As UK construction and support services group Carillion scrambled to find a way out of its difficult position at the end of 2017 – it had announced in November it would breach its banking terms and issued a profit warning in July – distressed debt investors cast their slide rule over the group. At that point, its debt was reportedly trading at around 17 percent of par. It was a significant discount, but most walked away, considering the company too much of a basket case to warrant even that price.
With hindsight, those that passed on Carillion look to have dodged a bullet. The company collapsed in January, burdened by more than £2 billion of debt
($2.8 billion; €2.3 billion), a pension deficit totalling nearly £600 million and just £29 million in cash. While that fallout continues, Europe’s distressed debt investors now look back on a year where a number of promising opportunities simply failed to emerge.
The early part of 2017 saw some predicting distress triggered by the outcome of elections in some key European states. “There were expectations that political uncertainty or change in Europe might trigger some opportunities last year,” says CVC Credit Partners managing director Ran Landmann. “But these didn’t materialise. The French elections were orderly and the economy is now in a reasonably good place and even in Germany, where there still isn’t a government in place, there has been little, if any fallout.”
Indeed, even for companies on shaky ground, continued liquidity in the debt markets during 2017 offered the chance to refinance. “Last year, the default rate remained low and many of the companies that expected to restructure did not need to do so,” says Stephen Phillips, restructuring partner at Orrick. “We saw a number of companies on our distress watch-list tap the high-yield bond markets instead.”
In energy, where there was anticipation of increased dealflow, rising oil prices prevented a number of companies entering distress, although there was some movement. Phillips points to the restructuring of CGG, Ocean Rig and the ongoing Chapter 11 process for Seadrill as examples.
“Everyone has been chasing the same deals in Europe for some time now,” says Duncan Riefler, senior advisor at placement agent Arbour Partners. “There have been a few blow-ups, but the combination of low interest rates and quantitative easing have allowed companies that are not doing well to continue trundling along.”
Yet the white-knuckle ride experienced by public market investors in the first full week of February is an indication that many people believe this is about to change – and much faster than most had anticipated. “The distressed debt market tends to be sentiment-driven,” says Landmann. “And on that basis, the recent stock market volatility, driven by an expectation of increased inflation and interest rates, may bring about some opportunity.”
Just before the recent rout, S&P published its Global Leverage Trends report. Subtitled ‘Debt high, defaults low – something’s gotta give’, the report opens with a stark warning. “Despite a recent rise in corporate profits and financial metrics, the still-high leverage of corporates poses a significant credit risk. Such leverage implies sensitivity to both higher funding costs and reduced access to financing. A material repricing in bond markets or faster-than-expected normalisation in money market rates could impact credit profiles, triggering the next default cycle.”
Indeed, it estimates that the proportion of highly leveraged corporates globally stood at 37 percent in 2017, higher than in 2007 by some five percentage points.
“With such a low default rate in Europe, it’s clear that the only way is up, but the question is when,” says Phillips. “The stock market volatility suggests expectations of faster than anticipated interest rate rises in the US – and if that happens, Europe will have to follow suit. It does look as though the cycle has turned and monetary policy is on the path to normalisation. If that’s the case, we’ll see more defaults and probably as soon as late 2018/early 2019.”
Predicting higher default rates isn’t controversial – the average annual global default rate was just 1.2 percent for the years 2011-17, according to S&P – but how events unfold when they do rise is less certain.
“We’re likely to see a normalisation of monetary policy and that’s a positive thing because central banks are not meant to be such a large part of the market,” says Landmann. “But that may be painful in the short term, particularly where debt structures have been put in place with high leverage multiples and on tight spreads because these don’t allow for orderly risk transfer.”
The structures used over the last few years are likely to prove troublesome, agrees Phillips. “The high leverage and cov-lite basis of many debt structures in the market today mean that the usual traffic lights won’t work – there will be no amber warning,” says Phillips. “That means realisations will be lower when the cycle does turn and there will be less time to perform a turnaround.”
We will see over the next few months whether concerns around rapid interest rate hikes turn out to be justified. However, it does seem likely that Europe’s distressed debt funds are entering a period of greater potential dealflow, with the UK a particularly rich seam to mine. The question, however, will be whether there is any value left by the time companies enter distress.
“When this happens, it will be interesting to see how it plays out,” says Landmann. “There are a lot more funds in the market today and fewer banks compared with the situation in 2006. Funds need at least mid-teens returns, which means that distressed debt will be priced low. Market normalisation will lay bare the risk-return characteristics of many investments – and that will be the single biggest influence on distressed debt activity.”