Bargain hunt excites buy-to-own distressed funds
* Distressed debt funds raising USD12bn war chest
* Poor secondary market liquidity could limit funds access
* High-yield bond investor appetite key for firms survival
By Natalie Harrison
LONDON, June 22 (IFR) - Tough capital markets, a savage recession and banks' unwillingness, or inability, to lend cheaply are providing the best chance in years for distressed debt funds focused on snapping up good companies with bad balance sheets to make stellar returns.
The anticipated boom time is fuelled by expectations of accelerating loan default rates, which have already increased to 2.2% from 0.3% over the past year, according to Fitch, and would end months of frustration for funds left disappointed by the low volume of discounted loan sales from banks.
In theory, rising defaults should bring a wider array of opportunities for funds specialising in buy-to-own strategies.
One such firm, Strategic Value Partners (SVP), won approval on Friday for its takeover of debt-laden German plastics firm Kloeckner Pentaplast, which generates sales of over EUR1bn, employs more than 3,000 people and has 17 global production facilities in 11 countries.
"We are definitely looking at more distressed corporate situations now than at any time in the last two years, and that's driven by what is happening in the real economy, and companies really struggling, rather than bank behaviour," said Iain Burnett, head of distressed debt at Bluebay Asset Management.
Seventeen Europe-focused distressed funds are on the road at present, seeking an aggregate USD12bn, according to market research firm Preqin.
The last peak for distressed debt fund raising was in 2008 after the sub-prime debacle proved a prelude to the current bank and sovereign debt crisis. The current economic stress is the catalyst for the expected cascade of corporate restructurings.
Some of those firms include U.S. funds such as Ceberus, Centerbridge and York Capital Management, which first appeared on UK shores a decade ago, and have slimmed down and staffed back up as distressed opportunities have come and gone.
Their interest has perked up again, partly because U.S. bargains remain slim, but complex bankruptcy laws across the European continent are a major caveat.
"The big U.S. funds are certainly looking at Europe as a better opportunity than the U.S., but they are staying pretty clear of Southern Europe and they're carefully picking which jurisdictions they want to get involved in," said Lyndon Norley, head of European restructuring and recapitalisation at Jefferies International.
Fund opinions vary on which countries they want to avoid, but experts say French and Italian laws are considered among the most hostile to creditors. Many companies have assets spread across Europe, which adds another layer of complexity to restructurings.
THE BIG STUFF
Buy-to-own strategies involve sorting through the EUR100bn-plus leveraged loan rubble for debt in companies valued well below par value, but which are expected to emerge from a debt for equity swap in much better shape. A successful turnaround of a business can generate strong returns for distressed funds.
Predictions from Moody's that up to 50% of the EUR133bn-worth of leveraged loans maturing over the next three years could default have left distressed funds licking their lips.
The best opportunities in the corporate space so far have been in the mid-market, where firms have been considered too small to access high-yield bond markets, but there is also a strong sector theme with shipping, retail and directories among the most vulnerable areas.
Jon Macintosh, a partner at listed investment company AcenciA Debt Strategies, says smaller firms have been falling like flies over the past two years behind closed doors and without much fanfare.
The less receptive high-yield market, which took up the slack from reduced bank lending in 2009-2011, is a key factor that may drive larger companies to the brink, experts say.
"What funds are now waiting for is the big stuff. The funds want distressed companies that they know they can buy cheap and restructure," said Macintosh.
UK high street names such as Clinton Cards, Fitness First and Game Group have been among the most high profile businesses to run into financial difficulties, and have forced banks to take impairment charges on loans previously held at par on their books. Cash-rich vulture funds are circling UK directories firm Yell, UK waste management company Biffa and pharmaceutical company Marken, one market source said.
But with so many firms chasing the same assets, buy-to-own is by no means an easy ploy. For starters, funds may have to tie up capital for much longer than they have previously been used to.
"Before the financial crisis a company could be sold on in a couple of years, but that time has gone," said Norley.
Mei Lian, a partner from law firm Shearman & Sterling, agreed.
"You can't play in this market with 18-month money because it's just too illiquid. But many funds have realised this and have been focused on raising longer-term cash," she added.
The lack of secondary market liquidity is a big hurdle. Distressed funds are struggling to buy so-called small "information pieces" of debt, which provide insight into how a potential restructuring process will play out.
The ultimate aim of investors is to work out the fulcrum position, which is the debt class within the company's capital structure where creditors would be equitised in the event of an enforcement. Investors holding positions subordinate to that debt would often be wiped out.
"It's hard to work out that fulcrum debt position because no-one's selling anything, which is another reason we haven't seen lots of debt trading," said Earl Griffith, a partner at Allen & Overy, which has been involved in the restructuring of Quinn Group and Four Seasons.
The recapitalisation of Kloeckner, which included a EUR190m cash injection by a group of investors led by SVP and EUR650m of new debt facilities underwritten by Jefferies - expected to be partly funded with high-yield bonds - reduced the company's debt by around 50% to EUR630m.
The EUR800m principal amount of Kloeckner senior debt was repaid at par, but the second lien and mezzanine debt was wiped out.
"Smart players will look at the structure, work out their valuation, analyse the legal risks in the documents and have an understanding of the restructuring tools available in different jurisdictions," said Lian.
"The complexity of these deals usually means that there are different opportunities in different parts of the capital structure."
Norley at Jefferies agreed that getting hands on debt in sufficient size and at the right price is tough.
"There's not a significant amount of trading in debt, where a series of bad news drives prices down to the 50s/60s, only to recover to the 80s," he said.
The overriding factor is that banks cannot afford to take steep losses on debt unless they are forced to, but ultimately, their hands may be forced.
"Funds have a lot of cash to deploy and they are looking at companies who may now struggle to refinance. That, combined with the pressure on banks to manage their balance sheets, should mean that we get more trading sooner," said Griffith. (Reporting by Natalie Harrison, IFR Markets; editing by Alex Chambers, Julian Baker)
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