When it comes to NPLs and other opportunities presented by bank deleveraging – selling assets to boost capital ratios – “Italy is the most exciting but also the most terrifying opportunity of all,” says a senior executive at a large debt fund manager mulling the market in Italian NPLs.
The plight of Monte dei Paschi di Siena, which received a €20 billion rescue package last December, is the tip of the iceberg. Italian banks have €200 billion of non-performing loans, says Luca Olivieri, Milan-based director in restructuring services at Deloitte, the professional services firm. To this should be added another €150 billion that are unlikely to be repaid or are past the due payment date. This makes it, he says, “by far the largest non-performing loan market in Europe”.
In the past, investors complained that the market was large in theory but frustratingly small in practice. Banks in the UK, Ireland and Germany were relatively quick to offload loans in the years after the financial crisis, but their Italian counterparts were reluctant to realise losses from having to sell at heavy discounts loans still priced at par on their books.
This has changed, however, says Olivieri. He cites a combination of factors behind banks’ increased enthusiasm for getting rid of NPLs: a drop in the yields requested by investors has, to a degree, reduced the previously gaping gap between the price at which investors were willing to buy and the price at which banks would sell; lenders like Barclays and Hypo Alpe Adria are anxious to offload loans because they are exiting the market; and the government is putting banks under more pressure to strengthen their balance sheets through asset sales.
As a result, the 2016 value of bad loans sold was, at about €40 billion, double the previous year.
The senior executive at the debt fund manager places this within a regional context. “When we look at everything coming out of the banks because of deleveraging, Italy has accounted for a very small percentage of overall European activity,” he says. “But when we look prospectively, at future transactions, Italy will inevitably become a much more important market.”
Partly because some countries, such as Germany and Ireland, have done so much of the necessary deleveraging already, “the opportunity is migrating south”. But despite these opportunities, investors warn about the particular dangers of getting involved in the Italian NPL market.
“Italy is an intrinsically difficult country from a political, regulatory, legal and accounting perspective,” says one distressed credit investor. The country finds it difficult, moreover, to do very much about this. “The larger institutions in the country find it hard to clean up everything that is going wrong. Everything is a makeshift solution.”
Investors cite the legal difficulties in recovering money owed to an NPL holder. The process is not only long but also unpredictable. The senior executive at the debt fund manager estimates that in Spain it takes two or three years before the holder of a non-performing commercial mortgage sees the money from the collateral in their bank account. “But in Italy … you have to predict borrower behaviour, time to the asset and time to liquidate the asset. If any of these is uncertain, you almost can’t put a price on the asset because the extension risk can kill you.”
Investors also warn that the process of turning round companies so that they can generate the cashflow necessary to pay off loans can become highly politicised. For example, trade unions and the government sometimes heavily resist job losses.
Experts also say that although banks are more willing than before to accept large balance sheet losses from selling NPLs, they can still be reluctant. This is particularly the case because the higher risks of doing business in Italy lead them to demand a higher return as compensation. For example, the senior exectuive at the debt fund manager regards an unlevered return for a bundle of non-performing UK residential mortgages of 11-13 percent as reasonable. However, “for Italy, it has to be wider than that, at up to 17 percent”. This creates tension.
Olivieri says returns demanded for Italian assets need to be higher than in other markets. He suggests that investors are targeting an internal rate of return of 12-18 percent for secured NPLs, and up to the low-20s for unsecured.
Nevertheless, investors say some difficulties are lessening. When it comes to pursuing foreclosure and bankruptcy through the courts, “everything has been made a bit easier over the past two or three years,” says Olivieri, citing the ability to issue injunctions electronically. “Even a small change that makes the system a bit more effective might have implications for NPL pricing.”
Experts in Italy say local knowledge also goes a long way. “You can’t come in on a plane from London, because you will not be able to find attractive deals,” says Stefano Vaselli, founder and managing partner of Oxy Capital, a private equity firm focused on Portugal and Italy.
“Even if you were to see some, it’s very difficult to close transactions unless you have local teams,” he adds. “You need a good understanding of local bankruptcy law, which means a good understanding of the local courts, which means knowing the right lawyer. Unless you have an insider’s knowledge of the market it’s very hard.”
Andres Rubio, partner in Apollo’s European Principal Finance Fund in London, offers a concluding perspective: “While Italy is the most exciting potential market for investors given the largest amount of NPLs of any European country, it remains a market where transaction activity is still nascent. It will take time and effort by both sellers and buyers to reach transaction levels of other countries, particularly in secured NPLs.”
DIGGING FOR GEMS
For banks not wanting to sell NPLs at a heavy discount, one possible solution is financial engineering.
Oxy Capital offers a deal where the bank does not sell the debt, but instead freezes interest payments and turns some of the debt into equity. Oxy Capital takes control of the company, injects some of its own debt to fund a turnaround and splits the proceeds of the sale of the company equally with the bank. Idea Capital Funds, an Italian fund manager, and HIG Bayside, a distressed debt investment firm, offer a similar solution through the fund Idea CCR. With the agreement of the bank, Idea CCR takes an equity stake in companies with distressed loans; Bayside invests debt; both partners offer expertise in improving the company’s situation. The partner banks typically transfer their distressed debt positions at book value to the CCR fund and take fund units in exchange. This saves them from having to book a loss. Debt investors will only enter such deals, however, if they like the company as a business. Bayside likes “good companies with bad balance sheets”, says managing director Giuseppe Mirante: companies that have a strong operational business, but are burdened by too much debt.
Given Italy’s low-growth economy, investors say this tends to be export-focused businesses. For example, Oxy Capital has issued debt to Ferroli, a maker of boilers and air conditioning units, with 60 percent of its €300 million revenue coming from foreign markets.
Mirante offers Bayside’s perspective: “You have to do a lot of digging before you discover those little gems of multinationals which by international standards tend to be very small.”