Factoring in Germany

Despite growth in recent years, asset-based lending is still considerably less popular in Germany than in many other markets, such as the United Kingdom. But Terry Hannaway sees room for expansion in the German factoring market, and much potential in the growing Mittelstand class.

As one of the dominant economies in Euroland, the German market tends to feature strongly as a potential target market for a myriad of foreign business entrants and even more so when assessing the potential for asset-based lending (ABL). As a relatively immature market compared to, say, the United Kingdom and the United States, the growth possibilities are significant and, perhaps surprisingly, the current economic environment is supporting its development.

The German economic struggle is well documented. Earlier this year, the German Chancellor, Gerhard Shroeder, outlined a long-awaited programme of economic reforms aimed at reducing unemployment and stimulating the country’s stagnant economy. This came against a background of disappointing figures. Private consumption fell in 2002 for the first time since German unification and with higher oil prices, increasing unemployment, a volatile euro and higher food costs, depressed figures are expected this year too.

Combining a sharp decline in investment, a decrease of 5.9% in construction output and the largest decrease since 1993 in machine and equipment investment, it’s no surprise that domestic demand fell markedly for the second year running and imports fell for the first time since the 1993 recession. Without the bolster that domestic demand can provide, GDP increased by just 0.2% in 2002, the lowest since the 1993 recession and the second consecutive year of lower-than-potential GDP growth.

By contrast, exports performed relatively well in 2002 despite subdued global demand. This is put down to Germany’s reorientation towards the United Kingdom, Eastern European countries and China. In fact, net exports sustained GDP growth for the second consecutive year, though recent appreciation of the euro could undermine export performance to non-euro zone countries by the end of 2003.

However, with a GDP forecast of only 1% in 2003 and with unemployment still rising (exceeding 10% on average), economic reforms are timely in their attempt to catapult the German market back onto its growth trajectory. The chancellor’s reforms included a review of the social-welfare state, amended rules regarding unemployment benefits and a US$18.5bn injection into housing and public-works projects to create jobs. In addition, he has also given employers increased flexibility in hiring and firing, a move especially beneficial to small businesses taking on temporary workers.

So, in this context, how is the demand for ABL growing? As in other countries, the main asset category for ABL is debtor finance. The German factoring industry has seen a huge increase in turnover of 168% since 1997, representing a year-on-year growth of 11% over this time. Even though German factoring turnover is the fifth largest in Europe at EUR30.2bn, it only represents 18% of the UK volume in comparison. Equally, as a source of finance, German factoring turnover represented just 1.7% of GDP in 2001, compared to over 10% in the United Kingdom.

Factoring is focused predominantly on larger enterprises, those with a turnover greater than EUR50m. Dominated by 15 large players, mainly linked to banks, six competitors hold nearly 70% of the total market.

Room to grow

Despite recent growth trends prompted by active new-business development, as existing and new independent financial-services players realise the market potential and increased openness to alternative sources of finance, there is still huge capacity for expansion. At present, only 3,000 companies are using factoring, a mere 9% of the UK market, where over 33,500 companies utilise invoice finance. With nine out of ten companies in Germany defined as small or medium-sized enterprises, growth in recent years has been driven by this market’s search for the additional liquidity associated with factoring.

Alternative sources of finance, such as factoring and mezzanine finance, have fast become buzz words in Germany in the face of the much heralded Basel II accord, increasing trade-credit terms and the arrival of European financial-service providers, such as Enterprise Finance Europe, which specialise in this area.

Basel II is a risk-based capital-adequacy system designed to guard banks against unexpected losses from banking risks, including credit, market and operational risks. The Basel Committee on Banking Supervision – the body that regulates international banking – wants to apply these complex changes to the large international banks of the world’s leading economies from late 2006. The proposals on equity rules will force banks to review their credit policies and appetite for particular credit portfolios in an attempt to minimise equity burden.

The ensuing debate suggests that, in Germany, there is already evidence that Basel II is having an impact. A recent survey conducted by a German credit institute and analysed by SAP in a February 2003 article, ‘The Challenge of Raising Capital’, found that bank policies are already more refined and restrictive than they used to be.

Coupling this possible restricted credit availability from banks with increasing costs and competition and extended trade credit, managers are feeling the squeeze on business liquidity. Companies are being forced to draw on equity reserves to provide cash, leading to deterioration in the debt-equity ratio and reducing funds for investment in growth and acquisition. As this ratio is used to determine the credit rating provided by lending institutions, the worse it gets, the less likely traditional banking is to extend additional facilities. As a readily available, robust and managed source of finance, factoring releases the significant cash value caught up in trade debtors, bridging the gap caused by reduction in debt availability and allowing the business to minimise its draw on equity reserves.

Non-recourse factoring also includes insurance against debtor default – a factoring company purchasing a debt has to take full responsibility for that debt without recourse to tits client if it all goes wrong – and takes away the risk of non-payment, so providing protection in the face of economic uncertainty and increasing insolvencies. In 2002, with more than 37,000 business failures reported, the most since German reunification, and with a further 11% rise expected this year, more and more businesses are recognising the importance of this benefit.

The wider ABL proposition, including debtor finance, plant and machinery and stock finance, has so far not had the same profile in Germany as in Northern Europe and the United States. In the United Kingdom, ABL became more widespread in the 1990s, when large US lenders infiltrated the UK market with a different and powerful funding proposition, having been successful in developing a strong and active market in the United States for many years previously.

This increased product offering and a more sophisticated approach to ABL generated huge interest in the United Kingdom, and the sector now provides £104bn to 33,544 businesses, according to the UK-based Factors and Discounters Association. By far, the largest growth product in the United Kingdom has been invoice discounting. As a result, there are now 70 providers there, compared to around 20 in Germany.

Despite legislative restrictions around the assignment of invoices as security, dampening the potential of invoice discounting in Germany, the robust nature of factoring as a source of finance and openness to its use by a new and innovative management base has served to raise its popularity. Furthermore, new service companies, which unlike traditional manufacturing businesses do not have the same fixed-asset structure, are focusing on alternative sources of finance, such as ABL, in order to utilise assets available to fund growth, expansion, mergers, acquisitions and management buyouts.

Not just a last resort

Today’s environment is a challenging one. Difficult economic conditions, increasing insolvencies, poor demand and possible tightening of credit policies on the part of banks all contribute to the challenge of managing business cashflow to sustain and improve growth rates.

ABL offers the German marketplace a highly liquid and insured source of finance that is no longer in the realms of ‘lender of last resort’. An increasingly robust profile, positive endorsement by business users and the entrance of dynamic, fast and independent niche providers focused on the previously untapped ‘Mittelstand’ are all working to bolster this alternative into the mainstream. As a result, my advice is to watch this space!

Terry Hannaway is chief executive officer of Enterprise Finance Europe in Dublin.