This traditional German debt instrument is attracting international interest
The German Schuldschein has been used as a traditional private debt instrument by German small and mid-cap companies for decades. But it has attracted little attention from major corporates and international market players. After the public bond markets came to a standstill following the financial crisis in 2008, the Schuldschein market has seen growing participation from major corporates and international debt issuers and investors. The eurozone crisis further increased the interest of international investors in Schuldschein instruments, as it offers a way to avoid market volatility. Since then, the interest of international issuers and investors in Schuldschein instrument has grown steadily.
But the reputation of the Schuldschein has experienced some setbacks recently after the news of the defaults of Steinhoff and Carillion surfaced. These cases drew attention to a few features of the Schuldschein that may cause some headaches if an issuer faces financial distress.
What is a Schuldschein?
A Schuldschein is a unique German private debt instrument that can be described as a mix between a syndicated loan and a corporate bond. From a contractual point of view, a Schuldschein loan agreement is a regular bilateral loan agreement between the issuer and each investor.
In connection with the loan, an issuer's note called Schuldschein was traditionally issued. The Schuldschein usually constitutes a written confirmation by the issuer of having received certain loans. The purpose of such Schuldschein is to facilitate the enforcement of the debt. The Schuldschein may also be designed to constitute an acknowledgment of debt and, thus, to provide self-sufficient evidence of such debt. However, it is less common now to issue a separate Schuldschein. Instead, the cover page of a Schuldschein loan agreement is in the form of a Schuldschein or the Schuldschein loan agreement provides for wording confirming the receipt of the loans.
Typically, the Schuldschein is used as source of financing by issuers with long-term financing needs and as an investment by investors with a long-term investment objective. A Schuldschein can be structured across a wide range of loan amounts, usually between €10 million ($12.3 million) and €500 million, maturities, typically between two and 10 years, but occasionally up to 30 years, and coupon types, including fixed and floating rate tranches in the same placement. While the vast majority of Schuldschein instrument issues are euro loans, more recent transactions also included US dollar and British pound sterling tranches.
In contrast to bonds, Schuldschein instruments do not qualify as securities. Consequently, there is no legal requirement to prepare a prospectus in connection with the issuance of a Schuldschein, although bond-style marketing documentation and road show presentations are common for larger Schuldschein instrument issuances. A Schuldschein is not traded on a stock exchange and settled through a clearing system but is sold over-the-counter.
Usually, Schuldschein loans are unsecured. However, if required by investors, they can also be structured as secured or guaranteed loans.
The Schuldschein market
Historically, the Schuldschein was issued by German administrative or municipal authorities, banks and small and mid-cap companies. The domestic issuer base, however, expanded substantially during recent years, now also including major German corporates such as BMW, Daimler, Siemens, Deutsche Telekom, Porsche and Lufthansa.
The Schuldschein has also been increasingly used by international issuers, including sovereigns such as Italy, Spain, Poland, Belgium and Austria, and corporates from Switzerland, Finland, France, Austria, the Netherlands and the UK.
A Schuldschein loan is not traded on a stock exchange and settled through a clearing system but is sold over-the-counter
According to research of UniCredit, between 2011 and 2016, the portion of foreign issuers was estimated to be between 25% and 45%. In 2016, almost 50% of Schuldschein issuers were non-German corporates, according to an estimate of Scope Ratings.
The investor base, which originally mainly consisted of German insurance companies and banks, is becoming more and more international, including international investment funds. For instance, Steinhoff's Schuldschein was placed to more than 100 investors, most of which were from China (almost a quarter), Spain, Austria, Japan and France – only 12% of them were from Germany, according to the Association of German Public Banks. It is also believed that several institutions from Taiwan invested in Carillion's Schuldschein instrument. It is expected that due to Basel III regulations the investor base will further broaden internationally.
As regards the role of banks as arrangers and intermediaries, the Schuldschein market was for a long time the domain of German landesbanks. However, the broadened issuer and investor base has made the market more attractive for commercial banks, which usually act as arrangers or intermediaries in issuances targeting institutional investors.
One of the key advantages of a Schuldschein, as compared to bonds or syndicated loans, is its very lean and flexible documentation, as it is mainly regulated by the statutory rules of the German Civil Code (Bürgerliches Gesetzbuch).
From an issuer's perspective, a Schuldschein offers a number of advantages such as:
- access to capital markets funding while avoiding the level of disclosure and publicity usually required for the issuance of bonds;
- diversification of funding sources through extension of the investor base outside the issuer's core circle of banking partners, including multiple investors in one transaction that could otherwise only be reached through a bond issue or a syndicated loan;
- no formal rating requirements making the issuance of a Schuldschein an attractive alternative for small companies; and
- limited documentation and fewer formal requirements enable issuers to raise funding faster and at substantially lower costs as compared to bond issues and syndicated loans.
From an investor's perspective, the advantages of a Schuldschein include:
- The Schuldschein can be tailored to the needs of the investors and allow more flexibility with respect to key features, eg coupon rates, issue price and maturity. This also allows structured Schuldschein instruments.
- A traditional Schuldschein typically does not need to be marked-to-market under the German accounting and IFRS rules. This enables the investors holding a Schuldschein to avoid profit and loss volatility.
- Since 2007, Schuldschein is ECB-eligible if it meets certain criteria. This makes investing in a Schuldschein more interesting for banks.
As the cases of Steinhoff and Carillion show, Schuldschein instruments also come with some disadvantages compared to syndicated loans and bond issues.
A traditional Schuldschein agreement is only few pages long and sets out the principal amount of the loan, interest rate and payment dates, repayment, assignment provisions and governing law and jurisdiction
One of the broadly discussed issues relating to Schuldschein are the difficulties in connection with restructuring. Although more and more elements of syndicated loans are being migrated into a Schuldschein, the majority lenders concept is typically not. Where syndicated loans allow certain restructuring measures to be approved by majority lenders, the Schuldschein requires an agreement with each single investor. Usually, all lenders' consent for debt restructuring by way of reducing principal, interest or margin or extending the payment terms is required under syndicated loans and Schuldschein loans equally. But, for waivers or amendments supporting a restructuring that typically require the majority lenders' consent under a syndicated loan, the Schuldschein issuer will still be required to get all investors' consent.
A similar issue arises with respect to a default scenario. In contrast to syndicated loans, which typically require majority lenders' directions to cause the agent to accelerate the loan, each individual investor in a Schuldschein may accelerate on its own. Such individual acceleration rights, and the ability to potentially trigger cross-defaults under other financing arrangements of the issuer, give the investors a very comfortable position in restructuring negotiations.
Even outside of a restructuring or default scenario, the lack of a majority lenders concept may prove cumbersome if the issuer wishes to change its reporting standards, the covenant test dates or any other covenants under the Schuldschein.
Another downside of a Schuldschein is the limited secondary market. Investors tend to follow a buy-and-hold investment strategy so the liquidity of the Schuldschein market cannot be compared to the liquidity of the bond market. One additional obstacle for the secondary market is the need to physically deliver the Schuldschein, if it has been issued. However, the secondary market for Schuldschein gained momentum in recent years. This is supported by the arrangers of Schuldschein taking a market-making role.
As Schuldschein loans are not considered securities, the transfer of a Schuldschein loan follows the rules for transfer of regular loan receivables. Thus, a Schuldschein loan is usually transferred by way of assignment. These loans can be assigned as a whole or in part. Alternatively, Schuldschein loans can be transferred by way of assumption of contract, which has a similar effect to a novation under English law.
In the case of an assignment, the original investor remains the formal contract partner while the new investor will be authorised to exercise all rights under the Schuldschein loan agreement to the extent permissible by law. In the case of an assignment of contract, the original investor withdraws entirely from the agreement and is replaced by the new investor as contract party. The new investor assumes all investor obligations and is entitled to exercise all investor rights.
There are two ways for issuers to place a Schuldschein in the market. In both cases, the issuer will be supported by a bank which acts as arranger or intermediary and often takes the role of a paying agent. In the case of a direct placement, the bank only acts as intermediary while the actual Schuldschein loan agreement is executed directly by the issuer and the investor(s). The more common placement approach is the indirect placement, where the bank acts as arranger and originates the Schuldschein and then sells and transfers it to the investors.
The placement methods have different banking regulatory implications. As the Schuldschein loan is considered a regular loan, the investment in such loans by way of a direct placement would be considered banking business for purposes of German banking law and, thus, require a banking licence if conducted on a commercial scale. A banking licence is not required if the investor invests in the Schuldschein by way of indirect placement. The indirect placement is therefore the relevant option for foreign investors who do not maintain a German banking licence. Since Germany allowed German and European debt funds to extend loans to German companies without the requirement of a banking licence, investors may now also use a debt fund structure to directly invest in a Schuldschein.
Part of the appeal of the Schuldschein is the simplicity of the documentation. A traditional loan agreement only takes a few pages and mainly sets out the principal amount of the loan, interest rate, interest payment dates, repayment, assignment provisions and governing law and jurisdiction. Features usually known from syndicated loan agreements or bond issues such as extensive representations and warranties, covenants, including financial covenants and negative pledge covenants, events of default, early redemption and conditions precedents are rarely used in the traditional documentation as it is embedded in the legal framework of the German Civil Code.
Given the recent internationalisation of the Schuldschein market, the documentation tends to include more and more provisions that international market participants would expect in syndicated loan agreements or bond issues. Also, a structured Schuldschein has become increasingly popular. As a consequence, the size of the documentation is growing.
Additional documentation may be required for the engagement of the arranger and the paying agent and the transfer of the loans to the investors in the case of an indirect placement.
Placement phases and timeline
A typical Schuldschein transaction can be divided into three phases: the preparatory phase, the bookbuilding phase and the execution phase.
During the preparatory phase of between two and four weeks, the issuer engages an arranger and determines the key terms of the Schuldschein to be offered to the investors. At this time, the documentation and the marketing materials, eg credit report and company presentation, are prepared.
During the bookbuilding phase, the Schuldschein documentation and the marketing materials are made available to the investors. The bookbuilding phase may also include a road show or investor calls. The arranger will usually create an order book that will be open for up to six weeks.
After the order book has been closed and the final pricing has been fixed, the Schuldschein documentation will be executed and the loans will be settled. In case of an indirect placement method, the arranger will at the same time transfer the relevant share in the Schuldschein to the investors.
The overall placing process takes approximately 10 weeks.
Debevoise & Plimpton (Frankfurt)
|Philipp von Holst|
Debevoise & Plimpton (Frankfurt)