Distressed debt: Opportunities in Europe

With Italy pledging €20 billion in state support for its troubled banking sector late last year, is Europe finally facing up to the scale of the problem confronting the region’s financial institutions?

As new accounting standards bite in the form of IFRS 9, forcing banks to recognise losses more quickly, there is speculation that non-performing loans may start to come onto the market. European Central Bank figures suggest there were €921 billion of NPLs held in ECB-supervised banks at the end of September 2016 – 6.4 percent of total loans and nearly 9 percent of the eurozone’s GDP.

For distressed debt investors, the prospect of banks unwinding these NPL portfolios presents an opportunity, but one that has so far largely failed to materialise. While some deals get done – AnaCap recently acquired a €177 million portfolio of performing and non-performing Italian SME loans from Barclays – they remain few and far between.

“We have been an active investor in distressed debt for many years now, but the last cycle has not quite met expectations,” says Peter Schwanitz, managing director at Portfolio Advisors. “There was a successful wave of distressed investing after the financial crisis, in 2007 and 2008, especially in NPLs in the UK, Ireland and Spain, but there’s been a lot less activity in distressed since.”

So could 2017 be the year these opportunities start flowing? A recent Debtwire survey conducted with Orrick and Greenhill found that 73 percent of distressed debt investors believed European restructurings would hit their peak this year (25 percent predicted 2018), with economic turmoil as the main driver behind this activity. Italy is expected to be at the helm of this new wave of restructuring activity, with nearly half of those surveyed ranking this as the top market for opportunity, although Spain is not far behind, with 32 percent of respondents putting it first.

Europe faces a number of geopolitical and economic headwinds that have the potential to trigger distress. The uncertain outcome of elections in France, the Netherlands and Germany is one factor, with the stability of the European project a potential casualty. Brexit, of course, has implications for the UK market, depending on how negotiations pan out, as do any trade deals struck by the new US administration. Meanwhile, low oil prices continue to provide distressed opportunities in oil and gas and adjacent areas.

And then there’s exchange rate fluctuations. “Retail is one area where companies are not only under pressure from structural change, but are also facing increased costs with a strong dollar and higher costs of raw materials, such as cotton,” says Ran Landmann, managing director at CVC Credit Partners. “The large, global players are getting stronger by the year, while many mid-sized local players are struggling to keep market share.”

Yet while there is some reason to believe distressed debt opportunities will flow through in 2017, many see highly optimistic projections as unrealistic. “The expectation of a significant increase in restructurings in Europe is puzzling,” says Stephen Phillips, partner at Orrick. “We are at the end of a very long credit cycle that must end at some point, but it’s hard to overemphasise how low the default rate is currently. Despite the general perception that we’re heading for a downturn, interest rates remain stubbornly low for the meantime. Default rates will stay at a low base as long as that is the case, absent some external shock to the economy.” S&P forecasts European default rates in the 12 months to June 2017 for speculative grade credit of just 1.8 percent, far lower than the US forecast of 5.6 percent.

The long period of low interest rates has also built in leeway for companies, suggesting that distressed situations may be more of a trickle than a flood over the short-term. “The raw material is very different this time around,” says Duncan Riefler, senior advisor at Arbour Partners. “While there may be high levels of leverage, the interest rate covenants on this are very low. If you borrow at 5 percent, it’s obviously far harder to get into trouble than if you had borrowed at 10 percent.”

And what about all those NPLs sitting on bank balance sheets? “The banks’ NPL stock is significant,” says Landmann, “but the normal triggers you might expect for a wave of sales have so far not moved substantial numbers of portfolios – many expected the oil price reduction last year to trigger sales, for example. Our focus therefore is on areas where there is fire – and there’s always a fire somewhere, whether that’s because of a more difficult economic environment, political upsets or because of disruptions to business models.”

Paul Burdell, group CEO of LCM Partners, is similarly sanguine about the prospects for NPL sales. “There are some forces that will impact banks, such as the adoption of IFRS 9,” he says, “and we will see more NPL portfolios on the market, but we’re not going to see a seismic shift. I rather think we’ll see a gradual unwinding.”

FUNDS OF FUNDS LEADING THE CHARGE
Distressed debt investors have their eye on the European market. While fundraising has been slow over the last two years – just one fund reached a close in 2016, according to PDI figures (IDeA Corporate Credit Recovery) – this year should see a boost. Indeed, while US investors took a step back for a couple of years, the signs are that they are looking over the pond. Apollo is believed to be raising a European distressed debt vehicle, Avenue Capital is raising a fund for stressed opportunities in the region and reports suggest Strategic Value Partners and Halcyon Capital Management are seeking more European opportunities.

Even though returns have not been stellar in recent years, there remains LP appetite for distressed debt investing. This is expected to be led largely by funds of funds, according to the Debtwire distressed debt survey, although insurance companies and pension funds will also be important investors. “There is some more interest in distressed strategies among LPs,” says Portfolio Advisors’ Peter Schwanitz. “This is a result of political and economic uncertainties as many are questioning where Europe stands right now. Many see it as a hedge, an insurance policy, in case things go wrong elsewhere.”

“People can raise money in the market today,” says Duncan Riefler at Arbour Partners. “The question is how successful they can be with a purely distressed strategy. Special situations may get a better hearing with LPs, although return targets are naturally lower – at around the low to mid-teens range.”

Many of the established names should raise capital with relative ease, but there is a question mark around new players. “LPs need to be highly selective in this market, as there is a lot of capital waiting to be deployed,” says Schwanitz. “They need to look at who really has access to dealflow and keep a close eye on strategy. We want to see players that are very familiar with specific markets because Europe is far from homogenous.”