A recent PDI survey found that more than 90 percent of the investors said they would either increase their allocation to distressed strategies or keep it the same. The majority of respondents cited the UK’s vote to leave the European Union as a source for more opportunities in the future and hence their plan to increase their exposure to the high-risk end of the capital structure.
“Brexit will likely create more distress in Europe and therefore more interesting opportunities for investors, especially in the real estate sector where the effect might to be depress valuations,” says Matthias Unser, a partner at German-based investor Yielco, a firm that plans to increase its allocation to the strategy.
With many anticipating loans in the mid-market space to be sold off at bargain prices, it is worth asking to what extent is this a result of Brexit or the fact that we are in a more mature part of the credit cycle. Despite a slow year on the fundraising front, European funds and their US counterparts are sitting on huge amounts of dry powder with pressure to deploy and still find the handsome returns investors are seeking.
In their recent third quarter earnings calls, Fortress Investment Group and Oaktree Capital Management announced a deployment breather on the European front. “As the cycle continues on, we tend to be realistic about the returns that we’ll accept and very, very importantly not reach for a return and accept higher risk to obtain it,” said Jay Wintrob, chief executive of Oaktree.
But awaiting the next turn in the credit cycle might not prove to be the most fruitful strategy. One investor asks why, if the great big bank sell-off of underperforming assets did not take place during the good times, should we expect it to happen during the bad? With banks in greater need than before to secure their equity base, realising losses on non-performing loans may not be an option available to the most distressed banks.
For leading distressed funds, it may be time to refocus their attention on a different strategy if the banks aren’t willing to negotiate a turnaround approach. Turnaround approaches can be a difficult task compared with other methods, requiring a changing of governance in a borrower or a reduction of its staff, but the rewards are there if they are able to acquire companies at a knockdown price.
Still, the opportunities are there and investors are keen to take advantage.
“In the future, Brexit might lead to interesting opportunities in the UK, especially in less stable mid-market companies, with a relatively high percentage of non-UK customers,” says Peter Schwanitz, a managing director at Portfolio Advisors Zurich.
“There are good pricing opportunities in the distressed market globally in the absence of yield in the fixed income asset class. The US remains the epicentre of the non-bank lending industry and Europe, especially after the Brexit vote,” says a Middle Eastern investor.
In one of the year’s most notable commitments, the Pennsylvania Public School Employees’ Retirement System invested $200 million in Apollo’s European distressed fund strategy.
Some funds have had successes. Banks across southern Europe, or those with exposure to the southern market have been the target for a number of distressed, special situation fund strategies. KKR was recently tasked with managing a portfolio of non-performing loans valued at €1.2 billion from two of Greece’s largest financial institutions, Alpha Bank and Eurobank. In March, credit specialist AnaCap acquired small and medium-sized NPL books secured against commercial and residential properties valued in total at €2 billion from both GE Capital and the Royal Bank of Scotland.
In the quarter following the vote the UK’s vote for Brexit, the country posted 0.5 percent GDP growth. Consumer confidence remains stable amid a plunging pound. While it may be premature to suggest Brexit has had no adverse effect on the UK economy, it is fair to say the predicted gloom has not yet occurred.
Nevertheless, what Brexit means is so far unclear. At the recent Conservative Party conference, UK prime minister Theresa May said she would prioritise restricting the freedom of movement over membership of the single market. This may present a problem for mid-market businesses who rely on relaxed immigration laws or uninterrupted trading arrangements with European neighbours.
Political decisions have also an indirect impact on mid-market businesses. But Brexit may prove to be damaging in the long-term if an AIFMD passport is not secured in the upcoming negotiations. So is it time to price in political risk for such unexpected events when structuring loans in the US or the UK mid-market? One partner at a London-based law firm doesn’t think so.
“Brexit is a once in a lifetime event. How it affects businesses in the mid-market is something we need to measure on a sector by sector basis. It will be good for some areas and bad for others. However, in the US and UK market, there is deep liquidity and a market player is always looking to undercut a rival,” he says.
Across the Atlantic, however, political schisms have the possibility of occurring every four years. Many have equated the election of Donald Trump to the US presidency as similar to the Brexit earthquake. But while many businesses feared how an unpredictable figure such as Trump would work in such a powerful position, the market has generally shrugged off the result.
On the morning after it was announced, representatives of consultancy firm Duff & Phelps warned that while sponsors may seek renegotiations on prices, times of uncertainty can bring opportunity as buy-side mandates become increasingly available. The conclusion: there is not too much for mid-market businesses to worry about until his plans become clearer.
For now, as the industry awaits what a Trump presidency or post-Brexit Britain may mean in the long term, the old joke that German streets are paved with the skeletons of fund managers trying to prise loans at a favourable price from the banks still rings true.