Shopping for bargains in Europe’s giant NPL stack

There is a consensus among Europe’s lawmakers and regulators that the deleveraging of the European banking system has been too slow. An estimated €1 trillion of non-performing loans burden the balance sheets of the leading financial institutions, according to the European Central Bank – a legacy of the global financial crisis.

The offloading of toxic assets is seen as a key route to bank profitability. Indeed, European Central Bank vice-president Vítor Constâncio said in a recent speech that the “NPL problem is one of the main reasons behind the low aggregate profitability of European banks”.

Perhaps some sympathy for the banks is in order. The usual process following a recession is to write off under-performing assets as a way of pushing the reset button. But the introduction of rules demanding higher capital ratios following the financial crisis meant many banks held onto such assets – at artificially inflated valuations – to meet the requirements.

Distressed debt investors looking to take over the management of the banks’ NPLs found pricing was too high, thus resulting in a clog instead of the steady stream of deals that was arguably required.

Attention is focused particularly on Italy and Spain, where the pressure to deleverage is most acutely felt. In the case of the former, Deloitte estimates that there are €360 billion worth of NPLs weighing down the nation’s banking system. Italy was the most active NPL market last year, finding buyers for loans worth €36 billion in 2016, according to Deloitte. That figure is expected to be higher this year.

Anticipating increasing opportunity, a number of firms have entered the distressed debt space, creating a more competitive field and putting pressure on returns.

Only one pure-play distressed debt fund (from IDeA Corporate Credit Recovery) reached a close in Europe in 2016, according to PDI figures. But things appear to be changing this year with Apollo raising a European distressed debt vehicle, Avenue Capital raising a fund for stressed opportunities in the region and reports suggesting Strategic Value Partners and Halcyon Capital Management are seeking more European opportunities also.

“With a greater number of distressed debt investment firms entering auction processes, there is an increasing pressure on pricing,” says Partha Pal, a partner at law firm Ropes & Gray. “Sellers like having more competitive tension.”

Many distressed debt funds looking to deliver the returns investors expect are developing their own relationships with the banks to try to circumvent auction processes.

“There is a small world of very specialised investors who don’t necessarily want to get involved in portfolio auction processes, who find more opportunities in bilateral situations and want to get involved in restructurings by acquiring individual exposures,” says Pal.

In any market that starts to heat up, investors are pushed to find innovative ways to meet return targets. That is the nature of the business. But with more than €1 trillion of opportunity in Europe for distressed debt investors, there remains plenty of room for those prepared to put the effort into developing the right relationships.