All roads lead to Rome – eventually

Italy is not the easiest environment for NPL investors, but it accounts for around half of the European opportunity, writes David Turner.

What takes a matter of days in the UK, but up to eight years in Italy?

The reader may be able to dream up all manner of witty responses, but for investors in non-performing loans the right answer is far from amusing.

David Lane, London-based partner in the Portfolio Lead Advisory business at Deloitte, the professional services firm, says that – at the extremes – this can be the time it takes to enforce and recover security on a loan in the fast-moving UK, compared with slow-moving Italy.

As Lane puts it, in Italy and some other countries debtors “may have a number of bites of the cherry at delaying the process”.

This is germane because the centre of gravity, for investors buying NPLs, has shifted southwards and eastwards to Italy from the UK and Ireland – having several years before shifted thousands of miles eastwards from the US.

“Clearly the biggest market opportunity now is Italy, with upwards of 50 percent of NPL deal volume,” says Justin Sulger, partner and head of credit at AnaCap Financial Partners, a private equity group and large investor in NPLs, in London. “However, there is still a growing and maturing NPL market across much of Europe.

“Italy went into recession a bit later than most countries after the financial crisis, and its banks held on to non-performing assets a bit longer. However, Italian regulators have clearly stepped up the pressure on banks to increase provisions and raise more capital – which, in turn, is increasing motivation and enabling NPL sales.”

Market observers note that once these provisions are made and the losses are crystallised on their balance sheets, banks lose the incentive to retain their loans in order to mask losses.

For Europe as a whole, €128.5 billion in sales of NPL and non-core assets was completed in the first half of 2017 or ongoing, according to a report on deleveraging in Europe published by Deloitte in July. Deloitte says the bulk of this is NPLs. The figure for Italy alone was €79.5 billion.

“In today’s market, a lot of deals are priced at a level that will require a sustained economic recovery to justify the price”

However, the southward shift in NPL sales to countries with more convoluted legal procedures for dealing with them has not deterred a number of big investors in addition to AnaCap. In July, UniCredit, the Italian bank, sold a portfolio of bad loans to Pimco and Fortress. Opportunities in Spain became all the greater after Santander bought Banco Popular in June 2017 and announced plans to dispose of half of its NPLs within the next 18 months.

Blood out of a stone

Many investors remain eager to invest in European NPLs despite the geographical shift in opportunities because they know they will be compensated for the extra effort involved in what can often seem like getting blood out of a stone. Portfolios in Italy are priced at significantly fewer cents in the euro than those in the UK, for example.

“When it takes a longer time to get hold of an asset, that generates a higher discount,” says Lane. Expert investors and their advisers can, he thinks, model the time it will take to enforce the sale of collateral, and the proportion of collateral value that will eventually be recovered, with reasonable accuracy. As he puts it, with an intriguing mixture of optimism and pessimism, “the enforcement process is not necessarily unpredictable; it’s just that in some countries it can be predictably long”.

The biggest problem in the European NPL market is, arguably, not a lack of investor interest but a surfeit of it. Old hands say that in the years after a country’s banks first sell NPLs, the price paid by investors has tended to rise 20-50 percent. This is partly because, as investors gain knowledge of the market, they feel able to price debt more aggressively because they have a better knowledge of how much they can recover.

All investors say the difficult task of working out a reasonable price is key to investment success, not least because it varies enormously. LCM Partners, a specialist investor in consumer and SME loans, pays between three and 70 cents in the euro for NPLs, says Paul Burdell, chief executive in London.

But pricing also reflects supply-demand dynamics, and some investors think many portfolios are now too expensive because there are now more investors competing for NPLs. One says: “In today’s market, a lot of deals are priced at a level that will require a sustained economic recovery to justify the price” – high GDP growth increases debt recovery rates. “That’s quite a new dynamic.”

Given these concerns, it is not surprising that some investors have voted with their feet. Some multi-strategy hedge funds, such as Davidson Kempner, have reduced their activity in European NPLs, say people in the market. Davidson Kempner declined to comment.

Where are the deals?

Some investors also complain that the supply is not coming fast enough. Robert Friend, managing director at Paamco, the fund of funds manager, in Irvine, California, contrasts the experience of the US with much of Europe. In the former, “the housecleaning occurred very rapidly”, generating many opportunities. However, in Italy, Spain and other southern European countries, “the wholesale cleanup of banks never really occurred”.

Some observers would dispute this conclusion, but what matters to investors is not just the extent of the cleanup but also its speed. The longer a country’s banks take to sell their NPLs, the smaller the opportunity in any given year. If there is already a large number of fund managers that have pitched tent in Europe to await these opportunities, this situation risks changing the supply-demand dynamic in favour of the banks supplying the NPLs.

Friend says Paamco has, through other managers’ debt funds, made small investments in Spanish NPLs. Internal rates of return for investments like this in the market have been in the high single digits and low teens, he says: “No home runs and no great stories to tell you, but satisfactory.” However, sceptics say that given the volatility in performance and class, high single digits is too low.

Having said this, many investors say strong returns are still achievable. Many fund managers are still targeting unlevered returns of 12-14 percent, say market observers. LCM Partners has achieved an average historical return somewhat beyond this – 14.9 percent in the past 18 years, though this encompasses both performing and non-performing loans. Although its historic return is not necessarily a guide to the future, Burdell suggests returns for NPL investors will rise if there is an economic downturn, because prices paid will fall. “Recovery rates have gone down in some cases during such downturns,” he acknowledges. “But they recovered.”

One solution to changes in the supply-demand dynamic is for funds to treat NPLs as simply one among a number of investment opportunities.

Stephen Carre, head of advisory and project management at the UBS private funds group in New York, says he is seeing less capital raised on a dedicated basis for European NPLs, compared with five or so years ago. Instead, he is witnessing more firms take a more broad approach to distressed opportunities, considering both distressed and “stressed” debt. He explains: “Many managers want to be prepared to invest across all points of the credit cycle.”