To see signs of further trouble in store for European banks, look no further than Italy.
In the case of Monte dei Paschi di Siena – the oldest and third-largest bank in the country by commercial and retail assets – a €6.5 billion state bailout is being requested after it failed to raise funds on the market. At UniCredit, meanwhile, a €13 billion rights offer is in the works to enable the financial services giant’s turnaround plan.
At London-headquartered Alcentra, the sub-investment grade credit manager, these developments are being watched carefully. Describing Monte dei Paschi di Siena as the “poster child” for European banking’s debt problems, the firm’s chairman and chief executive, David Forbes-Nixon, estimates that the non-performing loan opportunity on the continent is potentially worth around $1 trillion. Although much of this opportunity lies in the future, he believes that the travails being seen in Italy – and the growing acknowledgement and transparency around such problems – are beginning to open the floodgates.
“Some banks have been creative in how they have marked assets, but that game is up and a lot of NPLs are beginning to come to market now. We’ve been shown over €25 billion in just the past six months,” says Forbes-Nixon. In his view, European banks have failed to admit the scale of the problem but will be forced to soon, if not already. In mid-December, UniCredit agreed to sell €17.7 billion of non-performing loans to US institutional investors Fortress and PIMCO – a move which drew plaudits for the firm’s new chief executive, Jean-Pierre Mustier, who was seen as taking decisive action unlike many others before him.
In an overview of its global capabilities published in the fourth quarter of last year, Alcentra identified the ingredients of a coming wave of European stress and distress, including increased market volatility, a late stage of the credit cycle, the amortisation of pre-crisis CLOs and record levels of CCC debt issuance, among other factors.
Forbes-Nixon contrasts the situation in Europe with that in the US, where problems have been more readily addressed. “Since the global financial crisis, the US has cut NPLs in half through QE, the TARP [Troubled Asset Relief Programme] and more realistic marking to market. NPLs in Europe are actually still increasing, and that’s unsustainable. For us, it adds up to a double-digit return opportunity in special situations, stressed and distressed.”
Targeting the opportunity in a significant way would take Alcentra into pools it has not heavily fished in the past. The business has a current bias towards senior secured loans, which account for around 56 percent of assets under management, while special situations and distressed are currently only around 1 percent – a small part of the firm’s alternative credit activities.
“Some banks have been creative in how they have market assets, but that game is up and a lot of NPLs are beginning to come to market now”
Forbes-Nixon is speaking at Alcentra’s London base at 10 Gresham Street, just around the corner from St Paul’s Cathedral, where he is seated alongside global chief investment officer and president, Paul Hatfield.
A leveraged and structured finance veteran, Forbes-Nixon started his career at Chemical Bank in 1987. He spent five years there before moving on to Bankers Trust. “I ran the European loan distribution business there and it was an exciting time as the markets were starting to re-open.”
In 1996, he set up a loan trading business at Barclays Capital and then, in 2000, went on to create Barclays Capital Asset Management (BCAM), which he bought in a management buyout in 2002 and rebranded the business Alcentra. “The vision was to build a global sub-investment grade credit manager which would be top tier, top quartile, have global reach, and deliver solutions to clients through a range of products,” Forbes-Nixon recalls.
At the time, Alcentra had $2 billion in assets under management across four collateralised loan obligations and 20 people – divided equally between the UK and US. The growth of the firm since then has been notable. Assets under management now stand at around $31 billion, with 131 professionals working out of its London headquarters as well as New York and Boston and representative offices in Singapore and Hong Kong.
Credit analysis at heart
More than 50 of these team members are credit analysts. “At our core, we are a fundamental credit analysis specialist,” says Forbes-Nixon. “The businesses we back have to have a reason to exist; they should have a competitive advantage with strong management and, most of all, we must be confident that we will be repaid.”
Alongside the management buyout and rapid growth of the business, a couple of other important milestones merit a mention. One was the 80 percent stake in the firm acquired by The Bank of New York (now BNY Mellon) for an undisclosed sum in 2006 (this has since become full ownership). The acquisition put to an end Alcentra’s plan to list on the London Stock Exchange, but gave it the backing of one of the world’s largest asset managers.
“We have a strong symbiotic relationship with BNY Mellon and they have allowed us to grow as an autonomous business,” says Forbes-Nixon. “We [the management team] run the business and decide the strategies. They help us with seed capital, distribution, regulation, risk and compliance.”
He adds: “They see a huge growth opportunity in Alcentra and give us enough seed capital to monetise that opportunity, particularly in providing 5 percent risk retention investments for new CLOs. In addition, we have significantly grown our institutional investor base, and today have over 300 investors from 30 countries across all of our strategies.”
The other significant evolution has been the firm’s broadening strategic focus. Four years ago, CLOs accounted for about 85 percent of the firm’s activities. Today, just 35 percent is CLO-focused, with the firm now an active player across senior loans, high yield bonds, direct lending in Europe and the US, structured credit, special situations and multi-strategy credit.
One of the biggest growth areas has been alternative credit strategies such as direct lending, special situations and structured credit, which now represent over a third of Alcentra’s AUM. “The banks are constrained in lending and we have a very busy team there helping to fill the lending gap,” says Hatfield, another longstanding industry veteran who joined Alcentra in 2003 and whose past employers have included the likes of Arthur Andersen, FennoScandia Bank, Deutsche Bank and Intermediate Capital Group. “Only 20 percent of financing for companies comes from banks in the US,” reflects Hatfield.
“There are BDCs, which receive tax incentives for lending, loan mutual funds and it’s easier to get bond issuances away. In Europe, there are far fewer alternative sources of capital. Pre-global financial crisis, over 80 percent of the financing was coming from banks.”
Adds Forbes-Nixon: “The European direct lending opportunity is much bigger than we thought it would be. Five years ago we were mandated by HM Treasury to raise a direct lending fund [the £200 million Business Finance Partnership] alongside three other investment managers. The size of the opportunity today is over $1 trillion, but sourcing and selectivity is key to success. We have backed 25 companies in the last year and that represents only a 5 percent hit rate relative to the total number of opportunities we’ve seen.”
Alcentra’s claims regarding the potential in areas such as NPLs and direct lending are made more forceful by having the apparent backing of limited partners. “Right now, the private debt product is resonating with sovereign wealth funds, pensions, endowments and insurance companies,” Forbes-Nixon asserts.
“We have ultra-low interest rates and investors have typically been allocated 50/50 equity/bonds and they are now getting real returns of 2-3 percent rather than the 6-8 percent they need. As a result, we’re seeing the biggest asset reallocation in 40 years and much of it is going into alternatives and indexed funds. Private debt can offer equity-type returns together with the downside protection and cash yield that comes from debt.”
Forbes-Nixon says the firm has seen strong appetite from pension funds – especially those based in the UK – for its European Direct Lending Fund II, which, according to market sources, had raised almost €2.5 billion by October 2016. “They are really seeing the attractiveness of private debt,” he says.
The firm’s previous European Direct Lending Fund closed in November 2014 on a more modest €850 million. It had delivered a gross IRR of 11.0 percent (8.92 percent net) as of 30 June 2016, according to Alcentra, at which point it was approximately 85 percent invested.
While some compelling investment themes make Europe a major focus for the firm at present, Hatfield points out that the US also still has its attractions. “We’re late in the cycle in the US but loans look attractive in a rising interest rate environment. High yield performs well (up 17.5 percent last year), returns from loans will go up in an improving economy and there is decent yield for the risk. You need to avoid energy and retail landmines and stay default free, which should be possible to achieve because those landmines have already been well flagged.”
Forbes-Nixon predicts that, over the next five to 10 years, capital will continue to rotate into private debt and he expects to see a handful of large firms become dominant. Unsurprisingly he views Alcentra as having the characteristics necessary to be part of that elite. “We have scale, reach, talent, track record and focus on being partners to our clients. We have always had a large number of investors but we’ve deepened the platform, raising capital from new sovereign funds and pensions and growing our relationships across the globe.”
He believes there are a number of reasons why the firm is well positioned. One is the credibility of members of the senior team, many of whom were previously investment banking big-hitters. For example, Jack Yang joined as head of Americas and business development in 2013 having earlier in his career spent eight years at Merrill Lynch, more recently as global head of leveraged finance products; while Graham Rainbow, Alcentra’s senior loan portfolio manager, was previously co-head of the leveraged syndicate desk at Barclays Capital.
“The banks are constrained in lending and we have a very busy team helping to fill the lending gap”
Forbes-Nixon also thinks the large team of experienced credit analysts is a strong differentiating factor in what he describes as a “stock picker’s market” given the volatility created by an array of ongoing and upcoming political factors such as the Trump presidency, the triggering of Article 50 by the UK, continental European elections, US rate rises and tensions in the Middle East and China.
The analysts cover a wide range of sectors including automotive, chemicals, food and beverage, healthcare and energy. They also cover by strategy, with seven focused on stressed/distressed, four on structured credit, 11 on European direct lending and six on US direct lending, according to Alcentra materials. “You need scale to see all the opportunities, so you can commit capital to the attractive ones and reject the sub-standard ones,” says Forbes-Nixon.
That process of sifting out the best from the rest will be regularly deployed if, as Alcentra suspects, the opportunity arising from European de-leveraging accelerates in the months and years ahead.
A class act
When David Forbes-Nixon struggled to find the right school for his disabled son, he decided to see if he could help deliver that school himself by setting up a foundation. In September last year the vision was delivered in the form of The Upper School for Stepping Stones at Undershaw in Hindhead, Surrey, above, catering for students with moderate physical and learning difficulties.
Undershaw is the former home of Sir Arthur Conan Doyle, creator of fictional detective Sherlock Holmes, and the place where he penned novels including The Hound of the Baskervilles. Forbes-Nixon says the previously derelict house “has been restored to its former glory”.
Brochures for the school back up his claim, with the house itself fully repaired and renovated and a new wing built which comprises state-of-the-art facilities such as a large hall, hydrotherapy pool, an arts and crafts room, science labs and a gym as well as 10 classrooms.
Forbes-Nixon was inspired to act by what he saw as a “paucity of UK schools delivering outstanding teaching to those with learning difficulties”. He says: “The goal is to provide a bespoke curriculum to give independence skills and allow the students to live out the best life stories that they can, and get as many as possible into jobs.”
Forbes-Nixon’s foundation has partnered with Think Forward, an educational coaching programme developed by the Impetus Private Equity Foundation, which has a strong track record in mentoring pupils from failing schools and getting them into jobs and higher education.
He believes that the model being developed and applied at Undershaw may eventually be rolled out across at least a dozen additional sites.