European distressed: Myth or reality?
While many investors may be disappointed the highly anticipated European distressed opportunities have not yet materialised, it is a myth attractive returns cannot be generated in the current environment, says Kateryna Taousse.
There are a variety of ways to capitalise on dislocations within credit markets caused by the continued European crisis. While many investors agree history repeats itself, the next material market dislocation will be similar to the most recent ones, so fresh in our collective memory. Looking for another "Lehman event" or another "subprime trade" might actually get you in trouble as you may literally end up with a portfolio set up for a binary outcome with either too much or too little risk.
This is particularly true for directional and potentially 'high-octane' strategies such as investing in distressed securities. In today's environment, considering bottom-up investment opportunities, market structure and the uncertain macroeconomic and regulatory/political backdrop, a balanced long/short approach to European distressed debt exposure should ideally exhibit the following key characteristics: limited market directionality and a focus on generating alpha on the short side; diversified sources of outperformance; manager flexibility and skill to look for opportunities across Europe (including Italy, Spain, etc.); and the ability to be dynamic and nimble.
It is useful to remember the best systemic distressed opportunities of the past came from dislocations caused first by frenzied buying (which created the financial bubbles) and then a return to more sensible levels by the equivalently, if not stronger, forced selling. In Europe, the frenzied buying has already occurred, but we have not yet seen systemic forced selling; this is not the only way to generate solid performance in distressed assets.
There are also opportunities as certain sectors of the economy go through structural shifts – such as media, solar/ethanol – due to a shock to their "system" (technological or regulatory changes), or are challenged cyclically (industrials, retail) because of where we are in the economic cycle. One can make a very well-reasoned and intelligent argument for why we should see a systemic European distressed market ripe with opportunity. However, in the current environment, the market only offers pockets of opportunity.
Parts of the market are best avoided currently, such as non-control illiquid distressed and deep value plays with no identifiable catalyst. But there are also a number of ways to invest that should provide sufficient compensation for the risk taken.Stressed corporates: This has been, and is expected to be, the most attractive part of the market as dispersion and the risk on/risk off environment creates dislocations on the long and short side. Traditional distressed/restructurings: Given low high-yield defaults (0.98%) and moderate leveraged loans defaults (5.44% ), there are opportunities that fall into the idiosyncratic bucket with more value likely to be extracted from smaller, more niche situations. Given that we have not yet seen signs of a material pickup in economic activity, the fact banks continue to shrink their balance sheets and access to capital for highly levered and cyclical/structurally challenged industries provides investment opportunities. These capital structures will need to be addressed sooner or later, resulting in material re-pricing of their capital base. Liquidations: Investing in liquidating estates may continue to offer an attractive return profile (low-teen projected IRRs with limited losses to invested principal). While there are not a vast variety of situations, many of those that exist are large and offer a complexity premium (at times reaching 5-10%, or more) without taking a lot of the underlying systemic risk. The final outcome is more linked to the specific bankruptcy case rather than the general market environment. Structured credit: Opportunities should continue to exist within corporate and non-corporate underlying exposures with relatively senior characteristics, attractive yields and mispriced optionality linked to a catalyst or economic recovery.
Potential downgrades of individual corporates or sovereigns, such as Italy or Spain, could be catalysts that cause subsequent re-ratings of many corporates linked to the sovereign credit rating or considered as a 'comp' to that specific corporate. This could potentially create material selling pressure from ratings-sensitive holders.
We could also see a large high-profile corporate restructuring that could reasonably create a domino effect causing re-pricing of their 'peer group'. And, of course, the possibility exists of more extreme tail events including a potential dissolution of the European Union.
Considering that the timing of the above is subject to many factors, it is most prudent to diversify European distressed exposure across a variety of risk premia and hedge to prepare for large moves in equities or credit.
While many investors are focused on capitalising on dislocations caused by forced sellers, it is as critical to long-term performance to avoid becoming a forced buyer. This is of particular importance considering the lower liquidity of the underlying credit instruments in Europe and the magnitude of volatility in asset prices observed since 2008.
How do you achieve this? Well, first of all, it is a much bigger challenge for large European distressed funds that are under pressure to deploy capital. But for others, and from an asset allocation standpoint, it is important to keep in mind that the distressed debt strategy is cyclical and investment opportunities cannot be created by the will of asset allocators. From a portfolio manager's standpoint, disciplined entry/exit points are of paramount importance, as is a focus on analysing whether you are being compensated on an absolute basis for the risk rather than gravitating to the best 'relative value' trade.
This involves not just being aware and limiting exposure to crowded trades or themes, but also challenging the principles and sentiment that are so commonplace within the market at any given point in time. European credit markets are still dominated by private rather than public credit, banks rather than institutional direct holders, and only a few 'active' managers. All of this exacerbates negative feedback of the market sentiment when these core assumptions and beliefs come into question. But it is often the same set of conditions that makes the environment full of attractive investment opportunities.
Distressed investing in Europe is not for the faint-hearted, nor is it the right training ground for inexperienced investors. There are a multitude of complex, country-specific jurisdictions and, more often than not, untested insolvency laws. Add to this the many political and cultural intricacies, and you may find a situation in which it is quite difficult to determine the 'intrinsic value' of the underlying exposure you are buying.
Further, it is even more important to have awareness of the macroeconomic and regulatory environment, as it is inevitably linked to the risk/return characteristics of an investment.
Kateryna Taousse is an associate director and portfolio manager for the global distressed strategy at PAAMCO