28th February 2012
Vultures get a bad press. But they fulfil a vital function in clearing up carrion. The same may go for hedge funds and others who buy up bust and heavily in trouble bonds – they claim to fulfil a vital function in offering something, if only a cent or two on the dollar, for assets otherwise deemed worthless or difficult to sell.
And they say they provide a service by pushing liquidators and others for a better payout. This is controversial – any improvements may be at the expense of others such as employees or equity holders.
Four years into the biggest financial crisis for eighty years, distressed debt investors see a new dawn. Damien Miller, a manager at sub-investment grade specialist boutique Alcentra told the Financial Times that it was the "start of a golden age. There will be tremendous opportunities in stressed and distressed debt in Europe."
Distressed and stressed
There is no accepted definition of stressed and distressed debt but bonds with a yield to maturity more than 1,000 basis points (10%) above the risk free benchmark such as US Treasuries or UK Government Bonds (gilts) would count as "distressed" while 600 to 800 basis points (6% to 8%) is labelled stressed.
Whether mis-placed optimism or correctly seeing a market upturn, US and other hedge fund managers see distressed and stressed debt as a major opportunity asset.
The idea is managers buy debt from corporates and sovereigns (such as Greece) that currently have trouble either in meeting interest payments or in repaying the face value amount on maturity. These bonds often trade a fraction of their original denomination.
Some distressed bonds will go bust – holders can then try to extract as much value as possible from liquidators. But others will recover – perhaps as part of a debt for equity restructuring swap. The skill is picking few of the flops and as many of the recovery possibilities. This blog is an excellent primer.
According to Reuters, the "confluence of widespread deleveraging among European banks (this creates forced sellers, offering a present opportunity) and a significant wall of debt maturities that must be refinanced (producing liquidity problems for issuers but also opportunities for non-traditional and innovative sources of financing) has created a rising tide of distressed credit opportunities for U.S. alternative investors (hedge funds)."
Loss averse banks are a stumbling block
But there will be no sudden bonanza as the distressed markets may develop more slowly than anticipated late last year. Banks find it difficult to sell assets at an acceptable price but they don't want to absorb the losses by disposing of bonds at knockdown values.
So investors are biding their time – waiting for even more short term distress, hoping that European banks and other issuers will finally get around to making realistic decisions rather than putting off the inevitable by sweeping it under the carpet.
The two most important European destinations for distressed debt and restructuring specialists are Portugal – unsurprisingly – but also northern Europe. The latter is attractive as institutions dispose of assets and companies find they cannot refinance debt from banks which are increasingly retreating into the citadels where only the most secure credit risks are permitted. This increases the opportunity for turnround houses.
There is plenty of activity; Los Angeles-based Oaktree Capital Management, which has already closed a European-focused distressed fund, is currently raising a global fund. It raised $6.1bn last year while US investor Lone Star Funds raised $2.4bn for European deals in 2011.
Furthermore, banks, which are now more risk-averse than previously, are retrenching from credit deals while offering new loans or refinancing existing debt less often than before.
But it is not a one way risk. The current optimism could be mis-placed if conditions in credit markets deteriorate further, leaving new holders carrying losses.
The European Banking Authority, Europe's banking industry watchdog, told banks in December that they needed to raise €114.7bn (£100bn) in fresh capital to make them strong enough to restore investor confidence. But this is likely to be a substantial underestimate as banks mark down asset values further.
It's not just credit ratings. Investors also have to deal with a variety of legal
Many restructuring firms have taken their fill of Greece. Now they are looking at Portugal where a number of investors were forced to sell after Portuguese debt was downgraded to "junk" by ratings agency Standard & Poor's. It is the eurozone's current next weakest player after Greece – but hedge funds may wait until the present Greek crisis shows some clarity before they swoop.
Portugal next in line
"As the Greek deal works through, investors will probably focus on some of these other countries and Portugal was always going to be the next in line," said Stuart Culverhouse, chief economist at Exotix, a frontier market investment banking boutique specialising in illiquid and distressed assets.
"If it continues to weaken … that is likely to throw more opportunities for our traditional business," said Culverhouse, whose firm has been active in the Greek market.
Long-term Portuguese bonds trade at less than half their face value; those maturing in early 2014 trade at more than 70 cents in the euro. If these figures start to converge, it will be negative for the Portuguese economy but perhaps positive for distressed debt funds.
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