Zach Lewy, founder and group cio of Arrow Global Group, answers SCI's questions

Q: How and when did Arrow Global Group become involved in the non-performing loan market?
A: Arrow Global was established in 2005 as the European principal investment arm of Sallie Mae and was tasked with investing in distressed assets across the region. It was apparent that there were amazing opportunities for local champions to be successful, given that they remained relevant in financial services. In contrast, in the US for example, there are many national champions in each industry.

Because Arrow had its own balance sheet, we focused on small deals where local champions had a strong competitive advantage. The idea was – and still is – to execute a high volume of small deals that provide good diversification and unique access. We ended up working with 64 different platforms across Europe and, for around 78% of deals, we’re the only bidder.

In 2013 we went public, listing on the London Stock Exchange. Following on from that, we bought 14 platforms across Ireland, Italy, the Netherlands, Portugal and the UK, and integrated them into a coherent business with €66bn of assets under management.

From 2014, private equity funds began approaching us in the context of co-investment agreements. We were able to create an interesting nexus where private equity funds bought large packages of loans, using Arrow as a sourcing partner. So far, we have executed 647 deals, of which we’ve lost money on only 0.3%, while generating an average return of 18%.

Q: What are the firm’s key areas of focus today?
A: Historically, we have funded everything from our own balance sheet, but the focus now is to move to a capital-light business. The issue with relying on our own balance sheet is that we could either borrow money and grow or not borrow and shrink. This gave rise to a legitimate investor criticism: that it is difficult to grow the business while delevering at the same time.

As such, it made sense to launch our own fund and attract global investors with the opportunity to access a local deal set. We’re sitting as the critical conduit between two trillion Euro markets: the European banking system needs to delever and there is almost a trillion of assets that still need to be divested; on the other side is the alternatives investment market that is awash with cash and looking for yield.  We connect these two markets in a unique way.

We have, so far, raised €1.5bn in under a year from sovereign wealth funds, endowments, family offices, insurers and pension funds. At €1.5bn raised from scalable investors, the fund is large enough to enable us to grow. However, it was a sequential build: we needed a compelling track record and 14 specialised platforms to leverage first.

Q: How does Arrow differentiate itself from its competitors?
A: Our world is split into two: deals that are locally generated and deals that are centrally generated. In the case of locally generated deals, we have over 100 servicing clients, who sometimes want to sell assets to achieve certain objectives – for example, close out non-core lines of business or sell a portfolio of loans in arrears. About 80% of our local deals are originated in this way.

The remainder are assets that are already being serviced by us. If an institution has already outsourced the servicing, for both consistency of customer experience and administrative ease, it’s typically more straightforward to come to an agreement to sell them to us.

The central franchise also allocates capital, as well as manages our relationships with international banks – where it makes more sense to hold the relationship centrally, rather than dealing with each local arm of the bank – and the joint ventures with large funds.

From a business perspective, having such vertical integration is a significant source of differentiation and competitive advantage. An international bank can have a single relationship with a lender, yet efficiently access 14 different platforms across local markets.

However, the challenge then shifts to internal management: there are many different working parts, but our business culture and value chain blend well. For example, in buying 14 companies, it was important to work with ones that wanted to be on this journey with us – to create a best-of-breed network.

For those who did it right, we have all won big: we doubled the size of their business through our relationships. It’s an exercise in appreciating the different parts of the value chain: the whole should be bigger than the sum of its parts and the size of the prize means everyone is keen to work together to achieve.

We’re at the early stages of unlocking economies of scale. We have centres of excellence in various cities – such as IT programming in Lisbon, SPV management in Milan and finance and analytics in Manchester. This is one of the most rewarding elements of the company: the fact that local businesses are now part of a pan-European network.

Q: Which challenges/opportunities do you anticipate in the future?
A: The Covid-19 pandemic has helped and hurt. On one hand, there is a broader understanding of the need to address the European NPL overhang.

Outside of Europe, investors historically didn’t understand the European NPL situation – that stocks have built up over time and that it is an incredibly slow process to work them out. But everyone has realised by now that Covid represents a major dislocation event and we’re already set up to capitalise on this opportunity.

The number of people seeking income today versus this time last year hasn’t changed much, but the sources of income have been radically altered. Bonds are paying zero to negative yields, corporate dividends have been hit and other conventional sources of income – such as commercial real estate – have been badly damaged.

This has created a perfect recipe for substantial yield compression, which – coupled with a vast quantitative easing programme – results in more money seeking income with fewer safe places to find it. As such, secured asset purchases are likely to be supported.

However, on the other hand, some implications of Covid are less obvious. For instance, which governmental and regulatory accommodations will be removed and over what time period remains uncertain.

Clearly whole industries have been decimated in the fallout, while others are undergoing a K-shaped scenario. Foreclosure bans and forbearance are priced in for the moment, but gauging the impact of unwinding government measures is an uncomfortable risk journey. Against this backdrop, we’re dilligencing each situation forensically and remaining thoughtful about which part of the risk spectrum represents good relative value.

Corinne Smith