Friday letter: So much to do…

With the shock of the credit crisis still fresh in people’s minds, many wonder where the next jolt to the financial system may come from, but daren’t guess. For distressed investors, it’s in their interest to figure this out early, as the sooner they are in the vicinity, the richer the pickings.

There is no doubt that we are living in an unprecedented time in terms of credit. With very low volatility and yields at historic lows too, alternative markets promise attractive returns, and institutional investors are pouring their money in.

But with a shaky recovery, there are concerns that a correction in prices could be in the offing, with some saying as early as the second half of this year. How will this effect where distressed investors turn to next?

Even though market participants by and large agree the ship has sailed for distressed investing in Europe’s prime assets, there are certain investors whose activities are actually stepping up a gear.

As central banks prepare their balance sheets in preparation for tapering in the US and stress tests in Europe, 69 reserve managers who control $6.7 trillion in assets said they would be cutting their exposure to longer-term debt, according to a recent survey carried out by the Central Banking Publications and HSBC.

Following on from the deleveraging that has occurred in the UK and Ireland, more is set to continue, albeit to a less aggressive extent, in Spain and Italy. Even funds in Germany are starting to liquidate we’re told.

There’s been the spread tightening in Europe, and there are still sectors where this will continue, as at the lower end of the small-to mid-market and in the Asset Backed Securities sector.

And for the even more niche players in the alternative markets, some investors who have established themselves in Europe over the past number of years in preparation for deleveraging and refinancing are busier than ever, as dislocation in the European banking sector persists.

A report this week from INREV, the European association of private real estate funds, said that debt funds have become increasingly important in the European real estate market, with the UK by far the most popular country. In 2013, they raised a record amount of capital at €8.9 billion. Of this capital, about half of the funds have strategies which focus on senior and subordinated investments, with the bigger funds focused on non-senior debt.

Of course, other geographies are intriguing the distressed community as well. A report from Bloomberg this morning says distressed investors are looking to China, which would ring true. A report from Standard & Poor’s last week said that corporate debt in China has surpassed that in the US, at $14.2 trillion as at the end of 2013, compared to the US’s $13.1 trillion. It’s thought that at least $4 to $5 trillion of the country’s corporate debt is provided by private lenders.

As is well documented, China’s real estate sector could also be about to experience an increase in defaults, with many borrowers having over- extended themselves. This is an opportune time for distressed investors to ready themselves in the region. One example is Hong-Kong investor PAG, which has raised more than $800 million for its Asian Loan Fund II, which will invest in corporates and real estate. They are in talks with investors about raising a special situations fund.

As ever in the distressed business, the key to success with any relevant investment thesis will be to be in the right place at the right time, with capital available and ready to invest. Timing this market is notoriously difficult. But it seems clear that if deal flow is already strong, despite a relatively benign environment, imagine what well-positioned capital might be able to do once there’s been a correction. For investors looking for some counter-cyclical exposure, now seems a good time to place some bets.