Mid-market lending: Opportunity in distressed debt

By anyone’s standards €2.3 trillion is a large number.

This is the latest estimate by professional services firm PwC of the total value of non-core loans held by European banks: in other words, loans they no longer want. About €1 trillion of this is non-performing – distressed by anyone’s definition. A good deal more is “stressed” – at the risk of becoming distressed. Much of the €2.3 trillion total will be sold off by the banks, say analysts – making this one of the greatest sales opportunities in history.

“Banks are actively managing portfolios much more, and are much more open to selling loans than 10 years ago when it was literally unheard of,” says Thomas Solset, London-based portfolio manager for Triton Debt Opportunities, which focuses mainly on the debt of small and mid-market companies. Some of the sales are at knock-down prices, even for performing loans. Solset says that his firm buys many loans that are not distressed, “but we buy them at distressed prices”. Loans bought at 60, 70 or 80 cents in the euro may ultimately be refinanced at par, he says.

However, the opportunities for investors in distressed, stressed and opportunistic debt are not uniform. In some countries many of the distressed loans have already been disposed of; in some countries the banks have become so eager to lend again that it is hard for the distressed funds to compete. Moreover, mid-market investors are less interested in the huge grand total of deals available and more in finding and leading in a particular niche.

For LCM Partners, the niche is small SME and consumer loans, which it buys in bulk in packages worth up to €75 million from banks across Europe. Its total investment is split roughly equally between distressed and non-distressed debt, says Paul Burdell, chief executive. LCM has a gross unleveraged 18-year track record of 14.9 percent.

“Since 1999, [the year the firm was formed] we have had a static database which records every portfolio and every customer in that portfolio,” he says. “This is the core of our pricing, forecasting and modelling.”

LCM has also built up knowledge over the years in every aspect of debt management, in matters such as running the call centres and litigation. “You have to have the expertise to manage these portfolios,” he says. “It’s not a desktop exercise.”
Burdell argues that this requisite knowledge base presents a high barrier to entry for rivals.

So too, he claims, does the banks’ increasing reluctance to deal with fund managers they do not know.

“Banks are much more concerned about how their customers are treated even after their customers’ loans are sold on,” he says. “Regulators have told them that they remain responsible for a portfolio they sold. Even if the liability is tacit or indirect, the liability is there.”

Solset of Triton also emphasises the importance of trust: “It’s very relationship-driven because banks are very careful about who they deal with when selling the loan.”
In the case of Triton Debt Opportunities, this is because it is usually buying into a bank syndicate: it purchases debt of between €10 million and €50 million out of a company’s total debt of up to €500 million.

“Banks in the syndicate care about the buyer being a responsible, serious and professional fund manager,” says Solset. “That is a reputation you build up over the years” – in the case of Triton, 20 years of originating loans across much of Europe. He also thinks the hard work involved in origination, which requires good relationships with local banks, will make it hard for rivals to establish a firm footing in the fund’s niche. “It is not easy to sign up a team of four people and spend your time flying around Europe trying to source those loans.” Triton has nine offices in Europe, as well as one in Shanghai.

It is all very well for funds to seek a niche, but dealflow depends also on the overall environment. Although PwC has identified a huge potential market in bank disposals of loans, the opportunities are not spread evenly across Europe.

“Europe has specific pockets of opportunity,” says Jarek Golebiowski, partner in restructuring services at Deloitte, the professional services firm, in London. He cites Italy, whose banks hold €360 billion in impaired loans, according to the central bank.

But in the UK, “there isn’t much distress generally and there isn’t a great amount of good dealflow for distressed funds”.

He attributes this partly to the improving economy and partly to the large pool of money available for lending, emanating from a combination of banks, direct lenders and funds. “Banks are so hungry to supply capital that we could even say their lending criteria have loosened to follow the market,” he says. “My debt advisory team is still very busy writing deals, but a number of the names I have been looking at with a view to possible instruction seem to get refinanced.”

He has noticed an interesting response to this: “Funds that historically may have focused on doing purely distressed debt have evolved by going into opportunity capital.”
This may involve offering high-rate stretch loans: hybrid debt instruments consisting of both asset-based loans and cashflow loans.

“The opportunity set is getting bigger but the pricing at which you buy is higher in such a strong market, so on balance the opportunity today is less than it was a year or three years ago,” says Victor Khosla, founder and chief investment officer at distressed debt investor SVP Global. “At the same time, there is still a big pool so you can still do some pretty interesting things.”

He gives the example of its 2015 investment in Cory Environmental, whose boats can be seen by City workers taking the waste of London boroughs along the Thames to a plant where it is burnt. After buying debt and equity from banks and doing a debt-to-equity swap, SVP owns 60 percent of Cory. “The price we paid most recently was higher than the price we paid pre-restructuring, but we felt that even at that price it was a very good buy,” says Khosla.