On the morning of 2 October last year a four-masted, 104-metre long Argentinian naval-training frigate, called the ARA Libertad (pictured, right), sailed into a harbour in Ghana planning to take on supplies. The 300 crew were rather surprised when Ghanaian authorities informed the captain that the ship was being detained in the port on the orders of a court.
A so-called vulture fund, a subsidiary of Elliott Capital Management, was demanding payment on $1.3 billion (€1 billion) of debt resulting from Argentina defaulting on bonds in 2001, and was claiming the ship in lieu – or rather, a bargaining chip to get Argentina’s government to take their demand more seriously.
It wasn’t the first time distressed debt linked to the 2001 default had caused high-profile action. Back in 2007, a group of bondholders planned to detain Argentina’s presidential airplane, the wonderfully-named Tango 01, when it flew to the US for maintenance. At one point another creditor even planned to take works of art due to be displayed at Argentina’s stand at the Frankfurt book fair. (Argentina's president Cristina Fernández, whose plane was nearly detained by a group of bondholders, pictured, below left.)
The world of distressed debt is rarely so exciting – or bizarre, or ridiculous, depending on your point of view – but it is certainly catching the attention of investors at the moment. Swiss private bank Pictet has been advising families to put a small allocation into distressed debt, predicting that it offers a 5 to 6% return. US banks suggest that 15 to 25% might be possible over three to five years.
Distressed asset specialist Apollo has raised $3 billion for investing in distressed debt. Another, Oaktree, has $5 billion of assets that it is preparing to deploy, and plans to launch a new $3 billion fund. Others have also raised lots of money. Private equity firm KKR says that it has $2.5 billion to invest in special situations in Europe.
Investors are expecting distressed assets to come from two directions. The first theory is that the fruits of imprudent and overleveraged mergers and acquisitions between 2004 and 2007 will be a slew of defaults over the next 12 to 18 months. Plenty of good businesses are generating profits but are nevertheless struggling to throw off enough money to service unmanageable boom-years loans.
Take, for example, Energy Future Holdings, the Texan energy group bought by private equity firms TPG and KKR, along with Goldman Sachs, in 2007 for a reported $45 billion. Gas prices fell and the five-year hedges have now ended and the vast debts resulting from the deal are currently being restructured. Distressed debt experts and private equity firms are lining up to take on such deals.
Secondly, distressed southern European assets offer private equity opportunities. Italy, for example, is unappealing at the moment for many people, but those with a long-time horizon can see that its solid industrial base and history of exporting (and it does a lot of trade with China) mean there are cheap assets there right now that are facing short-term problems.
Others are looking to Spanish real estate (pictured, right); things might be tough there now, but in 10 or 15 years the costas will still be pretty. Funds are on the lookout for distressed buyers hoping to offload trophy assets or high-quality commercial property, and some large real estate fundraising has recently closed.
The really big opportunity that has turned the heads of the distressed debt giants, however, is the prediction that European banks will have to shed vast quantities of debt as they adjust to meet Basel III capital requirements. PwC predicts that €3.4 trillion will have to go from balance sheets over the coming years. Distressed debt investors hope that they can gobble up whole loan portfolios at knock-down prices.
It all sounds like we ought to be in the middle of a distressed debt feeding frenzy. But things have so far not exactly gone to plan. Although the distressed debt experts have been raising money since 2008, so far there has been little activity.
Thanks to the Fed’s low interest-rate policy, default rates in the US have actually been at record lows in the past three years. In Europe, the European Central Bank has provided banks with a backstop that has prevented them from offloading low-performing assets. Some suspect that banks have been reluctant to shed their underperforming loans, on the grounds that it might make them look weak, something they can ill afford.
“If you have an unhealthy balance sheet and trouble with assets, the fear is that you start selling and it ends up being like a fire sale, and you kind of show your hand and all of a sudden you find yourself in a weak position vis-à-vis the market,” says Jim Miller, founder of family office advisory firm Somerset Capital.
So far, the distressed story has been a damp squib. “I think a lot of people invested in distressed earlier in the cycle thinking it’d be a good play and have ended up a bit disappointed,” Miller says. “The other thing is that there are a lot of big players in distressed, so they rely on very big deals which haven’t come through. Since Lehman Brothers and AIG there haven’t really been any big deals.”
That said, he still reckons that the deals will come through, albeit slowly. He says that families have money in distressed assets in the form of private equity investments, or other longer lock-up vehicles, because they can afford the illiquidity premium. Indeed, recent Somerset research showed that 46% of families surveyed had no hedge fund exposure to distressed assets.
The optimists who theorise that banks are holding onto their poorly-performing assets while they build up their balance sheets argue that once the Basel III requirements are met, we ought to see loans being cut loose. That might well coincide with rising interest rates and defaults, meaning that the feeding frenzy could still happen. James McGrath, director of research at multi family office LGL Partners agrees that the meeting of Basel III requirements will “shake loose a lot of supply” on banks’ balance sheets, although he adds that “we don’t think the big returns are going to be realised in the next month or even in the next few months”.
The good news for those invested in distressed debt is that “in most markets the trend is for zero growth and in some there is still recessionary pressure”, says McGrath. As time goes on, and firms need to refinance, he expects that hedge fund and private equity firms will step in and play the role that banks used to.
However, not everybody is convinced that this banking story will play out as the received wisdom predicts. Andrew Bellis, a managing director at venture capital company 3i’s debt management wing, reckons that the (often American) investors who have poured money into distressed assets and special situations funds on the grounds that European banks will shed lots of underperforming loans may have misunderstood the way those banks work. “We’ve seen this prediction that the banks are going to shed lots of corporate loans, but it doesn’t really seem to happen,” he says.
“The European mentality is very different from the American one. Do banks or other European investors sell large blocks of distressed loans? I’m not convinced they do, apart from some of the UK lenders who have a bad bank and a clear mandate and are actively reducing positions. Often the European mentality is to hold, and if it does go wrong it is written off at a loss and then worked out.”
He thinks that European banks don’t actively sell off badly-performing loans, because they take the view that in the long term it is more important to stay on good terms with creditors, particularly if there is a private equity sponsor involved. If the banks do shed bad loans they will do so over time, Bellis thinks, and not in the sort of large tranches that the big distressed funds are looking for. This raises the horrible – for investors – suspicion that these mega distressed funds are the result of a cultural misunderstanding.
And what of the Libertad? It’s free once more and sailing the high seas. The creditors, however, are still clamouring for their money. The Argentines are digging their heels in. And for now, the only people making money are the lawyers.
Another way with debt?
Since 2008, CLOs – collateralised loan obligations – have been about as fashionable as invites to a dinner party at Bernie Madoff’s house, but things are changing. Asset manager Cairn Capital recently became the first manager to sell a new European CLO since Lehman Brothers’ collapse, raising €300 million. Rothschild’s Debt Fund Management division says it is two-third of the way through raising its own €300 million CLO. Canadian private equity firm Onex is also moving into CLOs, it has said. More than $50 billion of CLOs were issued in 2012, the highest figure since 2007. (Gerald Schwartz, chairman and CEO of Onex corporation, pictured, right.)
There will be a roll-off of old CLOs in the next six to 12 months, and a manager from a firm that is thinking of raising a CLO said that increased private equity activity should spur things along. Investors, he said, are far more confident about the pricing of newly-issued debt, but remain nervous about any involvement with legacy debt.
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