European distressed debt: investors divided by volatility

Last month conexust1f.flywheelstaging.com hosted a thinktank with a group of influential Australian investors to discuss the opportunities in European distressed debt. Participants included the Australian Government’s $80 billion sovereign wealth Future Fund, the $68 billion QIC, and leading asset consultants, with guest speaker sir David Cooksey, former board member of the Bank of England, chairman of the UK Audit Commission and chairman of UK Financial Investments.

 

While the continued critical political, social and economic circumstances in Europe are top of mind for many investors around the world, the Australian investors and asset consultants at the roundtable were divided on the issue. For some the confronting discombobulation is too risky, for others the volatility presents an investment opportunity.

Politics is dominating Europe and so it should. A united Europe, and the euro, is a political construction, not an economic one, and that fundamental structure underpins the risks and opportunities in Europe. However, the situation is far from stagnant and every day new agreements, laws and regulations shift the investment environment, causing many investors to keep a close eye on the assets in the region.

European distressed debt is an opportunity for sophisticated institutional investors who are able allocate opportunistically, but cautiously.

Sir David Cooksey, former board member of the Bank of England, chairman of the UK Audit Commission and chairman of UK Financial Investments. says the huge political desire to keep Europe together has resulted in the European Central Bank slowly being provided with more power.

“At the meeting of the heads of state of the European Union last month it was agreed to have banking union, which will mean that the European Central Bank is the regulator and bank of last resort for all 6000 banks in the eurozone. So, you are going to see an enormous institution being formed,” he says.

“Also, in principle, the countries of the eurozone have agreed to fiscal union, which means that there will be a single authority for tax and spend across Europe.” Change is afoot.

 

Airing the balance sheets

Cooksey says there are a number of forces working in unison that are creating a mismatch between demand and supply of debt opportunities across Europe.

There is a very different culture in banking across Europe from country to country and very different legal structures for dealing with default or insolvency, with Britain being the most US-like.

In addition, the International Financial Reporting Standard, which requires assets to be marked to market, has been adopted in the UK and is slowly being adopted in Northern Europe.

Furthermore, the requirements of Basel III are fundamental as a driver, which essentially requires more regulatory capital as well as risk weighting of assets to be applied.

“The adoption of risk weighting is going to mean that the banks are going to push very hard to get the higher risk-weighted assets off their balance sheets,” Cooksey says, adding that the size of the issue is “quite enormous”, estimated to be around €2.5 trillion. Some of the assets will be written off and some will be worked out but – either way – it is quite an opportunity.

“It won’t all be defaulted debt but there will be a large amount of defaulted debt there, and it won’t come out into the market in a single rush – countries all move at different paces – but it is going to happen in the next five to eight years.”

“If you are in the position of SVP, it is sensible to go to the highest risk-weighted assets because they’re the ones that the banks really want to get rid of. The truth is you haven’t heard a lot about actual transactions because the banks don’t want to disclose the write-offs they’ve taken.”

 

Democracy and the paymaster

John Brumby says he can see that increased powers of the ECB will help resolve the fundamental imbalances in the banking system in Europe, but that a fiscal union with a fiscal transfer is essential to grow the economies of Europe.

“As I see it, in the medium and longer term, if you want a distressed asset now to become a valuable asset in the future, then Europe needs to continue growing and the key to that is the fiscal union,” he says.

Cooksey says that Jean-Claude Juncker, head of finance ministers in Europe, was right in his comments: “Juncker happens to be premier of Luxembourg but he’s head of the finance ministers as well, and has said ‘we all know what to do but the only problem is we can’t get re-elected if we do it’. I think there’s gradually a realisation emerging in Europe that austerity on its own isn’t going to work. I mean you can’t move an economy from failure to success if you’re shrinking the economy the whole time. I think this is the fundamental point worth making.”

Cooksey says Germany is driving, and will be largely responsible, for the fiscal changes that are necessary. “They know they are going to have to be the paymasters. The German banking system has always been very strictly regulated compared with the rest of Europe and as a result, on the whole German banks didn’t get caught as badly as some of the others in Europe,” he says.

“The truth is the weaker countries can’t afford to rescue their banking systems.”

An example of how pervasive the problem is in Europe took place in the past two weeks when banking giants Deutsche and UBS both announced bad banks of €250 billion and €325 billion, respectively.

 

The largest economy in the world is not going anywhere

Steve McGuiness, formerly of Goldman Sachs, says there are a lot of sales going on in Europe.

“We are monitoring or in discussion or watching approximately 235 names and the total value of those credits or corporate debt situations is $380 billion. A lot of these we probably won’t go near, but a lot are very solid from old-line industries and are very key to life and business in Europe. So, the thing is you have to pick the spots and be choosy about it because business will go on. There is a lot more to come,” he says.

His colleague at SVP, Jean Louis Lelogeais, agrees.

“Europe is the largest economy in the world, it’s not going anywhere. But you cannot plough through Europe; it’s almost sifting through a bunch of stuff and saying no to most things.”

 

Go and fish somewhere else

However, investors have mixed opinions when it comes to assessing the distressed debt opportunities across Europe.

David Neal says the fundamental problem in deciding to invest in Europe, particularly as a long-term investor, is the uncertainty around the political decisions that need to be made.

“There may be things that look like good value opportunities, but why would you invest if you can’t predict the result? There are such massive changes that could go in either direction. Why would you not just go and fish somewhere else? There are other investments to make. With something that’s so unpredictable, why wouldn’t you just minimise your gross exposure to Europe?” he asks.

 

The price is right but is the place?

Cooksey believes that those risks have been priced into the assets, and he also highlights the importance of geographical discretion in choosing investments in Europe.

“The pricing of the deals reflects this uncertainty to a great extent, therefore there is more opportunity on the upside if you get it right. It is also pretty clear which countries are going to be in trouble, those that are levering themselves out of the downturn. I think that if you restrict your area of investment to certain countries in Europe, then you’re taking advantage of the uncertainty in terms of better pricing, and also riding on the back of what will be expansion of these countries as they emerge from economic distress.”

One of the reasons for geographic disparity in distressed debt opportunities is the very different culture in banking across European countries. There are also broadly variant legal structures for dealing with default or insolvency.

“There are signs that Northern Europe is taking its medicine and is beginning to move forward. Quite frankly, in the distressed debt market that is the area that I think there are opportunities. I wouldn’t invest in Spanish real estate, even at 10 cents in the dollar, because you don’t know if you’ve chosen the right asset or not, and the legal framework for unscrambling insolvency is very imprecise at the moment. But that will come, and I think you’ll find that the governments of Europe do see that they’ve got to inject funding because it is necessary to get growth back into their economies,” Cooksey says.

 

Caution: keep talking

VFMC is also cautious, with Justin Pascoe emphasising the importance of looking at distressed opportunities globally. However, he sees the merit of being invested as it allows for access to different types of conversation and allocates as part of an opportunistic bucket.

“Having a toe in the water, I think, is an interesting proposition because it gets you having different conversations with people, rather than looking at it externally and having nice theoretical conversations. If you’re actually involved in the marketplace, it does change the nature of how much time and effort you spend digging in those issues.”

His VFMC colleague, Paul Murray, is feeling the fallout of 2008 and is worried about a potential catastrophe because the banks can’t process what needs to happen.

But Cooksey says the regulatory capital situation is much different to 2008, with banks today holding up to four times the amount of capital compared to their total assets then.

“So the cushion is much better than it was then,” he says.

At its most recent board meeting Hostplus approved investment in direct lending, but Sam Sicilia says the fund is unlikely to go into distressed debt because of regulatory and political uncertainty.

“One of the reasons we chose direct lending rather than distressed debt is that the companies can be distressed because their lender is distressed. When the world is running perfectly fine, the investment matrix dominates. But when you’re in the kind of situation the world’s in at the moment, in particular continental Europe, there are non-investment considerations that could make the investment case evaporate,” he says.

 

Case by case

Lelogeais says this is a view that resonates in other parts of the world, with European investors cautious of the risks. However, he says many sophisticated investors in Europe are investing and SVP has a $500-million mandate from a Dutch fund to invest in European distressed debt.

QIC is also an investor and Adriaan Ryder says the opportunities are an asset-by-asset approach.

“Volatility gives rise to investment opportunities, that’s the great advantage of investments,” he says. “Because of the macro risk associated with this, the opportunities are all bottom-up, and it is going to be asset-by-asset, and it doesn’t matter if the debt is in distressed real estate or distressed infrastructure. The investment opportunities will be bottom-up and we are going to factor that into the risk/return.”

But Ryder does emphasis the importance of manager selection, and complete transparency, in investing in distressed opportunities.

“We won’t deploy money unless we’ve got confidence in the execution and it is done in a measured way. There’s a lot of debt-laden stuff out there and at some point in time they could turn into great opportunities, but you need patience,” he says.

 

Flexibility and caution

The Future Fund’s Neal has certain expectations of how managers should work with the fund and advocates flexibility.

“You’re not entirely sure where the best opportunities are going to come from, but clearly there are these big pressures and you’d expect something to occur. You need the ability to be as flexible as possible, which means probably not being that enamoured with very narrowly defined strategies,” he says. “Larger funds are going to be pushing for more flexibility and more control when and if the capital gets deployed, which means mandates and the ability to turn the tap off. Those are the types of conversations we are having, and we are finding them quite difficult because there aren’t very many managers who have shifted to that type of mindset where they’re prepared to be more flexible with capital. But that is what we’re looking for and trying to push for in such a dynamic.”

Lelogeais agrees and says other sophisticated investors, including Canadian funds, have similar expectations.

Other roundtable participants, particularly the consultants Allison Hill and Graeme Miller, were cautious about investing in distressed debt.

“There’s an extraordinary amount of opacity around the issue in terms of how best you might want to invest,” Hill says.

Similarly, while Telstra Super has some distressed allocations, Kate Misic says “we’re worried on almost every level”, but there is a continuous conversation about the opportunity set.

Miller says Towers Watson has recommended investments in lower hanging fruit in the debt sector, but they may be drying up.

“Institutional investors have actually done very well by investing in garden-variety credit over the last 18 months or so. This is much less complex and has much fewer risks. But I think the reality is that a lot of those opportunities have now dried up.”