Like a small boy who keeps a broken toy in his clenched fist because he does not want to reveal it to his parents, many European banks have been reluctant to own up to the true value of distressed loans.
However, regulatory pressures and improvements in their own balance sheets have persuaded many of those banks to acknowledge severe write-downs in loans – a precursor to selling them on to distressed investors.
This has injected new life into the distressed market, despite Europe’s emergence from recession and ensuing acceleration in economic growth, which has resulted in low levels of default in high-yield bonds.
Aside from non-performing bank loans, distressed fund managers also see opportunities in other distressed assets, including companies with good underlying propositions but have been damaged by mistakes made by private equity owners.
“There is a view that distressed is a boom-and-bust business, and there is no question that there is more opportunity after a crash,” says Victor Khosla, New York-based founder and chief investment officer at distressed debt investor SVP Global, which has large teams in Europe and the US. “But if you do your job well there are always places to go, to look for opportunities that are quite interesting.”
Perhaps the biggest current opportunity is in Italy, say a number of market participants.
Last year banks sold €99 billion of loan portfolios, according to professional services firm PwC, of which €42.5 billion was sold by Italian banks in about 50 different transactions. The bulk of this, both in Italy and Europe as a whole, is distressed debt.
Richard Thompson, global leader of the Portfolio Advisory Group at PwC UK in London, attributes the sharp rise in Italian sales, up from only €7.5 billion in 2014, in part to the creation of a more creditor-friendly regime, which has attracted more funds. He also thinks Italy has benefited from the “snowball effect” that has occurred at different times in different national markets: pioneering deals generate price discovery, which piques investor interest, and increases investor knowledge about the relevant regulatory and legal issues.
The metaphor is all the more apt because the snowball gained mass early in a number of colder northern European countries such as the UK and Ireland, but took longer in many of the hotter southern European countries. As well as Italy, which Thompson says is on track to remain the largest market this year based on not yet published figures for the first half, he also sees a snowball effect in Greece. By contrast, sales of Irish loan portfolios dropped to only €2.5 billion last year, down from €30.5 billion in 2014, when the country was the biggest market.
Total sales of European loan portfolios are actually on “a declining trend”, according to Thompson, after peaking at €140 billion in 2015. However, he still sees plenty of life in this market yet, because of the “give-or-take €1 trillion of non-performing loans still sitting in the banking system”.
Another area of increasing volume is the sale by banks of loans that are performing but “non-core”, sometimes because the bank is anxious to sell foreign loans given mounting pressure from regulators and shareholders, and sometimes because the bank wants to retain core loans to key corporate clients from which other relationship business can be generated, says Jeff Davis, partner at Eaton Partners, the placement agent and advisory firm, based in Rowayton, Connecticut.
He says these loans are not for deep distressed debt specialists such as Fortress but have attracted the interest of managers that buy at least some special situations and stressed debt, like Warwick Capital Partners and Alchemy Partners.
Anthony Robertson of Cheyne Capital notes that this market has even been given a fillip this year by new rules from both the International Accounting Standards Board and the European Commission, which force banks to be more stringent in valuing and disposing of non-performing loans. The IFRS 9 Financial Instruments accounting rule requires banks to recognise likely future credit impairment at the time when the bank’s risk modelling process is applied. This greater stringency may incentivise banks to sell stressed and distressed loans more quickly, because distressed loans burden the bank with higher capital charges at an earlier stage.
Other fund managers are also noticing greater enthusiasm among banks to dispose of assets. “We have had more dialogue with German banks over the last three months than we had over the previous two years,” says Amyn Pesnani, an investment advisory professional working in London for the Triton Debt Opportunities Fund, which invests in the debt of stressed and distressed companies.
He credits increased dialogue in Germany and a number of other European countries partly to the increased regulatory pressure on banks to sort out problem loans, and partly to recent highly levered LBOs that that have failed to meet their growth plans.
Checking out retail
The huge wave of private equity investment in Europe has also created opportunities by creating plenty of examples of ill-conceived over-expansion, say market observers.
Robertson cites the UK casual dining sector. Private equity-owned chains that have recently pared outlet numbers include Strada and Prezzo. Cheyne Capital has not yet bought casual dining debt in the UK, but is “evaluating a number of situations,” says Robertson. “The shakeout means the competitive space will be diminished, and then the overcapacity issues will be eased,” he predicts. As always, distressed debt specialists must have a reasonably optimistic outlook for a troubled sector before investing in it.
The troubles of UK casual dining chains, as well as retailers, are largely because of Brexit, say analysts. Jarek Golebiowski, partner in restructuring services at Deloitte, the professional services firm, in London, says the sharp fall in sterling following the Brexit referendum has hit retailer margins by increasing sourcing costs, which they were not able to pass fully onto the consumer. UK households’ spending has itself been hit by higher consumer price inflation.
This observation leads on to the thorny and much debated issue of whether distressed debt investors should buy into retail. The case against conventional bricks-and-mortar retail businesses is that, faced with internet competition, turnover is static at best, while margins are in long-term decline.
Khosla of SVP Global describes much of the retail sector as “melting ice cube businesses”. Distressed investors need to calculate the true value of the business, but this is hard when a retailer is being compelled to cut the number of stores from X to Y and then to Z. He prefers debt with more predictable cashflow, a consideration that makes him a particular fan of toll roads. SVP has four toll road debt investments with a face value understood to be in excess of €5 billion in Spain and Portugal, where increasing employment has boosted car use and rapidly rising GDP has assisted truck use.
Robertson is open-minded rather than enthusiastic about retail, saying: “We haven’t done anything in retail, but it might be possible to identify some retailers that can navigate this difficult environment.”
He thinks that a debt investment in a business that is exclusively bricks and mortar is “more difficult”, but the debt of a retailer making a transition to an e-commerce-heavy model, if bought at 40 or 50 cents in the dollar, “could be very attractive”.
Robertson is more wholeheartedly enthusiastic about autos and auto parts. He describes this as “without doubt, in my mind, the next iteration of opportunity” in European distressed debt, as the industry makes the disruptive transition from internal combustion to electric engines.