Distressed debt: eye of the storm?

Banks stuck with substantial portfolios of under- or non-performing loans, under pressure to fix their balance sheets; companies (including some backed by private equity) struggling with debt burdens in the face of a widespread economic slowdown. For distressed investors, this really ought to be a perfect storm.

Investors certainly think so. LPs have been eagerly committing to distressed debt and restructuring-focused funds ever since the end of the boom years. In the period since 2007, managers have raised 109 distressed debt funds, garnering a total of $163 billion in commitments, according to Private Equity International research. Fundraising peaked in 2008, when 25 funds raised $51 billion. Last year, 22 funds raised a combined $29 billion. 

LP respondents to Coller Capital’s latest Global Private Equity Barometer survey still seem bullish. About two thirds of North American and Asia-Pacific LPs now invest in distressed debt, and just under 40 percent of European LPs. All told, 89 percent expected medium-term net returns of more than 11 percent.

So GPs and LPs alike appear to be sold on this sub-segment of the asset class. There’s clearly an abundance of capital. But where are all the deals?

Not enough defaults

At the end of 2011, the combined default rate in Europe stood at just 4.8 percent, according to ratings agency Standard & Poor’s. In fact, since peaking in mid-2009, default rates have actually been falling, with only a modest uptick at the end of last year.

“Surprisingly, default rates haven’t been that high on corporate debt,” observes Rory O’Neill, managing partner of TPG Credit Management, which has bought 14 pools of non-performing loans since the 2008 financial crisis. “Banks and CLOs are restructuring, but on the whole they’re amending and extending to avoid defaults. Because the rate is so low, there’s not much supply of defaulted corporate debt, so the pricing when loans do come to market is pretty competitive,” he adds.

Susan Long McAndrews, a partner at Pantheon and head of the firm’s North American fund investment activity, agrees. “There have been moments of technical corrections when managers have been able to deploy capital selectively over the last few years. But those moments are limited and fleeting,” she says.

Howard Marks, founder of longstanding distressed debt investor Oaktree Capital Management, thinks the holders of debt just haven’t felt sufficiently pressurized to offload it – even in the last year, as the macroeconomic news has got steadily worse.

“The deluge of asset sales that was expected nine months ago hasn’t materialized – the selling pressure hasn’t developed as buyers would have hoped,” he tells Private Equity International. “In Europe, the central bank has helped to recapitalise financial institutions, meaning those institutions haven’t been pushed to sell assets.”

Pricing is one of the main checks on deal activity at the moment, says John Sinik, founder and managing partner of Metric Capital Partners – and has been since2009. “There’s still a pretty material gap between the price at which banks are willing and able to sell, and the market clearing price. The appetite for banks to take a material capital impairment is limited; if banks sell loans at distressed prices, the capital loss they would incur would be significant.”

The net result, according to David Lamb, a partner and head of European investments at Vision Capital, is that the amount of capital raised is disproportionate to the market opportunity.

“For conventional distressed debt, way more capital has been raised than the opportunity suggests is appropriate. There is probably the opportunity to meet it in volume terms, but not if the sort of returns that had been promised are going to be delivered. Banks just aren’t quite as distressed as people think. Although there’s a sense that banks do want to refocus, I don’t think there’ll be any fire sales,” Lamb says.

Watching, waiting

Much of the focus has understandably been on Europe, where the economic and political problems seem particularly intractable. (One senior London-based private equity figure says he is constantly telling his US colleagues that the situation in Europe “really isn’t that bad”).

“Over in the US, private equity groups and hedge funds view the European distressed debt market as a real opportunity, particularly as the US market gets softer,” says Natasha Labovitz, a partner at law firm Debevoise & Plimpton based in New York. “Groups like Oaktree and Apollo have raised significant pools of capital targeting the European opportunity, and you have people like Christopher Flowers moving to London, saying it’s because Europe is where the action is.”
 
However, most people in Europe are still in ‘wait and see’ mode – and it’s partly due to the nature of the loans made at the height of the buyout boom. One senior London-based distressed debt fund manager told Private Equity International: “The crazy banks over here [in Europe] financed companies at stupidly low rates. They’re not making money from those loans, and the sponsors are on to such a good thing, they’re not willing to refinance as new debt would inevitably be much costlier.” 

Romain Cattet, a partner at debt consultancy Marlborough Partners, takes up this theme. “A lot of companies are currently performing OK; they’re not breaching covenants, and trading isn’t too bad. As a result, there’s no real impetus to refinance their loans. If a company is 5-6x leveraged, with very low rates and loose covenants, there’s just no incentive to refinance. Economically it wouldn’t be great, and it would be messy and complicated to do so. So for the moment, it’s basically a waiting game.”

Some firms have managed to transact in Europe, however. KKR Asset Management’s distressed debt and restructuring arm, for example, has had its busiest ever 12 months, according to Mubashir Mukadam, a director and head of the European special situations group.

Mukadam argues that periods of peak dealflow for distressed debt investors are actually some time after major corporate default events. “In the early 2000s, when Enron went bust, you had a massive catalyst for dealflow. But the best period to invest was actually two to three years after that, when a lot of debt came onto the market. Europe is a bank debt-led market, but those banks take time to react to economic circumstances and provisions,” he argues.

Cattet has also seen pockets of activity. “Sophisticated sponsors, particularly at the larger end of the spectrum, have generally been proactive at refinancing debt in their portfolios. If you have a great asset, you can get whatever you want, debt-wise. Take Pets At Home – they are paying less than 1 percent fee to their CLOs. With any other company, they’d want more than 2-2.5 percent. If you have a great credit and a brand name, people will kill themselves to bankroll it.”

What’s more, in the longer term, the banks will have to deleverage eventually. Besides, most are ill at ease being equity owners of companies, argues Vision Capital’s Lamb. “Looking at the banking sector in Europe, there are a lot of assets – several billion Euros-worth –where the banks are now equity owners, having initially been lenders. In retrospect, a lot of businesses were overleveraged before the crisis, and there have been many restructurings where the debt may still be too high. The problem is that most banks are not set up to be equity owners. There’s also the added problem now of capital adequacy issues.”

For a bank, owning and managing a business day-to-day is too time-consuming, Lamb says. “There’s the resource issue. A good leveraged finance banker can probably deal with about 40 different credits. A good equity guy, on the other hand, probably wouldn’t want more than four companies on his books; any more than that would grind you into the ground. Just maintaining the status quo will get you a return on your debt – but as equity owners, you need outperformance.”

In fact, he says: “As a result of the crisis, there’s never been a situation where so many assets are held by the wrong people.”

Delaying the inevitable

The ratings agencies are united in predicting a substantial problem on the horizon. Moody’s, for instance, predicted 25 percent of the €133 billion of European leveraged loans (spread across 254 companies) would default by 2015 – a proportion that could rise to as many as a half if economic factors combine to shut down the high yield bond market for extended periods, it said. 

Due to the proliferation of ‘amend-and-extend’ arrangements, 22 percent of the overall debt will now mature after 2015, compared to just 11 percent in last year’s equivalent report. This shows banks and sponsors alike are working hard to avoid having to write off loans.

“If banks had to provision on a mark-to-market basis, a lot of [them] would be insolvent,” argues KKR’s Mukadam. “So a lot just say: ‘Don’t worry about the covenant breaches, just amend and extend.’ The capital they have to hold against debt is much less than if they equitised those positions as they ought to.”

However, this may only be a short-term fix. “You can amend and extend for as long as you like, and hope things get better. But economies are not bouncing back as banks thought they would, and underperforming companies are having to restructure. Debt is maturing and liquidity is now becoming an issue, so banks have to make a decision.”

Tougher liquidity rules and new regulations may affect that decision, he suggests – assuming regulators actually police them properly.

However, others are sceptical about the likely impact of new regulation. “Basel III isn’t something that is going to be a ‘cliff’ event,” says John Davison, global head of SIG at RBS. “It’s been sensibly introduced so it brings about a change in behaviour rather than a sudden switch.

Even experts are unsure how the market will react. “From the banking perspective, we’ve yet to see exactly what effect Basel III will have. No-one really knows whether the expected wave of sell-offs will occur.”

Lighting the touch-paper

So what can unlock this market – and provide an outlet for all the capital being raised?

“There will need to be a big event to trigger a wave of sell-offs – a sovereign event, or significant corporate distress,” suggests Oaktree’s Marks. 

John Sinik agrees: “The big macro risks that people are well aware of may precipitate increased distressed opportunities – for example, further dislocation in the Greek or Spanish banking system.”

But even if this does happen, the deleveraging process is unlikely to be swift, argues Labovitz. “There is a lot of inventory at the banks that needs to be cleared. But the deleveraging that needs to occur is a 10 year process. Over in the US, they began that process earlier and so they’re further along the road.”

The sheer complexity of these deals can also act as a barrier, according to TPG’s O’Neill. “In theory, there’s a lot of competition for these loans. But in practice there’s a lot of talk and not much action. There aren’t that many groups with the expertise to do these transactions. It’s easy for New York-based firms to come over to London and say they’re going to do them, but the reality is a little different,” he says.

To that end, many firms have been hiring aggressively to supplement their teams – in particular, many US groups have brought in executives with knowledge of and experience in the European market. Europe has its own unique challenges – not least a plethora of different insolvency and restructuring regimes. So as one senior industry figure put it: “They’re going to need bigger teams.”

The good news, according to RBS’ Davison, is that confidence will increase as more deals get done. “A number of secondary debt sales have been completed now, including a couple of significant ones in the last year. These demonstrate that the vendor and acquirer can achieve their differing objectives and should breed confidence in this type of deal.” What’s more, that complexity might be attractive to many, says Labovitz – because “if you’re able to unpack that complexity, you could be looking at a great investment.”

Attitudes are also changing, according to O’Neill. “In the 1990s, the banks didn’t view selling non-performing loans as one of their options for reducing non-performing ratios,” he says. “Nowadays, it’s a much more accepted way to clean up the balance sheet; there’s less stigma attached. The other big difference now is the size of the problem – there are many more non-performing loans out there, and more banks affected.”

Steering clear of vultures

Most private equity firms operating in this space are quick to distance themselves from the more aggressive and opportunistic hedge funds that target distressed debt. 

“We manage long-term, locked-up capital,” says KKR’s Mukadam. “There are a lot of hedge funds that try to invest in European debt using quarterly money, which is super-dangerous. There’s an asset/ liability mismatch there with the type of money investors have provided and the nature of the asset itself. We take a long-term view. Some of these situations can take several years to sort out – the average European restructuring can take three to four years.”

The ability to bring several skillsets to the table is important too, he argues. “Companies in difficulty typically not only have financial difficulties but operational ones too. We don’t consider ourselves a distressed fund manager, but rather, a fund which helps companies with problems. People don’t want a distressed fund; they want a partner to help them through a difficult period. The modus operandi of some funds is to see how much they can gouge out of a struggling company. But companies don’t want to see a vulture on their doorstep,” he says.

Oaktree takes a similar approach, says Marks. “We’ve been here in Europe for about seven years. In that time, we’ve built relationships with financial institutions so they’ve come to realise what we can offer. We try not to be antagonistic, and to get the message across that distressed debt funds aren’t the cause of the problem. The cause is companies being loaded with too much debt, which eventually means there has to be a restructuring. That’s where we come in. We’re part of the solution, not the cause”

Perhaps the best news for GPs, however is that LPs still seem enthusiastic about the area – despite its failure to match the hype thus far.

Pantheon partner McAndrews says: “We’ve been interested in growing ourclients’ exposure to this segment of the asset class, but it’s an area where timing is more of an issue. We look for managers who have a record of investing during the right part of the cycle, and who have a number of different tools in their kit, so they’re able to put capital to work at different points.”

“Regarding return expectations, you may give up something in terms of the multiple with distressed debt. But with the right timing, IRRs should be similar to or possibly higher than traditional private equity. There’s got to be a big opportunity for distressed debt in Europe, but it still hasn’t fully materialised yet.”

“It is far from too late to find good investment opportunities,” insists Ian Jackson, a director in The Carlyle Group’s global distressed and corporate opportunities team. “We believe the best ones are yet to come. Patience is underrated in this market at the moment. We are now approaching a second phase to current financial and economic uncertainties, one that may provide investors like ourselves with far more ‘alpha’ oriented restructuring and turnaround opportunities than we have seen previously.”

But will distressed debt fund managers be able to deliver that alpha? Evidence suggests that for GPs with an appetite for complexity – and a healthy dollop of patience – there could be some spectacular bargains to be had in the next few years…