, repo and derivative transactions, and capital markets regulatory issues. She has gained significant expertise in other areas such as energy law issues and trading of emissions allowances, real estate issues, and company law.

She graduated from the Faculty of Law at Pázmány Péter Catholic University Budapest, and holds an LLM in Banking Law from the same university.

Papp is a member of the Hungarian branch of the European Association for Banking and Financial Law. She speaks English, German and Hungarian.
Contact information

Dr Alexandra Papp
Martonyi Law Firm

Október 6.u.4.
1051 Budapest
Hungary

t: +36 1 999 0140
f: +36 1 267 6390
e:alexandra.papp@boltonmay.com
w:www.boltonmay.com