In Japan in the late 1990s they were called hagetako fando (“vulture funds”). In Germany a few years ago they were dubbed “locusts”. Now, as policymakers and regulators restructure the financial system, distressed debt investors – as they prefer to be known – are circling again looking for opportunities.
The collapse of Lehman Brothers a year ago triggered what may become the most fruitful cycle ever for funds that survived the market turmoil that followed.
Demands on restructuring professionals’ time have become overwhelming, too, as companies tried to reduce their debt burdens.
“The mixture of over-leveraged and under-collateralised complex capital structures, lack of liquidity, derivative risk-shifting instruments such as credit default swaps, and aversion to equity risk among most creditors, have created a new and much more complicated restructuring dynamic in many large scale restructuring transactions post-Lehman,” explains Jeff Werbalowsky, co-chief executive officer of investment bank Houlihan Lokey.
Europe in particular, with its fragmented and diverse bankruptcy regimes, is expected to be one of the most attractive regions for investors, as it goes through what some see as its first real distressed debt cycle.
A string of companies has been taken over by way of their debt. Oaktree Capital, the US buy-out fund, acquired the UK’s largest estate agency this year and has been in talks over debt-for-equity swaps at the German groups Bavaria Yachtbau and Almatis, an aluminium company.
The funds Apollo Management, TowerBrook Capital and York Capital were part of a lender coup to wrestle control of Monier, the roofing materials company.
“Europe has always been a relatively small market, with $1,000bn of the $37,000bn globally of high-yield loans and bonds, but it registers as the region of greatest opportunity for us,” says Victor Khosla, founder of Strategic Value Partners, a global distressed and credit investment firm, which manages more than $3bn in assets and has half its investment team in Europe.
“Debt prices in Europe are much lower than in the US, and if European investors need to sell in a hurry, the pricing can be even worse,” he adds.
The financial crisis has shaken out many of these funds’ competitors.
“Potential investors remain cautious about allocating capital to distressed debt after the difficult investment period in 2008. However, they recognise that Europe is less exploited as a territory than the US, and they are searching for investment managers with a long history in this market,” says Theo Phanos, founding partner at Trafalgar Asset Managers, a hedge fund with $1.5bn of assets under management investing in European credit and distressed debt.
“We expect a long and unpredictable distressed cycle, where versatility and knowledge of European credit and asset markets are essential.”
But the cycle has not played out as some had expected. Banks with collateralised debt obligations – structured investment vehicles that pool risky loans and which fuelled much of the cheap leveraged debt in the run-up to the crisis – have been accused of being reluctant to sell assets or take big write-offs.
As a result, there has not been the wave of distressed sellers that funds might have hoped for.
Moreover, as restructurings have been implemented in recent months, there have been concerns that they have just been sticking plasters, as lenders tried to avoid debt write-offs, threatening to create a legacy of zombie companies with continued high leverage, surviving simply to service obligations to their new owners: the banks or debt investor.
Part of the problem is that lenders have been torn over how to value businesses in the face of an unprecedented financial crisis. “One of the key debates is about whether you can restructure companies on their value at a later date to preserve value for subordinated creditors and avoid crystallising losses today,” says Martin Gudgeon, head of European restructuring at Blackstone.
Jonathan Rowland, head of EMEA financial entrepreneurs group at Citi, says companies have faced two main types of debt renegotiations this year. “If from a leverage and operational standpoint, performance is off plan, banks will push for a lot. But, in the more distressed situations, banks tend to be more benign, as they don’t want to end up owning businesses.”
Mr Khosla believes the need for repeat restructurings will mean Europe’s distressed debt cycle will last longer than in the US, potentially for three to four years.
But as confidence has started to return and markets have rallied – allowing many companies to refinance – some believe the approach to restructuring is changing.
“So far, fewer business have gone through the restructuring process than we would have expected, but we can see that starting to change,” says Sion Kearsey, partner at Kelso Asset Management, the UK turnround fund.
“The real difficulty in committing capital over the past two years has been the uncertainty over projecting companies’ top line. Now that we are seeing some stability returning, I believe we have foundations we can work off.”
This year has seen a shake-out of the banks and investment community and a wave of start-ups in debt trading or restructuring advisory. Banks rebranded their leveraged finance teams as debt restructuring advisers and M&A advisers also “rebadged”, but some say there are not enough advisers to meet the need.
“There’s a lack of financial restructuring expertise in London, as the rise in the default rate and the increase in distressed situations has outstripped the number of financial advisors who can deal with them,” says Dorian Lowell, who heads Gleacher Shacklock’s Special Situations Group, which launched in March.
After a wave of balance sheet restructurings and covenant amendments, bankers expect a greater focus on operational restructuring rather than financial engineering.
Philip Davidson, head of European restructuring at KPMG, says: “To ensure companies survive the downturn and are able to adapt quickly to the change in the cycle, rigorous operational restructuring may be needed.
“There appears to be more certainty in the lending community, which should enable the resolution of problems that have been considered too difficult up to now. While fixing the balance sheet may be appropriate for some companies, others may need operational restructuring as well.”
Graham Rusling, who heads Barclays’ Commercial Bank business support team, which has grown by a third in response to the crisis, expects the number of companies coming to his unit to remain high in 2010.
“Businesses tend to be just as vulnerable, if not more so, coming out of recession as going in,” he says, adding that there will now be focus on checking whether companies that were given breathing space at the start of the downturn are delivering.
“We are probably entering phase three of the restructuring cycle, when it will become apparent whether those companies that were restructured early in this recession are delivering on their stabilisation and turnround plans. This will be particularly so if their restructuring was ‘lighter touch’.”
Management teams are also looking for their potential rewards in restructurings, as they come under pressure to deliver. “Management teams are actively looking to re-cut their packages either with their incumbent [financial] sponsors on refinancing or with their prospective new owners, such as lenders, to get an equity stake in the business, so they have incentives to stay,” says Jacques Callaghan, managing director at Hawkpoint.
“What is the point of being an employee and working for the bank? It is important in restructuring negotiations because otherwise management could potentially walk out.”
Failure itself can bring opportunity. Pip McCrostie, global vice-chair for transaction advisory services at Ernst & Young, says: “There will probably be an rise in M&A coupled with a parallel rise in business failures. This will provide opportunities for acquirers to capture market share and increase revenues in ways that were impossible two years ago.”
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