Fund managers buying distressed European assets tell David Walker why the gloomy business climate is a good environment for their investments.
On the other side, their consumers are far less confident, says Marshak. He has invested in distressed since 1993, and foresees a troubling economic picture for Europe: “Weak economic growth with peripheral sovereign debt issues, resulting in cutbacks in spending for governments across Europe, and a consumer in many markets that is very stretched.”
FOCUS ON CORPORATES
In countries such as Germany, consumers might be better off. But Marshak says they are “also concerned about what is happening, and that will cause consumer behaviour to pare back spending as well”.
He highlights a general difference to late 2008 “when you had governments throwing money at the problem. Now you are looking at what is happening to government spending, and to unemployment”.
Jeff Majit, managing director at Neuberger Berman, says: “It is on the corporate side that we are likely to see more opportunities in the near- to medium-term.
“European corporates have been slower to deleverage than their US counterparts, so a number of high-yield companies have maturity of payments coming due in the next couple of years.
“Even in a situation where a company itself goes into a bankruptcy process, there tends to be forced selling of the company’s securities by those who cannot hold defaulted debt. This can result in prices moving to extreme levels that do not reflect the true value of the business.”
Given all this, why in early February did prices on bond default insurance (i.e. CDS) suggest fewer than ten Euro- pean companies had more than a 50% chance of default?
After all, one investor – who accesses distressed via Brevan Howard Credit Catalysts fund – says it has “certainly felt like a very stressed period for Europe, but it is not as if there are dozens of European companies filing for bankruptcy, or that spreads on the iTraxx index are at an all-time high. Capital markets have remained quite open”.
One answer managers commonly give is Mario Draghi, who provided thirsty European banks with about €1trn of cheap loans, equivalent to 80% of their debt redemptions until 2014.
The ECB’s long-term refinancing operation (LTRO) is a key reason that Bridget Gandy, Fitch’s managing director and co-head of EMEA financial institutions, said “there will be some sales of assets that incur high capital charges, but nothing substantial.
“Much of [what] banks are looking to sell results from ongoing restructuring, following government bailouts in 2008. The property crises in Ireland and Spain have added portfolios in these countries to the list, but this is something we have been aware of for some time.”
Charlotte Valeur Adu, chairman of the Brevan Howard Capital Catalysts investment trust, said its manager felt LTRO relieved some pressure on banks to sell troubled securities such as loans, “and the introduction of additional cash into the system has made it easier for over leveraged companies to borrow”.
But in January, assessments by the EBA said Europe’s banks planned to cut loan portfolios by €39bn and make €73bn of asset sales, though the BIS’s latest quarterly review suggested the ultimate figure could be up to twice as much, based on assumptions about the average risk weightings of such assets.
Both figures were far less, however, than predictions from the market of between €500bn and €3trn. The BIS said LTRO “eased the pace of asset-shedding observed in late 2011, but did not turn the underlying trend”.
Some agencies suggested as European banks delever, it will be emerging market clients that are squeezed, not domestic borrowers.
Robinson says banks refocusing on domestic markets was understandable – “when empires start to crumble, you rush back to Rome to defend the Colosseum” – but that will not save all corporate borrowers. “If you are a Mittestand company and you once got five banks quoting you for [loan] terms, and now you get none, that is not helpful,” he adds.
Marshak says European banks are not yet an extremely rich source of loans at discounts to fair value – and buying performing loans from them is “like pulling teeth” – but funding problems for the sector could still see shake-outs.
Majit says: “LTRO reduces the chances of massive amounts of forced selling in the near term. But should the European situation deteriorate, there is potential for banks to have no choice but to become aggressive sellers.”
A BETTER OUTlOOK?
Spanish cajas (savings banks) and Britain’s Lloyds Banking Group are among banks that already made orderly sales of corporate and property loans.
One distressed fund manager says: “Many financial instruments bought by European investors are radically different to what the buyers thought would be the case. Buyers bought securities they thought would have a very low risk of principal loss.
“But all of those assumptions after 2008 have come into question, whether they be bonds or mortgage-backed securities, or other collateralised securities.
“There is $3trn of this difficult credit, and much of it was bought for the wrong reasons. There are business loans that do not make sense to hold any more, and bonds the premise of which has changed.”
As ‘over-optimism’ that fuelled much of the buying of mortgage-backed securities evaporated, markets fell. Last year, the average US residential mortgage-backed security lost 20% to 30%, and the average for European leveraged loans sold by banks was still only 86 cents on the euro.
Marshak says it is vital to seek good businesses that happen to have too much debt, to look at where one is in the capital structure, and where one thinks ‘value breaks’. “Also, look at how long you expect it to play out, and what kind of value you have below an entry point.”
He points to a number of possible catalysts unlocking value. Some European firms went into 2008 with about 10% of revenue from high-growth emerging markets. But this rose to 25% or 30% as emerging markets continued growing, and US and European sales slowed or regressed.
Companies may now consider selling their emerging markets section to a rival or list it separately “to give them time to make it through the difficult environment in their home economy”. Another opportunity for distressed investors is where a new audience of buyers materialises if securities’ prices rise.