Distressed Debt Investors Focus on Europe

For one group of hedge funds, Europe has been a constant source of frustration: neither terribly bad nor roaring with success. So far, that is.

Despite a banking crisis, skyrocketing leverage and stagnant growth, distressed bond investors – those looking to profit by acquiring the deeply discounted bonds of failing or failing companies to be – have seen opportunities slip away from them across the eurozone bloc.

They’re hoping that will finally start to change – although there’s plenty to suggest that unless they get more creative, it won’t.

“Since 2010, people have been raising a lot of money for distressed funds in Europe,” says Luke Ellis, chairman of Man Group, Europe’s largest hedge fund group.

“And they’re all saying ‘there’s a lot of stuff in the banks that needs to be moved and they’re going to sell it to us for 20 cents on the dollar’. Well, so far that hasn’t happened. There still has many more buyers than sellers for distressed assets.

As Howard Marks, the founder of private equity firm Oaktree – which has raised billions for struggling European funds in recent years – admitted last March, returns have disappointed. Having hoped for profits of up to 30% per annum on its capital, Oaktree had to settle for numbers in the lower teens.

Part of the problem is that European companies have benefited from a huge refinancing facility: a wave of yield-hungry investors has driven down the cost of new capital – dramatically in some cases. Hedge funds are pointing the finger at companies such as Europcar, which would once have been prime candidates for restructuring, but which in the current environment have avoided trouble.

In short, Europe’s big draw – a bloated banking sector with underperforming assets it needs to unload – has so far failed to draw the crowds.

“The deleveraging process is slow and will continue to be slow,” says Theo Phanos, founder of one of Europe’s largest distressed debt hedge funds, Trafalgar, and now managing director of CapeView Capital. “The area that has been particularly slow is distressed single-name businesses. The price at which hedge funds want to buy is still much lower than the price at which banks are willing to sell.

Perhaps most notably, Phanos says, it has become more difficult to make money from corporate situations themselves. The Italian directory company Seat Pagine Gialle, he notes, has just undergone its third restructuring. “You would think that having already been restructured and with a very difficult structural profile, Seat’s debt would have been trading at higher value levels at the start of this year, before further restructuring was announced.” Instead, the restructured bonds were trading at 60 cents on the dollar. They are now trading at 20 cents. Hedge funds that participated in the operation were badly burned.

But there are signs that investing in European troubled debt may finally be peaking.

“Recovery” transactions, where hedge funds bought assets in countries like Greece, Portugal or Spain, have been particularly lucrative. “We are in a post-crisis environment,” says Michael Weinstock, managing director of US distressed debt hedge fund Monarch Capital, which recently opened an office in London. “It’s like what we saw in the United States in 2003 and 2009 – it’s a very good time to invest.”

And with the European Central Bank’s asset quality review looming, many believe banks will finally have to start removing some of their troubled assets from their balance sheets – a process so far hampered by the vast ECB liquidity operations. Sources at the ECB itself have been beset by hedge fund inquiries.

Fundamentally, the opportunities are plentiful for struggling hedge funds willing to look beyond just corporate bonds.

“Probably less than half of our troubled European investments are regular corporate debt,” says Weinstock. Structured credit, residential and commercial mortgage-backed securities, covered bonds, maritime loans and regional government debt all offer “extremely lucrative” opportunities in Europe, he says.

More complex companies like Punch Taverns – whose assets are almost entirely securitized – are trading at levels attractive enough for significant upside. A £200million mezzanine note issued by the company was trading at 60 cents to the dollar earlier this month, for example. Meanwhile, Enterprise Inns, another ‘corporate global securitization’ in the UK, saw the yield on a bond due in 2018 fall from 24% in 2009 to just 6% currently.

Hedge funds say the restructuring of shipping company Torm in 2012 also provided a host of opportunities, as the effects of its renegotiated contracts with other shipowners and builders affected a wide range of loans and credit arrangements. .

Even when banks are unwilling to sell their holdings of underperforming assets, the most cautious hedge funds have been able to strike big and bold deals: funds such as the US-based Magnetar, which made a name for itself in 2007 by profiting generously from the collapsing subprime housing market, turned to “balance sheet arbitrage”. The funds enter into structured transactions with banks where they agree to take the first losses on a pool of underperforming assets in exchange for large premiums. Banks benefit from the reduction of their risk exposure without losing all the upside potential of their assets.

“If you can find the right opportunities, then Europe is one of the best yield environments in the world,” says a struggling debt trader in London. “Coming up with $2 billion or $3 billion doesn’t work. You need to be smarter and more patient. There are absolutely huge offers out there.

Additional reporting by David Keohane

Carol M. Barragan