Waiting in the wings

Last year saw slim pickings for distressed debt investors circling Europe. But there are signs that 2018 may be different.

Carillion: investors dodged a bullet

In late December 2017, as UK construction and support services group Carillion scrambled to find a way out of its difficult position – it had announced in November that it would breach its banking terms and had issued a profit warning in July, sending its share price into freefall – 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 bypassed Carillion at the tail-end of last year look to have dodged a bullet. The company collapsed in January, burdened by over £2 billion of debt, a pension deficit totalling nearly £600 million and just £29 million in cash. While the Carillion fall-out 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 fall-out.”

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 deal flow, 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 Seadrills 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.”

Buckle up

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. Sub-titled “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,” it says, “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 normalization 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 is hardly controversial – globally, the average annual global default rate was just 1.2 percent for the years 2011 to 2017, 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’ll 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 deal flow, with the UK a particularly rich seam to mine (see box out). 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.”

UK LEADING THE PACK

While the S&P points report to higher leverage, much of that stems from China and the US, with European corporate debt remaining more stable. Yet many believe the UK is likely to yield a number of opportunities for distressed debt. Nearly two-thirds (64 percent) of non-UK distressed debt investors are expecting the UK to enter a recession in the next two years, according to a survey just published by Debtwire, with 71 percent of all respondents believing that property and construction will offer up the best opportunities, perhaps on the back of the Carillion episode.

It’s a view shared by Orrick’s Phillips. “We are beginning to see signs we’re in a different market now, particularly in the UK,” he says. “Construction of commercial real estate continues, yet many companies, especially in the London financial services space are looking at reducing their headcount in the UK. This, combined with continued austerity, means that we are likely to start seeing some casualties over the next few years, with real estate and construction one of the affected sectors. The collapse of Carillion was well publicised, of course, but there are a number of other construction companies under pressure.”

Retail and casual dining in the UK are also looking shaky. Toys R Us has recently completed a company voluntary arrangement, while New Look and House of Fraser are believed to be in discussions with landlords, restaurant chains Jamie’s and Byron Burgers are some of the casual dining operators scaling back their sites and clothing retailer, East, recently went into administration. “The combination of the trend towards online shopping, increased inflation, re-rating of business rates, increases in the minimum wage, plus long-term lease liabilities and Brexit will make retail a tough space to be in over the next few years,” says Phillips.

Yet there are other, rather smaller pockets elsewhere in Europe that continue to provide bread and butter work for more equity-oriented investors. “The mid-market is an interesting space,” says Peter Schwanitz, senior advisor to Portfolio Advisors. “There are fewer buyers here than at the larger end, and while many of these opportunities may not be pure-play distressed, players are finding deal flow in special situations and completing debt for equity swaps or buying debt positions at a discount to create senior secured returns of between 9 percent and 13 percent – that’s attractive for investors on the credit side.”