Hedge Funds Have $74 Billion as Europe Fire Sale Delayed

Date: Tuesday, August 14, 2012
Author: Anne-Sylvaine Chassany, Bloomberg

Hedge funds and private-equity firms have amassed an unprecedented 60 billion euros ($74 billion) to invest in distressed debt in anticipation that Europe’s sovereign-debt crisis will push banks into the biggest fire sale in history. The problem is few are selling.

Apollo Global Management LLC (APO), Oaktree Capital Group LLC (OAK), Avenue Capital Group LLC and Davidson Kempner Capital Management LLC are among U.S. firms that have flocked to Europe, setting up offices and raising funds to benefit from the most severe period of distress in the region. The money raised for distressed-debt funds gives the firms about 100 billion euros to spend on deals including leverage, according to PricewaterhouseCoopers LLP.

European Central Bank PresidentMario Draghi has cut interest rates three times to a record low and flooded the financial system with cash since taking over at the helm of the central bank in November, taking pressure off banks to sell their assets at depressed prices. The European Banking Authority said last month that banks have been able to shore up their balance sheets over the past year without “fire sales.”

“There are quite a lot of opportunities, but the problem is whether banks are selling,” Christopher Hart, president elect of TMA UK, a trade organization representing turnaround specialists, said during a London industry gathering in June. “As the adage goes, ‘a rolling loan gathers no loss.’”

Distressed Debt

Distressed securities are those that have been issued by companies or government entities heading toward or already in default. Distressed bonds typically have yields over Treasuries of 1,000 basis points or more. Investment firms that have amassed money for distressed-debt funds have a broader universe of what they call “special situations” that they can invest in, including high-yield debt, leveraged loans, mortgage-backed securities, real-estate assets and in some cases even equity- linked securities.

Draghi, who took over as the head of the central bank nine months ago from Jean-Claude Trichet, has pumped more than 1 trillion euros in bank loans and has loosened collateral requirements as he seeks to contain the region’s debt crisis. With the ECB’s main lending rate at 0.75 percent, European banks haven’t sold the worst of their loans as they seek to avoid markdowns, while companies burdened with debt are better able to make payments.

EBA Report

The EBA last month said in a report that banks have shored up their balance sheets and increased capital reserves by selling shares, holding on to profits and converting lower-quality capital to common equity rather than by cutting lending or resorting to fire sales. Deleveraging measures reduced aggregate risk-weighted assets at the companies by 0.62 percent since September 2011, according to the EBA report.

In the U.K., where the Bank of England has pushed borrowing costs even lower, to 0.5 percent, turnaround investments fell to 146 million pounds ($229 million) last year, an even lower amount than in 2007, after a one-year peak of 1.9 billion pounds in 2008, according to the British Private Equity and Venture Capital Association.

The plight of distressed-debt specialists echoes that of leveraged-buyout firms, which have been hard-pressed to put their money to work in Europe amid a financing squeeze. Buyout firms such as Blackstone Group LP (BX) and KKR & Co. (KKR) have amassed $122.4 billion from investors for traditional corporate takeovers in Europe, according to London-based researcher Preqin Ltd. The value of announced LBOs in Europe has fallen 23 percent to $30.5 billion this year through Aug. 10 from the same period in 2011, according to data compiled by Bloomberg.

Investment ‘Mania’

Jane Mendillo, chief executive officer of Harvard University’s endowment, said investor demand for European distressed assets resembles a “mania.”

“We see a lot of investors lining up for the distressed credit opportunity in Europe today,” Mendillo said last month at an industry conference. “Investment dollars may exceed the opportunity, at least in the near term.”

On a rainy morning in June near the City of London, a dozen deal makers specializing in turnarounds and restructurings gathered at the Bleeding Heart bistro to lament the scarcity of distressed-debt deals. Interest rates aren’t expected to rise and European regulators aren’t pressuring lenders for a radical balance sheet clean-up, instead encouraging them to sell assets in an orderly fashion, according to Hart, who helped organize the gathering.

On the other side of the Atlantic Ocean, some investors have come to similar conclusions. Elliott Management Corp., the New York hedge fund founded by Paul Singer, said governments were delaying the inevitable.

‘Paper Money’

“The troubles in Europe have not yet created the volume and types of bankruptcy and restructuring opportunities that might be expected from difficulties of such monumental proportions, most likely because the governments and banks are essentially holding each other up and keeping the private sector afloat -- for now -- with lots of freshly minted paper money,” Elliott Management wrote in a letter to investors in April.

Howard Marks, chairman and co-founder of Los Angeles-based Oaktree Capital, said banks aren’t compelled to sell their assets because of the recent actions by the ECB.

“When a distressed investor can make enormous returns, from time to time, it is because the sellers are making a mistake and they make that mistake because of an impetus to sell, because they’re forced to sell, or they’re panicking, or they’re under capital pressure,” Marks said in a July 12 Bloomberg Television interview. “Those things are not happening today in Europe.”

Hanover’s Move

Marks’s Oaktree Capital, the biggest distressed-debt firm, finished raising 3 billion euros this year to invest in troubled European companies. Leon Black, founder of New York-based firm Apollo Global Management, in May compared opportunities in Europe to those in the U.S. during the financial crisis of 2008 and 2009. His firm last month was getting ready to close 2.5 billion euros for a fund to buy European distressed loans, according to an update sent to investors at the time.

Marathon Asset Management LP, a New York-based hedge fund that manages $10 billion, started a Europe Credit Opportunities fund last year and has beefed up its European team to buy troubled loans. Louis Hanover, co-founder and chief investment officer, plans to spend three weeks each month in London to take advantage of what he called the “greatest global opportunities” to invest in corporate restructurings.

Avenue Capital, the distressed-debt firm co-founded by billionaire Marc Lasry and his sister Sonia Gardner, raised $2.78 billion to invest in companies hurt by the region’s sovereign-debt crisis, exceeding its $2.5 billion target, a person familiar with the situation said last month.

Different Laws

Europe can prove tricky for investors because bankruptcy laws differ from one country to the next and some jurisdictions, such as France, can be less favorable to bondholders than the U.S. or the U.K. The biggest challenge for U.S. distressed-debt investors landing in Europe is that there aren’t that many liquid assets to trade quickly, according to David Abrams, head of Apollo’s non-performing loans business in Europe.

“A lot of firms are coming from the U.S. thinking they’ll find the same kind of opportunities here that they have traditionally found in the U.S.,” Abrams said in an interview in London. “Europe is mostly about buying portfolios of illiquid, nonperforming loans from banks. And this requires a lot of infrastructure, patience and resources.”

Investment Thesis

Firms that have raised money to invest in Europe, in theory, have a solid investment thesis. European lenders, under pressure to increase their capital buffers, have vowed to trim at least 950 billion euros off their balance sheet within the next two years, according to data compiled by Bloomberg, and they have up to 2.5 trillion euros of noncore loans, according to data from PricewaterhouseCoopers. European banks may sell about 50 billion euros of loans this year as the crisis boosts their need to reduce reliance on wholesale funding, a 66 percent increase from last year, according to estimates from PWC.

Austerity policies have hurt economic growth throughout Europe, reducing consumption and hitting industries that include retailers, carmakers and building material companies. Debt used to finance acquisitions or leveraged buyouts before the slump will have to be refinanced, while companies risk breaching their covenants.

OpCapita Rescue

Some deals are coming to market against that backdrop. London-based private-equity firm OpCapita LLP in April rescued U.K. computer games retailer Game Group Plc from administration.

In June, a group of creditors led by Connecticut-based hedge fund Strategic Value Partners LLC, won control of Klockner Pentaplast Group, a German plastic manufacturer owned by Blackstone that breached its loan terms last year. The investors led by Strategic Value ended a battle with a group of senior creditors including Oaktree, after raising enough financing to prepay them.

Moody’s Investors Service on May 29 found that 254 European leveraged buyouts had a combined 133 billion euros of debt due by the end of 2015, with more than half owed by 36 borrowers. Private-equity owners won’t inject more equity and about 25 percent of them will therefore default, the rating company wrote.

European banks are selling what they can while limiting the damage on their balance-sheet. Lloyds Banking Group Plc (LLOY) in June agreed to sell 809 million pounds of Australian corporate real estate loans to a Morgan Stanley and Blackstone joint venture for about 388 million pounds.

RBS Sale

In December, Royal Bank of Scotland Group Plc, the state- owned British lender, sold part of a 1.4 billion-pound portfolio of commercial mortgages to Blackstone. The deal almost fell apart when Blackstone failed to secure outside debt financing to fund part of the acquisition. RBS saved the transaction by providing 550 million pounds in so-called vendor financing, people with knowledge of the transaction said then.

Private equity firms use a combination of equity and debt to buy assets to boost returns, and typically sell them for a profit 3 to 5 years later.

“Deals are slow to materialize and I am not sure it will accelerate anytime soon,” said Fraser Pearce, a London partner at Boston-based firm Gordon Brothers Group LLC. “European banks just don’t want to take the losses that are necessary.”

Smaller Discounts

European banks are looking to dispose of assets they can sell with no loss or at a small discount compared with their book value to help keep capital levels intact, said Andrew Jenke, a director at KPMG, who advises on the sale of portfolios of loans. Societe Generale SA (GLE), France’s second-largest bank, is close to selling an 800 million-euro portfolio of mortgage loans to Axa SA (CS)’S real estate unit, for a less than 10 percent discount, according to two people with knowledge of the deal. Officials at Societe Generale and Axa Real Estate declined to comment.

As for their underperforming mortgage loans, banks have a hard time with discounts demanded by private-equity investors, which can be as much as 50 percent, according to Jenke.

“The vast majority of bank deleveraging is done through redemption and restriction of credit,” Jenke said. “There are disposals and activity is picking up because the pressure is on, but the problem remains for many under-performing loans where the pricing gap is too wide.”

Despite a deepening of the euro-zone crisis, this relative scarcity of deals is likely to continue for some years in Europe as regulators intervene and keep interest rates low.

“It’s moved more slowly than people thought,” Tom Barrack, CEO of Colony Capital, which has a team investing in underperforming mortgage loans in Europe, said in an interview. “The banks work in concert with the government and the corporate framework much more so than in the U.S.”

Still, he says, “there are rifle shot opportunities for those with a cultural sixth sense.”

To contact the reporter on this story: Anne-Sylvaine Chassany in London at achassany@bloomberg.net