Distressed investing in Europe
July 2016 | COVER STORY | FINANCE & INVESTMENT
Financier Worldwide Magazine
Though 2015 was largely a non-event for distressed investors, to date 2016 has presented the same investors with more opportunities. The European landscape has been volatile for some time, set against an uncertain political backdrop – a situation exacerbated by a potential ‘Brexit’, worsening macroeconomic conditions and an indication that credit markets are approaching another peak; distressed investment opportunities are becoming more attractive and more plentiful. How, then, will the market develop heading towards 2017?
For acquiring companies and distressed investors, the last two years have been a fascinating time. The crash in the commodities market has created significant opportunities and shows no signs of slowing. In Europe, looser monetary policy has had an impact on the number of distressed opportunities available to organisations. However, there has been a low default rate, whereas in the US, the decision by the Fed to end quantitative easing has been a key factor in the increasing rate of defaults there.
According to Partha Kar, a partner at Kirkland & Ellis, the distressed investing market in Europe has been reasonably challenging for the last few years, especially for investors in single name credits. “The whole market environment in Europe seems to be affected by a lack of certainty and, to some extent, a lack of faith,” he says. “The macro situation remains tough, which means turning around a business, even with a restructured balance sheet, may take longer than expected. There’s also a lot more activity going on in the US, so investors have shifted some of their focus back there.”
For some analysts, the distressed space in Europe has lost some degree of its lustre. “The two words ‘boring’ and ‘flat’ come to mind,” says Martin Stewart-Smith, a partner at Bracewell LLP. “Since July 2007, the level of debt trading has dropped massively in Europe and most trading that has been done since has been technical. The biggest issue that influences the European markets is the time expiry on many of the CLOs and the fact that Europe has not really taken advantage of the recent years of historic low interest rates to deleverage. We have new money coming in – for example, Phones4U which was heavily oversubscribed – and funds raised for specific opportunities, such as distressed energy. But hedge funds have struggled to deliver the levels of returns on European debt, which has resulted in recent outflows of capital. Eastern Europe is seen as too risky and pregnant with compliance issues, many have been burned in Greece and the uncertainties around Brexit only add to the market volatility with increasing hedging costs for dollar investments.”
Though many investors went into 2015 hoping for a multitude of opportunities, they were, for the most part, disappointed. The deluge did not occur as Europe’s banking sector proved more durable than expected. Equally, the continent experienced something of a mini recovery. Though the distressed debt market has been somewhat subdued in the first half of the year, some deals have broken through. Indeed, pockets of activity have been seen in a number of distressed sectors, including steel, retail, healthcare, oil and shipping.
Yet there is hope that the second half of 2016 will provide investors with opportunities that are presently absent. Europe’s economy, while a long way removed from the depths of despair it experienced in the immediate aftermath of the financial crisis, still suffers from a great many structural problems. Growth and demand has remained subdued across much of the continent, and whether the European Central Bank’s efforts can stave off further financial trouble remains to be seen.
With uncertainty permeating the oil & gas space, geopolitical challenges across a number of regions and uncertainty in both developed and emerging markets, analysts have grown accustomed to discussing volatility. According to a recent survey from Debtwire, Rothschild and Orrick, ‘European distressed debt market outlook 2016’, we are likely to see yet more volatility throughout the remainder of the year. “2016 will likely see the uncertainty which emerged in 2015 amplified: further volatility; a more uncertain political landscape; uncertainty around Brexit; worsening macroeconomic conditions and an indication that credit markets are approaching another peak,” said Andrew Merrett, European head of restructuring and co-head financing advisory at UK Rothschild. “The macro picture is undeniable: China is slowing down, Russia is under sanctions, and growth in Brazil has reversed. Additionally, the rate rise in the US has forced many European investors to ask when the Bank of England – and, probably later, the ECB – will follow suit. These uncertainties should result in more opportunity for distressed investors through the year.”
Yet, to date, the impact of chaos in the commodities space has been fairly negligible in Europe. “The energy and commodities downturn has not resulted in many secondary opportunities in Europe,” notes Mr Kar. “This is unlikely to change until prices start to go back up and stabilise. Otherwise in other sectors I expect more of the same in Europe. There are certainly opportunities, especially for investors who know the key jurisdictions well. Funds are also finding direct lending opportunities in Europe. European banks will continue to sell assets and we have seen the yield on the large volume of bond debt that has been issued in Europe over the last few years ticking up. This will create inventory for distressed investors – the question is whether these investors believe this is the best use of their money,” he adds.
Much distress in Europe is focused on the North Sea and oil services, as well as the retail sector in the UK, which saw two notable High Street fixtures – BHS and Austin Reed – fall into administration in April. The collapse of the UK steel industry, too, has caught the eye of investors across Europe.
Clearly, given the state of distressed Europe in recent years, the market is a difficult place for investors. Raising funds could be a challenge moving forward, particularly as distressed debt fund managers focused on North America and Europe have record levels of capital available for investment. According to data from Preqin, fundraising for these regions remained steady in 2015, with 11 funds closed raising an aggregate $21bn. Furthermore, dry powder in Europe-focused distressed debt funds has climbed to $48bn.
Recently, a number of firms, including Oaktree Capital Group LLC, Bain Capital’s Sankaty Advisors and Fortress Investment Group LLC, have raised funds for distressed investments as asset managers have seen defaults accelerating. In April, KKR joined those firms and raised $3.35bn for its second special-situations fund, exceeding its $3bn target.
“We see a fair number of smaller funds looking for seed capital and they tell us that the fundraising environment is tough,” says Stephen Phillips, European co-head of the restructuring practice at Orrick. “Many fund strategies have been under real pressure over the past year and we have seen a number of fund failures. We suspect that investors are looking to focus their investments in the bigger, more established funds and are less willing to invest in smaller funds than was the case in the past.”
Mr Phillips believes that distressed funds have been a relatively good asset class over the past 15 years in Europe, so the market will continue to attract allocations from pension funds and institutional investors. “One trend over the past few years is that the larger fund managers gradually seem to add different investment styles, so now it is hard to think of a large private equity house which hasn’t got its own distressed debt or direct lending unit under management. Investors are going to have to get realistic about returns and funds are going to have to be more realistic about the returns they are forecasting. In a zero interest rate world, a 10 percent return is pretty good. I think investors see a long term opportunity in Europe but may be struggling to employ capital in the immediate term,” he adds.
Despite the difficulties of investing in distressed Europe, there are areas of encouragement. Southern Europe remains an attractive destination, likely to generate the highest level of debt restructurings in 2016. Furthermore, according to Debtwire’s survey, the majority of respondents expected to see an increase in high yield-related restructurings in the next 18 months.
Real estate debt is one space proving popular with US investors. Cerberus Capital Management LP has been active, purchasing $32bn worth of the debt last year, including mortgages from failed UK lender Northern Rock Plc, which was offloaded by the British government. Loan disposals by banks have grown every year since 2010, a situation which has piqued the interest of US investment firms such as Lone Star Funds, Apollo Global Management LLC and Oaktree Capital Group LLC.
But non-performing loans are a mixed bag of opportunity, according to Mr Phillips, part of a general misconception among some investors when considering investing in Europe. “From a structural point of view, there appears to be considerable opportunity. For example, there is reputed to be in the region of €360bn worth of non-performing loans in Italy alone. And yet, when actually trying to deploy capital, funds are struggling to find the right opportunities. A second point is that there is a lack of homogeneity in European insolvency law – and importantly, court systems – which means that contrasts in outcome, and method of implementation, between one jurisdiction and another are very stark. Many investors, particularly from the US, find the disparity surprising, given that Europe is bound together within the European Union.”
This lack of harmony in European insolvency law can act as a roadblock to further investment in distressed Europe. A uniform European insolvency and restructuring regime would help to increase the efficiency of proceedings. In turn this could help boost restructuring investment across the continent. Though some efforts have been made by different European countries to develop ‘restructuring friendly’ legislation, more work is needed on valuation frameworks, the role of creditors, the availability of debtor-in-possession financing, among others. Evidently, there is some political desire to build an EU-wide insolvency regime. In March 2014, the European Commission published its ‘Commission Recommendations of 12.3.2014 on a new approach to business failure and insolvency’. The introduction of UNCITRAL Model Law and the EU Regulation on Insolvency Proceedings continue to shift cross-border frontiers. But full harmonisation may be a pipedream. For now, this lack of uniformity may well act as a barrier to more investment from the US.
We live in uncertain times. Political issues will continue to be a cause of considerable concern, as Mr Stewart-Smith notes. “Several important factors will influence the market in Europe. These include the outcome of the US elections in November 2016, the June decision on Brexit and how the EU will be able to ‘kick the can down the road’ again for Greece while maintaining the pretence that the bailout money will ever be repaid other than over an extremely long time horizon indeed. This makes for continued negative real interest rates and slow economic growth, coupled with some deflation perhaps. Having said that, there are some specific opportunities for distressed debt, such as debt to equity conversions of sub-50 high yield debt or books of certain non-performing loans. But there is a general shortage of good opportunities that will deliver the returns that are expected by investors.”
Volatility in the commodities space is likely to persist, with the oil & gas sector presenting restructuring opportunities throughout the second half of 2016. The sheer number of energy companies which have been forced into insolvency in the first half of the year lends considerable weight to this outlook.
Real estate, too, will prove an attractive proposition for distressed investors eyeing Europe. According to a report by Cushman & Wakefield published last year, asset management firms are sitting on substantial assets, with commercial and residential mortgage debt set against property standing at €233bn.
Quantitative easing, which had a significant impact on the European market for a time, is no longer a major feature of European investment; equally, economic growth across Europe has remained weak. The future of the EU has been called into question by the uncertainty surrounding the potential Brexit and, as such, a huge quantity of capital has sat idle for some time. The decision taken by the British public on 23 June vote will undoubtedly have a bearing on distressed investing across the continent in the months and years to come.
Clearly, there will be windows of opportunity for distressed investors in Europe against a challenging geopolitical and macroeconomic landscape. The European Central Bank will no doubt have to intervene again over the second half of 2016 and into 2017, so monetary support for the European economy will likely increase, or at least remain steady. The region’s economy is too fragile to withstand a withdrawal. The furore around global tax will also likely have an effect on Europe’s stuttering economy.
Many variables will impact upon the space going forward, not least the inconsistent European insolvency regime. Regardless, for those parties willing to put in the work, there will be plenty of opportunities for distressed investing in Europe moving forward. Savvy distressed investors will ensure they have local knowledge and expertise at their fingertips when pursuing deals, allowing them to root out the most attractive opportunities.
Market dynamics may be changing but Europe remains a land of opportunity for distressed investors.
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