As growing economic and financial turmoil takes its toll on Europe’s corporate sector, stresses are appearing in numerous over leveraged companies. When companies with sound assets and business models struggle due to excessive debt or leverage in need of re-financing, value often shifts from equity to creditors.

US hedge funds and private equity firms, such as Centerbridge Partners and Baupost, which specialise in distressed debt, are gearing up for what they predict will be a wave of opportunities as Europe struggles with its sovereign debt crisis and near-stagnant growth. The speed and timing of the wave of opportunities in Europe is still uncertain and has, for the moment, been delayed by recent events such as the European Central Bank recent pre-Christmas gift of €489 billion in liquidity provided to European banks.  However, behind the scenes distressed cases are mounting and investors in the strategy have already begun to benefit from shifts of value from equity to debt securities.

Ben Babcock, European head of restructuring at Morgan Stanley, says: “Deleveraging is taking place at the consumer, corporate and sovereign levels, against a weak economic backdrop and a looming maturity wall.”

Distressed debt investors are circling companies such as Thomas Cook, Premier Goods, Italy’s Seat Pagine Gialle and Norway’s export credit agency, Eksportfinans, while banks, such as Lloyds TSB and RBS, are selling large portfolios of loans in order to deleverage their balance sheets and pay back the British taxpayer.

These transactions are often executed at valuation and on terms that provide very attractive downside protection to distressed investors, often benefiting from capital protection through over collateralisation, significant capital gains upside, short-term preferred cash distributions and, in many instances, very attractive cash yields.

Seat Pagine Gialle’s provisional restructuring proposals involve converting €1.2bn of the company’s debts into 90% of Seat Pagine’s equity. At the time of writing, its bonds were trading around 50-60 cents a euro. Meanwhile, Thomas Cook’s €400m bond was yielding 42.8% and its €300m bond 34.3%.

Eksportfinans was downgraded to junk bond status in November, triggering forced selling of its bonds by investors restricted to holding investment grade debt. Apollo, one of the biggest debt investors, has purchased at least £12m of Premier Food’s debt from Allied Irish Banks at 70 pence on the pound.

Lloyds Banking Group is expected to take a loss of about 35% on a £1bn basket of commercial property debt as four bidders for the portfolio tabled bids in the region of £650m. Lloyds has £24bn of bad property loans to unwind.

Royal Bank of Scotland has done a deal with Blackstone, the US private equity group, in which the bank will hand over control of a £1.4bn book of distressed property loans, representing the largest such disposal of UK commercial property debt.

Analysts at RBS forecast that the high yield default rate will more than double from the current 2.6% to 5.6% during 2012. One senior distressed debt trader, who declined to be named, said: “Distressed debt is going to be a really big thing in 2012. Banks have shown forbearance for several years, but they are now calling in their loans and this is putting companies under pressure to restructure their debt or sell out.”

Standard & Poor’s European Leveraged Loan Index distressed ratio, which follows the percentage of performing loans trading below 80 cents on the euro, jumped to 32% at the end of November 2011, from 27% at the end of October, almost twice the level at the start of 2011. This suggests a default rate higher than at the height of the financial debt crisis, according to S&P’s Leveraged Commentary and Data.

As for bank loans, KPMG estimates that about €1.5trn-2.5trn of bank deleveraging is required over the next two years. But the sale of these assets has been slower to take off than expected, due to disagreements between banks and distressed debt funds on pricing. However, banks are loath to sell assets at a loss (especially those funded by the UK taxpayer), while investors in distressed debt are keen to ensure target annual returns of 20% or more.

Graham Martin, global head of KPMG’s capital solutions business, which is currently advising banks on €20bn worth of sales in Europe says the sale of bank loans will take place gradually over several years, as it would damage banks’ balance sheets to sell off assets more quickly.

Distressed debt investing is pursued by a minor, yet significant, portion of institutional investors. According to Preqin, out of 4,000 institutional investors tracked by their database,  24% have exposure to distressed debt and special situations funds.

But the term ‘distressed debt funds’ embraces a multitude of different strategies from distressed debt (purchasing securities when trading below fair value and trading out when valuations recover), turnaround (creating value by taking control of distressed businesses either through acquisition of debt or equity securities) and special situations (typically event-driven strategies creating value through price arbitrage around a specific event, such as a recapitalisation or merger).

Some distressed debt funds, as  managed by Avenue Capital, Monarch Capital and Mount Kellett may maintain a flexible strategy often involving opportunistic trading of securities. Other investors, such as Apollo Global Management, Oaktree and KPS Special Situations, like to exert control over their investments, actively repositioning their investments through change of management, renegotiating labour or supplier arrangements or changing the overall business strategy.

Investors should be aware that not all strategies prove to be counter cyclical to the market. Trading based strategies are fairly cyclical, while distressed for control strategies are often truly uncorrelated to the market trends.

Furthermore, some strategies prove not to be so consistent over time and almost all strategies struggle once size of a fund grows significantly. The very nature of special situations and distressed debt relates to unique opportunities which may not be easily scalable and repeatable.

Overall, there is a wide dispersion in returns. A recent survey on private equity conducted by bfinance revealed that 97% of institutional investors expected net returns in IRR terms from special situations at, or above, 10%. However, only 76% of these investors achieved this expectation based on realised investments. Preqin reports median net IRR returns from 126 tracked distressed debt funds at 14.4%. While the dispersion between upper quartile funds and lower quartile funds is over 1,300 basis points, interestingly distressed debt compared favourably against buyout strategies. Median buyout net IRR returns according to Preqin have been 9.6%, far lower than distressed debt and with a higher dispersion of 1,500 basis points.

Lorenzo Rossi, head of private markets at bfinance, says: “Much of the distressed returns can be attributed to timing. Some distressed debt and special situations funds which invested in 2008 achieved net IRR returns of 50%-70% because they got their timing right. However, we see several fund managers that have demonstrated that often one can get better returns and with lower risk over the long term from debt strategies than from traditional buyout equity investments” 

Rossi believes that, generally, special situations and distressed strategies are most successful when companies in distress are struggling to find new funding from banks or from the capital markets. It is in these circumstances that debt investments, especially distressed debt and special situations, can generate returns in excess of upper quartile buyout equity investments.

“Considering that private investments in equity, such as buyouts, are increasingly under pressure and tend to return on average 1.5 x money and mid teens net IRRs, investors should consider allocations to private debt strategies as a good complement and perhaps a better risk-adjusted replacement for private equity investments,” Rossi adds.

His advice is for investors to be very selective and to focus on managers that are transparent on their portfolios’ underlying positions and can demonstrate consistency of capital protection at underlying asset level. There is little room for error in debt strategies and relying on market timing can mask the risks taken by a strategy.

While in buyout strategies good fund managers may generate 2 x money at fund level, while still losing capital on 20-30% of the companies in a portfolio, in distressed debt strategies, the loss ratio must be significantly lower in order to ensure attractive returns over the long term.

Investors often overlook the fact that private debt investing can be just as attractive, or even more appealing than, private equity investing if they are able to look at their investment holistically, enable the generation of mid-teens net IRRs through a combination of distressed, special situations and direct lending strategies. This can provide a combination of yield and capital gains with significant capital protection, which is typically not the always the case with private equity strategies.

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