The first half of 2022 resulted in a major reversal of capital markets activity in Europe and globally, characterised by significant socio-economic and geopolitical developments.
Inflationary pressures, exacerbated by the Russian invasion of Ukraine, combined with monetary tightening and fears of recession, have led to an increase in the cost of capital and created a climate of market uncertainty and volatility more generally.
These affect the financial markets, where there are signals of investment deceleration in the second half of 2022 and ongoing difficulties for private equity investors to exit their positions via Initial Public Offerings (IPOs).
The slow progress in the EU’s equity markets is reflected in the declining proportion of global equity market capitalisation of listed shares: EU domestic market capitalisation accounted for 10% of the world’s total in 2022, a decline from 18% in 2000.
This has been a result of a combination of factors, including an ongoing trend of company de-listings (from 7600 domestic listed companies in 2000 to 7200 in 2022), fewer IPOs (from an annual average of 370 in 2000-06 to an expected 100 in 2022), and most recently lower company valuations (price-to-earnings ratio of 12x in the euro area against 19x in the US and 17x in Asia).
In the meanwhile, the EU securitisation market has remained subdued, which contrasts with the medium-term growth in the United States, Australia, and China, and exhibits a larger contraction than that observed in Japan. In the EU, average annual securitisation issuance has declined by 10.9% compared to pre-pandemic averages.
This is combined with more limited NPL disposals: lower volumes of loan sales can be attributed in part to the sustained efforts of the banking sector to reduce stocks of non- performing loans (NPLs).
In opposition, risk capital investments via private markets in SMEs count new inflows and new peaks, with 34.3 bn€ in H1 2022, around 73% of the total pre-IPO investments registered in 2021.
So that, how the EU SMEs have been impacted by the general turmoil of the recent months on the financing side?
Total capital markets funding for EU Non-Financial Corporations (NFCs) during H1 2022 was the lowest since 2012, with firms instead relying on bank loan financing, with both bond and equity issuance falling sharply since 2020-2021. As of H1 2022, 9.4% of EU NFC funding was derived from capital markets sources, down from 14.1% in 2021 and 11.3% in 2019, pre-pandemic.
Consistent with trends in the US and the UK, the recapitalisation of EU corporates throughout 2020-2021, during which record volumes of primary market issuance were recorded in European capital markets, has abated during the first half of 2022 as EU capital markets issuance decreased 32% YoY (annualized) during H1 2022.
The reduction in EU capital markets issuance during the first six months of 2022 was driven by a decline in both equity issuance, of 68% YoY (annualised) and debt issuance, which decreased 21% YoY (annualised).
The drop in IPO issuance has occurred as EU economies face increased economic uncertainty as a result of increased energy prices and other inflationary pressures across the continent.
Furthermore, the record IPO volume issued during 2021FY was partially supported by deals which were delayed from 2020 as a result of the pandemic and associated lockdowns. Secondary offerings remain the dominant constituent of equity funding for EU NFCs, comprising 84% of total equity issuance in H1 2022, up from 54% during 2021.
Breakdown of EU market finance by category (YoY change %) – Source: Dealogic
Looking at the categories of financial markets, the Investment Grade (IG) bond markets have remained the most resilient category in terms of primary issuance across the EU capital markets funding as NFCs have issued 128 bn€ as of H1 2022, down 5% YoY (annualised) compared to 2021.
In nominal terms, High Yield (HY) bond issuance has fallen by the largest magnitude across capital markets, with volumes in H1 2022 down 67% YoY (annualised) and 2022FY issuance expected to be around 60 bn€ lower than the total amount issued during 2021.
The evolution of the price to access equity, debt and bank lending explains the recent dynamics in corporates’ funding mix. As shown on the chart, AFME estimates indicate that the cost of equity funding has increased circa 200bps for Euro Area NFCs over the last year, and the cost of market-based debt (estimated as coupons paid for 10Y corporate debt origination) has also increased.
Various factors may have contributed to the sharp increase in the cost of equity, both for the equity risk premia and the risk-free rate components: ongoing geopolitical tensions in Eastern Europe, supply chain issues holding back post-covid recovery process, and wider volatility and asset repricing.
The cost of debt has also risen on the back of surging inflation and monetary policy tightening.
Additionally, the chart does not encompass the early summer and autumn communications of interest rate increases by the Central Banks, that lead the cost of bank up to 4.0-4.5% as minimum spread applied to new loans and to floating rate mortgages.
Cost of equity, cost of market-based debt and cost of bank lending (%) – Source: Dealogic; Eikon
With this public market background, the private market funding sources continue to benefit EU NFCs with 50 bn€ of additional financing raised in private credit funds during 2021, representing around one tenth of total public markets issuance by non-financial corporations (469 bn€ in 2021).
Alongside its traditional role as a source of growth capital for SMEs looking to expand, the sector also acted as an important provider of much needed liquidity for SMEs and mid-market businesses during the Covid-19 pandemic: during 2022 the sector has again provided liquidity to businesses affected by higher inflation, increased energy costs and the broader turbulence these factors are causing in the economy.
Despite the heightened uncertainty in capital markets, the EU is still regarded as the market with the greatest near-medium term growth potential by global private credit managers. While capital invested in EU businesses by private credit funds has typically focused on EU SMEs based in more mature capital markets, the sector is increasingly broadening its footprint across the EU27.
Nonetheless, there are wide disparities in pre-IPO risk capital funding across jurisdictions: Estonia and Ireland lead in risk capital availability, predominantly driven by private equity and business angel investment. Among large Member States, Italy and Spain stand out as the countries with the highest potential to increase the presence of funding from risk capital sources. There is also sizeable difference between the EU and the UK, as 27% of UK SMEs funding has been sourced from risk capital sources compared with 6.8% on average for EU SMEs.
From a Capital Market Union (CMU) perspective, this is an important development for the EU as it represents a material enhancement to the financing options available to EU corporates in those markets while also providing EU investors with new means by which to support the EU economy and make an attractive return on their capital.
As EU reaches the advanced stages of the current legislative cycle, the call is on policymakers to give a high degree of priority to the advancement of the CMU project in its retail and wholesale market dimensions.
Current initiatives under discussion as part of the second CMU Action Plan and upcoming Commission proposals have the potential to deliver significant steps in the CMU journey: success ultimately depends on the quality of regulation and its effects in advancing the CMU objectives, and not the number of legislations adopted.
It is clear that the EU needs to continue to work towards significantly expanding and deepening its capital markets capacity. The strong case for the CMU in view of the capital mobilisations demanded by the green and digital transitions has been reinforced by the combined challenges arising from the recent geopolitical and macroeconomic developments in 2022 and the ongoing recovery from the Covid-19 pandemic.
The EU needs, more than ever, a strong and diversified financial system capable of effectively mobilising Europe’s deep pools of savings, supporting businesses of all sizes, promoting innovation and attracting leading global players.
Source: Afme, Dealogic, Bebeez, Eikon
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