How has the recent volatility connected to Europe’s the US’ debt woes affected the private equity industry?
While dislocation typically implies a dysfunctional market environment, displacement in the financial markets can actually prove advantageous from an investor’s perspective. Case in point: the massive dislocation that has characterised the European credit markets for roughly the last two-and-a-half years. In fact, the complex ecosystem comprising businesses, banking and multiple regulatory regimes throughout Europe has conspired to produce lingering dislocations, with deeper penetration within the capital structure. This is particularly apparent where large and middle market companies are concerned, as the same banks that are now in trouble, together with structured credit products (CDOs and CLOs), were the main senior lenders.
As a result, the private equity industry has a unique opportunity to take part in the restructuring of European businesses that goes beyond the traditional strategies of distressed debt purchases, financial re-engineering and operational turnaround.
The abundance of investment opportunities in the distressed debt world – both US and European funds alike – might have been expected to produce a relatively short period of outsized returns. Indeed, this has been the case in the senior, publicly traded part of the market, where risk was mispriced for a brief period of time. Nonetheless, for those who more fully understand the longer term, geographic and strategic complexities of the opportunity set, and possess the appropriate combination of dry powder and dynamic allocation, a clearly defined opportunity for attractive returns exists.
What are some of those opportunities?
The private equity opportunity set as commonly conceived refers to three core strategies where distressed investing is concerned: distressed debt purchases, financial restructurings and operational turnarounds. Albeit less conventional, it is possible in today’s environment in Europe to enter the distressed capital structure of overleveraged companies, under non-control terms, and restructure loans that would otherwise be written down in the service of cleaning up bank balance sheets.
Executed quickly and efficiently, such a strategy requires replacing conventional approaches to asset allocation with a dynamic concept of portfolio construction that may have as much in common with capital structure arbitrage strategies associated with hedge funds as it does with traditional private equity strategies. While far from “new,” this kind of dynamic approach is conspicuous by its relative absence in private equity since it employs sector, geographic and industry screens rather than relying on “best-in-class” managers deploying capital in VC, buyout and other conventional silos in a wait-and-see approach.
The distinct market opportunity for distressed investment requires LPs to re-assess their own views of the function of private equity within their larger investment profiles. This is private equity seen as a fluid asset class, with investment decisions conditioned by knowledge of the macro environment combined with the ability to pinpoint wellsprings of value locked in distressed capital structures. To capitalise on these types of opportunities it is incumbent upon GPs to ask their LPs, “What do you want private equity to accomplish for you?” LPs must construct a portfolio-level solution that accomplishes this objective. We believe customised managed accounts will play a key role accessing this opportunity.
Where are deals coming from?
For a variety of reasons, US banks are feeding their distressed assets into the market relatively slowly, thereby keeping a clutch on supply. In contrast, banks in Europe are under significantly more pressure to divest. There are a number of reasons for this, including cross-ownership of sovereign bonds and higher capital reserve restrictions imposed by Basel III. The result is a growing number of forced sellers, particularly in the European mid-market, where the banks are more prevalent in debt capital structures.
There is also simply less capital pursuing distressed debt in Europe than in the US. Historically, the leading investors pursuing credit opportunities in the European market have been the proprietary trading desks of investment banks, which are now largely disbanded. Moreover, private equity managers who possess the right network and sourcing capabilities, as well as the expertise to focus on specific layers of the capital structure, are in relatively shorter supply in the EU than in the US. Ultimately, the cross-nation complexity of EU bankruptcy laws, which contain varying levels of friendliness to creditors, defines the opportunity in the European distressed debt market.
At a macro level, the eurozone’s combined GDP is predicted to grow at the slowest rate among the world’s largest economic regions, at 1.7 percent in 2011 and 2.0 percent in 2012. At a corporate level, companies are dealing with overlevered capital structures that were created in the boom markets of 2005-2007.
Are Asia’s fund managers sophisticated enough to begin to navigate US and European deal markets?
While depth of expertise and knowledge can naturally vary, a key question in Asia is, ‘Does the PE industry have the deal flow and the teams to dedicate resources to the opportunity?’ I think the answer to this question is generally no, which is why many PE firms are mostly focused on outsourcing these specialised strategies.
How are distressed assets in Europe and US being priced?
A lot depends on size. Many distressed opportunities can be very large and are priced and sold in big auctions.
Would Asian limited partners have the capital to go after these deals?
Leading Asian investors will have both the capital and access to participate in these deals. Typically they will do that by partnering with select GPs as co-investors. However the opportunity is also in the smaller end (i.e. unsecured consumer lending, or mid-market loans) and these will be harder to access remotely.