"The Economist" (19th November 2011 edition) has just written about the market for assets being spat out of European banks. The article is reproduced below. For my part I see the market for leveraged loans in Europe becoming very attractive to buyers who know how to be selective, with, unlike the bank asset story, an inevitability about it. So part two of this article is my rejoinder to that in "The Economist".
Waiting to turn trash into treasure
“THIS is going to be the next great trade,” one American hedge-fund executive effused early this year. For more than two years funds have been salivating over the slew of assets that Europe’s banks will have to sell. Many have been opening offices in London and hiring to prepare for this “tidal wave” of opportunities.Up for grabs will be distressed corporate loans, property debt and non-core businesses as European banks shrink their balance-sheets to meet stricter capital requirements. Huw Van Steenis of Morgan Stanley estimates that banks will have to downsize their balance-sheets by €1.5 trillion-2.5 trillion ($2 trillion-3.4 trillion) over the next 18 months. Funds have only about $150 billion to spend on distressed debt in Europe, he reckons, which means they should have their pick of assets.
For now the “next great trade” is not looking that good, mainly because there have been no fire sales. Most banks that are selling assets have priced them close to face value, providing little to entice buyers.
Even where sales are agreed, financing is scarce. In July Blackstone, a large alternative-asset manager, agreed to buy a £1.4 billion ($2.2 billion) real-estate loan portfolio from Royal Bank of Scotland, but has yet to raise an estimated £600m to pay for it. Worse still, many banks may not be able to sell assets cheaply even if they wanted to, because it would force them to take losses that would erode scarce capital.
"We’ve been lying in wait for this opportunity since 2008. But it will come piecemeal. It will take years and years and years,” says Joe Baratta, head of European private equity at Blackstone. Some predict that Europe could go the way of Japan’s glacial deleveraging and take a decade or more to clean up its banks. Politics play a role too. European politicians, no hedge-fund lovers, won’t want to see them buying up assets at truly distressed prices and profiting from Europe’s gloom. It may even be “politically impossible” for banks that got a government bail-out to write down assets significantly, says Jonathan Berger, the president of Stone Tower, a $20 billion alternative-asset firm.
What could turn things around? Some fund managers hope a plan to recapitalise Europe’s banks to the tune of €106 billion by next June will at last force disposals at banks. So too may the introduction of Basel 3 rules that will require banks to hold more high-quality capital. Marc Lasry, the boss of Avenue Capital, a distressed-debt hedge fund, wants to buy from these “forced sellers”, because they will offer lower prices.
Banks aren’t the only prey that funds are hunting. A wave of refinancing that will hit private-equity-owned firms over the next few years may prove profitable for distressed-debt funds. And plans by some European governments to privatise infrastructure assets may also be enticing.
In the meantime, inventive fund managers are figuring out other ways to do deals. Some, such as Highbridge, a large American hedge fund that is owned by JPMorgan, and KKR are scaling up their lending operations as banks cut back. They are able to charge high interest rates, because companies are desperate for cash.
Banks are being inventive too. Unable to sell assets, they have come up with a compromise of sorts, and have started agreeing to “synthetic risk transfer” arrangements with hedge funds. For example, BlueMountain Capital, an American hedge fund, has agreed to take on some risks on a credit-default swap portfolio from Crédit Agricole, a French bank. Another hedge fund, Cheyne Capital, has reached an arrangement with two big banks in Europe to take the first 4% or so of losses from a securitised portfolio of loans, in exchange for a very healthy return.
For those hedge funds set on playing Europe, the main dilemma they face is how long to wait before buying. Steve Schwarzman, the boss of Blackstone, insists that it is important to stay put. “It’s like dating someone,” he says. “You can say let’s wait two years. But she probably won’t be around then.”
Comment from Simon Kerr
The deal flow resulting from the partly state-owned British banks reducing their assets has been slower and smaller than many expected. This is partly because the banks have effectively lobbied to have new capital adequacy regulations phased in over a longer period than first thought, and because the regulations which seem onerous in high principle on their announcement seem less so when the detail means of implementation locally are made public. In sum, along with accumulating retained earnings, there is less risk of a capital shortfall for these banks than there was, so the pressure to conduct asset sales does not come with a visible deadline.Arguably the same could not be said for the European market for leveraged loans. The peak of loan origination, the previous peak of bank-financed M&A, was in 2007 - see graphic 1.
Graphic 1 - European Leveraged Loan & High-Yield Bond
New-Issue Volume
source:S&P LCD
The recovery of issuance in 2010 versus 2009 was not as constructive as it at first looks for total volume. Nearly two thirds of all leveraged loan and bond issuance in 2010 was to refinance existing debt, whereas in 2007 the proportion was approximately 20%, when new buyout and recap activity dominated.
The economic environment over the last few years for European companies with leveraged loans is reflected in the default rate. Graphic 2 shows the inverse relationship between economic growth (with a lag) and the rate of defaults amongst companies using leveraged loans as part of their balance sheet.The inference of the two graphics of default rates is that some of the European takeover deals which are above average for size that have been financed by leveraged loans are beginning to unravel.
Graphic2 - Default Rates for European Leveraged Loans
source: S&P LCD
That recent change has been a small negative is picked up by data for companies that are seeking to renegotiate their borrowings with their lenders. Graphic 3 shows a low level of restructurings and renegotiations, but against a background of some economic growth in Europe. Graphic 3 - Number of new restructurings and covenant resets – European leveraged loans
source: S&P LCD
So there has been a build of new loan issuance in Europe to a peak in 2007 and then a large falling away of new issuance, except for re-financings. However, bank loans are not permanent capital, and the companies that take out the loans intend to re-pay them within 3-5 years and replace the loans with cheaper longer-dated financing when they can. However the state of the capital markets, and the conditions of the banks have both made this intended next phase difficult to execute. The consequence is that there is a maturity wall for leveraged loans beginning in the year after next - just 14 months away, if you needed reminding. The wall is illustrated in graphic 4.
Graphic 4 - Maturity & Rating Profile of Outstanding European Leveraged Loans
source:Fitch
Fitch estimates that of the companies they provide shadow ratings on in Europe (approximately 300 borrowers representing €240bn debt), 60% by value is due to mature between 2013 and 2015. Just over half the debt currently has a shadow credit rating of B or above with an average leverage of up to 5.4x. On the basis the high yield bond market continues to support strong rates of issuance, these loans are more likely to be refinanced in a conventional manner. The remainder, €117bn, is shadow rated B- or worse and with a current leverage on average above 6.5x represents "a significant challenge" to refinance in today’s credit markets.
PwC has commented that "The ability to refinance this wave of maturing loans is made more challenging by the fact that the majority of CLO investment vehicles (which were a key driver of market liquidity in the boom years up to 2007) will cease to be able to reinvest their funds just as the quantum of maturing loans reaches its projected peak...We expect that the majority of healthier corporates will be able to use high yield bonds and new leveraged loans to address their upcoming maturities. However, we expect there will be a significant number of companies who are forced to enter restructuring negotiations to resolve upcoming maturities."
So the European market for high yield and leveraged loans has some serious indigestion problems ahead of it. This will create some gross mis-pricings as the weight of paper needing refinancing relative to the size of the buyers is a considerable mis-match. Those buyers that are still active in the market will be able to be very selective, and they will have many opportunities and considerable work to do as the restructurings start to happen.
Some market participants are starting to get ready now. GSO Capital Partners, the global credit management arm of Blackstone, only last month acquired the largest manager of leveraged loans in Europe, Harbourmaster Capital. The AUM of Harbourmaster, at €8bn will be attractive to GSO/Blackstone, but the juice in the deal is the capacity to analyse the opportunities that will arise as the wall of maturities approaches. This area of investment is not one in which one can acquire the necessary understanding quickly by adding a few bodies. Having a large team (40 professionals in the case of the new combined entity) will give GSO a capacity advantage that will belong only to them and the other early movers yet to emerge. This is an excellent strategic deal on Blackstone's part.
Addendum
6th December 2011:
MKP Capital Management LLC, the New York-based global macro and structured-credit hedge fund with $4.5 billion in assets, is starting a credit team in London to invest in European debt. Steven Jeraci, a partner at MKP, will relocate to the firm’s London office to hire investment professionals and build the team’s infrastructure, the hedge fund said in a statement today. The team should be in place by the end of next year, the company said.(source: Bloomberg News)
Comment - the fact that a team will be put in place by the end of 2012 says something about when the opportunity to commit capital will be ripe for exploitation, and reinforces the point that to build a quality team will take some time.
Addendum
25th January 2012:
Mesirow Advanced Strategies Inc., which allocates $14 billion to hedge funds, has been increasing the amount of cash it holds in the last couple of months in preparation for potential opportunities including those in the European credit markets. “What we want to have is the flexibility that if particular things do deteriorate, we can play offense relatively quickly, being able to put capital to work in interesting opportunities,” Marty Kaplan, chief executive officer of the Chicago-based fund of hedge funds manager.
Kaplan said Mesirow may also deploy more capital to relative-value strategies such as capital structure arbitrage, which seeks to profit from mis-pricing of different securities sold by the same company. Mesirow has redeemed out of some strategies that take more directional views on the markets, such as long-biased equity and event-driven hedge funds that bet on corporate activities such as mergers and acquisitions. “As the situation in Europe deteriorates, right now you don’t see tons of corporate activities because confidence in board rooms has declined,” Kaplan said. Mesirow generally favors credit over equities strategies, said Kaplan, and prefers structured credit, which tends to be mortgage-backed, over corporate credit.(source: Bloomberg News)
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