Distressed timing and tactics discussed

The need for increased clarity around government intervention in the market was the main message from attendees at IMN's European Distressed Credit Investing Summit last week. However, plenty of advice was also on offer in terms of timing and tactics with respect to the distressed opportunity.

"There continues to be uncertainty around how government intervention will play out, which isn't helping the market. We need some structure to policymakers' efforts," said one panellist, Graham Martin, partner advisory at PricewaterhouseCoopers.

By way of an example, he explained that the Resolution Trust Corporation (RTC) was successful in addressing the value/pricing issue, as well as providing clarity regarding both the government's and tax payers' obligations. Another example is the Swedish crisis, where the government had the ability to force banks to disclose losses and regimented the process in terms of valuations. "But over the past 24 months there have been so many different initiatives that they have served to create confusion in the market," Martin added.

Another panellist, Jonathan Fragodt, head of European distressed illiquid credit at TPG Credit, pointed out that - in addition to retroactive assets - there should be a provision to help distressed but performing borrowers to refinance. Thanks to its support of a number of lenders, the UK government is estimated to control 45% of the UK mortgage market, so it is in a position to help. However, so far it is perceived to have been reactive and therefore has served to put the breaks on any progress.

TPG has two main strategies: in the US it buys performing mortgages and uses the FHA to modify them; and in the UK it buys non-performing loans and works with the servicer to create duration. Fragodt confirmed that there appears to have been a complete halt in bank lending. "The UK government's action has slowed down the resolution process - although its Asset Protection Scheme could ultimately be beneficial."

But one potential positive development could be the formation of a support network around an RTC-type vehicle. Monique Suter of Alpstar observed that the European market needs to develop a better infrastructure in terms of servicers and independent advisors/asset managers.

"Generally, Europe has never had an asset management industry to the extent of that in the US," she said. "The fact that there is a lack of independent asset managers has been problematic for prices: since there are few sellers and one side of the market doesn't mark-to-market, there has been pricing dislocation. But independent managers can spur prices - there needs to be enough of them to create an efficient market."

Against this backdrop, the timing of an investment in distressed assets becomes evermore important. "Timing is important in terms of how quickly the underlying cashflows can be accessed, which enables exposure to be reduced and allows flexibility in terms of decision-making," commented David Castillo, senior md at Further Lane Securities. "A lock-up is also necessary in terms of mitigating mark-to-market and liquidation risks - longer time horizons are important in order to realise the value of these assets."

Peter Coates, head of the European office at Lighthouse Partners UK, noted that his firm is generally cautious on Europe, given the lack of transparency and the fact that headline pricing hasn't declined as much as it has in the US. "There are opportunities in the US playing capital structure arbitrage, but Europe is 6-12 months away from experiencing distress in this area. Peak defaults are likely to occur sooner in the US," he argued.

Miguel Ramos, md at GSO-Blackstone, agreed that it's tough to get comfortable with European assets because of the lack of transparency on the underlying, as well as concentration between managers in later vintages. He added that, for some transactions, it might be better to wait for rating agency actions to play out before entering the market - with potential opportunities consequently arising in the second quarter.

Panellists highlighted that a number of funds came unstuck after entering the distressed credit space too early and with high leverage. But Coates suggested that the size of the opportunity and the diversity of assets on offer mean that there is no need to rush into the market. "We're balancing our short-term event-driven opportunistic activity (using managers to essentially force control positions) with other appropriate long-term distressed opportunities."

2009 is expected to see a significant rise in leveraged loans breaching their covenants and struggling to be refinanced. Panellists expressed interest in waiting to see how private equity houses will react; for example, under which terms they'll add cash to and/or restructure a loan.

Alpstar's Suter advised investing in high quality non-cyclical names or loans that already have a distressed story. "Uncertainty about the legal situation means that it might be better to invest in cov-lite loans, so there is less likelihood of covenants being breached," she added.

Stuart Mathieson, director at Babson Capital Europe, agreed that non-cyclical high performing loans are a good bet. "The market has bifurcated between high quality assets trading with yields of around 15% and those where investors are essentially waiting for them to default," he remarked. "CLOs have certain rights as secured creditors and so it is possible to limit the downside of a portfolio if you're selective. The aim is to have security over cash-generating assets, so it is important to understand the mechanics and be careful about funding requirements."

Ramos said that his firm is looking for specific situations at the double-A level in CLOs that offer value, such as structural or documentation features. However, he warned: "CLOs are difficult to price and so investors should be paid for the lack of liquidity, but it's important to be aware of sources of risk - both technicals and fundamentals have changed in the market."

Debtor-in-possession (DIP) financings were also highlighted as an area of opportunity. According to Lighthouse Partners' Coates, DIP financings in the US "are a no-brainer" and have become even more attractive to hedge funds since GE exited the market.

Jason Clarke, md at Strategic Value Partners (UK), concurred that the DIP market in the US is keenly priced and liquid because such financings are perceived to be super senior in the capital structure. But he pointed out that this isn't the case in Europe, where lenders charge eye-watering fees and tend to attach strategic constraints to the facility.

Looking ahead, with recovery rates likely to drop dramatically, the ability to work out loans is vital. Indeed, secondary loan trading is expected to begin picking up once clarification of certain legal issues and untested jurisdictions has occurred.

CS