US players are set to rule distressed Europe, writes Jennifer Bollen, but local players could offer crucial cultural advantages

Europe might be the stage for the biggest wave of distressed debt opportunities since Lehman Brothers collapsed but it is expected to be a very American affair. US firms look set to retain their dominance of the European distressed debt industry, dwarfing investment by their European counterparts, having amassed huge funds on the back of their more mature home market.

Christopher Flowers, head of private equity firm JC Flowers, signalled US investors’ growing appetite for European distressed deals in May when he reportedly moved from New York to London.

Other US firms that have bolstered their teams in anticipation of the rise in deal flow include Oak Hill Advisors which, in May, hired Declan Tiernan as its first client coverage specialist in its London office and, in April, appointed Doug Henderson, former chairman of the European credit finance group at Goldman Sachs, as a London-based partner to lead its European performing credit business and boost its distressed operation. Last year, Kohlberg Kravis Roberts appointed Mubashir Mukadam as European head of special situations, based in London.

“Prior to the middle of 2007 when the problems started to arise, there were 30-odd European distressed debt funds and of those, the ones still standing you can count on one hand,” says Jon Macintosh, a director at Acencia Debt Strategies. “It’s partly because they had bad performance and because market liquidity dried up and they were smaller so they were uneconomic and shut down.” By contrast, he says that the US distressed debt industry emerged from 2008-09 stronger because they were bigger, better established and could survive on smaller assets.

The fundraising trail
US managers account for half of the firms currently raising Europe-focused distressed debt funds, with Apollo Global Management attempting to raise the biggest, with a €2.5bn ($3bn) target, according to data provider Preqin.

There are eight Europe-focused distressed funds hoping to raise an aggregate €6bn, of which 86% is being raised by US-based managers with the remainder being raised by European firms.

New European distressed funds are emerging, including a €350m fund by ESO Capital Group focused on the UK and German-speaking Europe and a €185m fund being raised by Iceland-based Framtakssjóður Islands. But some new funds will struggle to raise money. “More European start-ups are emerging to capitalise on distress,” says Amit Staub, a portfolio manager at credit specialist European Credit Management. “The issue for many of those is what is their track record and how they are going to differentiate themselves in a market dominated by heavyweight funds.”

Macintosh says that new European funds will find it difficult to raise fresh capital unless they are of high calibre and have a high-profile team.

The fundraising comes as European companies increasingly suffer from the euro-zone tension and falling GDP, while debt maturities for European leveraged loans alone are expected to peak in 2015 at about €50bn, according to rating agency S&P’s. Meanwhile, rival agency Moody’s estimates that within Europe, the Middle East and Africa more than $325bn of speculative grade non-financial corporate debt needs to be refinanced between 2012 and 2015.

Biding time
Some executives say that the distressed debt cycle has begun in Europe but that the biggest volume of opportunities remains far off because banks in the region have been slow to de-lever their balance sheets in accordance with Basel III. Iain Burnett, head of distressed debt at BlueBay Asset Management, says that the distressed opportunity will be a protracted process; Macintosh says that the cycle will play out as a steady stream over a couple of years.

“The big hurricane is not yet here,” says Jarkko Matilainen, director of hedge funds at Finnish pension provider Varma, which expects to avoid the first few waves in this cycle because opportunities to generate its desired returns of more than 20% have yet to come. “It seems to be very tricky so we do not want to be committed too early. There is a dread that distressed might turn into bad distress - and that will be painful.”

Many companies have avoided default so far through ‘amend and extend’ agreements with their lenders. Burnett says: “Temporary solutions have been put in place but the underlying problem of over-leverage is still there and because time has not produced a solution, these businesses have not recovered.”

Others are likely to have scraped through because the ‘covenant-lite’ terms on their boom-era loans are so loose that they are difficult to breach. According to Macintosh, a huge volume of debt from the boom years was issued with floating interest, meaning that an interest payment is hard to miss unless the company is in a disastrous state.

According to rating agency Fitch, global corporate default rates remained low in 2011, ending the year at 0.3%, compared with 0.5% in 2010 and 2.6% in 2009. However, pressure on bank credit quality caused the overall corporate finance downgrade rate in Europe to nearly double last year to 23.6%, from 12.8% in 2010.

The high-yield bond market made it possible for some large businesses to refinance their debt but the market shut down last summer amid the heightening tension in the euro-zone, and remains volatile. “The high-yield primary markets are effectively shut in Europe. In the US, it’s a more mature and a larger market that is, therefore, more resilient to volatility,” says Staub. “The propensity for the market to shut makes it hard for companies to time their issuance. In addition, there is a calendar that banks have got to manage because there is only so much the buy side can look at in any one time.”

The first distressed debt deals are expected to come from core Europe, with peripheral Europe - including Greece, Spain and Portugal - likely to lag. “Peripheral European banks will be at the end of the process,” says Burnett. “Spanish banks clearly have so many property-related problems still unrecognised on balance sheets that they’re years away from being able to tackle problems in corporate loans. It’s three to five years before we see corporate restructuring opportunities in peripheral Europe.”

The waves of distressed deals should enable a large amount of dry powder - committed but uncalled capital - to finally get to work after missing out on the 2008-09 cycle.

Mark Northway, a managing director at Brookfield Investment Management, says the dry powder had led to frustration. “Investors have lost patience, which may mean that funds have adjusted their targets in terms of scope and pricing,” he argues. “We anticipate more realism in the targeted sell levels of institutions and more realism from investors in terms of the acceptable internal rate of return.”

Jurisdictions
The nature of Europe’s fragmented markets means that investing in the region is likely to be fraught with challenges, particularly due to hugely varied bankruptcy and insolvency procedures. “The unpredictability of multi-jurisdictional European bankruptcy processes will result in an increased tendency for creditors to agree pre-packaged arrangements to avoid the involvement of the courts,” says Northway.

Macintosh agrees that creditor-unfriendly jurisdictions could deter distressed funds. “There are some jurisdictions where distressed debt funds are not prepared to go unless the price is so cheap that it justifies the risk,” he says. “That risk comes in two forms - a slower judicial process and law that is very employee-friendly. It is hard to close companies down or dismiss anybody or do anything in countries like France where you can never actually call a default on your debt.”

However, Burnett sees an opportunity for European firms to capitalise on local knowledge and gain an advantage over their US rivals. “To understand particular outcomes, you need technical knowledge of all the key jurisdictions and that could be through being here [in Europe] and having done it,” he reasons. “There is also a cultural knowledge here. You do recognise that the purpose of the environment in France is not to maximise returns for creditors. It takes a long time to build up that knowledge and experience.