Distressed debt & special situations report
The number of classic distressed opportunities in the market at any one time can be finite and episodic.
“The expectation in the traditional distressed market is to earn IRRs of 15-25 percent, or 1.75-2.5x money multiples, by buying the debt at a steep discount, converting the debt into equity, and then turning the company around,” says Jeffrey Griffiths, a principal in the London office of Campbell Lutyens & Co, the private equity advisory firm and placement agent. “But there are very few opportunities today to do that.” Many see opportunities in stressed and special situations investments offering returns in the low double digits, in addition to the periodic opportunities in distressed. PDI considers four areas within the broad field.
1. Niche sectors
The difficulty of understanding some forms of distressed debt also creates barriers to entry that benefits the few investors able to understand them.
Michael Murphy, co-head of the private fund group at Credit Suisse Asset Management in London, sees opportunities in niche areas that “may be out of favour at the moment with the banks”, such as lending against royalties, aircraft and ships. Kevin Naughton, his fellow co-head in New York, agrees.
“You have to understand the nuances of the shipping industry or the airline industry. These include the types of ship or aircraft, since some are more lucrative than others, and the nature of leases,” he says. Murphy adds: “There is a limited number of people that are really good at this, and that’s why it’s a niche area.”
Deutsche Bank and Commerzbank are both trying to sell their distressed shipping loan books, and several debt funds have acquired expertise in this industry, including Hayfin.
Observers think opportunities are likely to increase in 2018 and 2019 when a large amount of bonds and loans are due, with an estimated peak in maturity above $10 billion next year.
Ran Landmann, managing director at CVC Credit Partners in London, emphasises the importance of exercising discipline when considering niche areas, saying: “We don’t have a single shipping asset because we never felt confident enough to bid as high as the seller wanted – to be prudent, we always compensate for our lack of certainty by pricing in a margin of safety.” Other investors with specific expertise do not need to price in the same margin of safety for deals they know and like.
2. Roads less travelled
“In the US the coastal states are doing pretty well, but if you go to middle America’s second and third-tier cities, there’s still an opportunity to get access to companies with some level of stress,” says Peter Martenson of Eaton Partners.
“I’m talking about cities far from the coastal money centres where financial types are. If you can’t get a direct flight from one of our major coastal cities, it’s a city of opportunity.” Martenson cites Sioux Falls, South Dakota, as an example.
Michael Murphy of Credit Suisse suggests that some lenders prefer to look at businesses in the UK, Germany and Sweden, “given the creditor-friendly legal environment there”.
Some observers think this creates an opportunity in countries such as Italy that have less creditor-friendly environments, but many remain wary of the risks of doing business in such countries for precisely this reason. Murphy also says that non-sponsored transactions are “often less competitive”. In addition, “a lender can develop a close relationship with the issuer, offering a more customised financing solution agreeable to both parties”.
3. Bank sales
“In my mind, the only truly interesting opportunity set in special situation credit right now is in one area: the disposal of legacy non-core loans from European banks’ balance sheets,” says Anthony Robertson, head of the strategic value credit group at Cheyne Capital, the alternative asset manager, in London. “This window is narrowing, but there are still three or four years to exploit these opportunities, ahead of the implementation of Basel III rules in 2022.”
He explains that banks are keen to trim their loan books before this point – in addition to non-performing loans, banks are also disposing of sub-performing loans and other non-core performing loans, which also incur higher capital charges. Robertson sees opportunities in this strategy across Europe, including the UK, Spain, Italy and Germany.
Landmann thinks opportunities in buying bank loans could be higher this year than last due to a number of factors, including the fallout from Brexit in the UK and the introduction of a new international accounting rule, IFRS 9 Financial Instruments, requiring a bank to recognise likely future credit impairment at the time when its risk modelling process is applied. These may incentivise banks to sell stressed and distressed loans more quickly, because these loans burden the bank with higher capital charges at an earlier stage.
However, Griffiths of Campbell Lutyens thinks opportunities in buying non-performing loans from banks have diminished, and are unlikely to increase again until one or two years after the peak of the next recession. This is because banks often prefer to amend and extend loans to troubled borrowers for a period of time before disposing of them.
4. Uk stress
“Brexit has created more opportunities in stressed and distressed in the UK,” says Landmann of CVC. He notes the rise in inflation following the pound’s fall, which has hit retailers by squeezing consumer spending, and the fall in foreign investment, which has hit infrastructure. Landmann also says consumer confidence is lower because of uncertainty about the UK’s political future.
He notes that there are also causes of stress and distress that have nothing to do with Brexit. These include high commercial rents and business rates – a further burden on retailers, which are in any case beset across Europe by the growth of online shopping – and “razor-thin margins” on construction contracts, which played a role in the recent downfall of Carillion.
But although CVC has recently bought the debt of a UK construction and facility management firm, it has no UK retail debt, since it currently regards this sector as too crowded with stressed debt investors. Landmann thinks this makes the risk/return profile unattractive.
Martenson sees opportunities in UK commercial real estate, since banks have become more reluctant to refinance debt following a fall in prices. “UK real estate will still be one of the few cornerstones of global real estate, so now’s the time to get in,” he says.
Potential opportunities, where competition among debt investors is not too high, include small office buildings and second-tier boutique hotels with 25-35 rooms – generally speaking, deal sizes of £25 million-£50 million. n