Distressed Debt Investing Interviews Simon Davies

It gives me great pleasure to introduce Simon Davies, Managing Director of the Restructuring and Reorganization Group at Blackstone in London.

Mr. Davies’ restructuring transactions have included AES Drax, Basis Capital, Boxclever, Carron Energy, Convenience Food Systems, Cox Insurance, Eggborough, Esprit Telecom, Eurotunnel, Galvex, Golden Key, Jarvis, Klöckner Pentaplast, Lisheen Mine, Luxfer, Mauser, MyTravel, Northern Rock, Petroplus, Pressac, Treofan and Wheelabrator.

Before joining Blackstone in 2007, Mr. Davies was responsible for structuring and corporate development at SVG Capital, structuring and raising funds for the private equity industry. Prior to that, he was an Assistant Director within the European Special Situations Group at Close Brothers Corporate Finance in London. He is co-editor of the Economist Outlook section of The Corporate Rescue Journal and a regular contributor to the journal. Mr. Davies began his training as a lawyer at Linklaters and spent seven years in the legal profession working on a range of restructuring, acquisition finance and LBO transactions.

Simon will be speaking at the upcoming European Investing in Distressed Debt Forum, a conference we are encouraging all readers to attend. Remember, there are still a few free spots left for the buy side (contact anastasia.guha@iqpc.co.uk and mention you are a Distressed Debt Investing reader).

Enjoy the interview!

To start off with, could you please give the readers a quick introduction?

Yes, sure. I work on the restructuring advisory side of Blackstone as a managing director in Europe. Based in London, we provide corporate finance advice to companies, to their creditors and other stakeholders in situations of financial stress and distress. We tend to deal across the board of effectively capital structure advice, providing solutions to companies' balance sheets when they need some form of corporate change event.

We know the structured finance market, especially CLOs led to significant leveraging of a number of companies in Europe. Does Europe have the same issues as the ‘maturity wall’ in the United States? If so, how do you expect that to affect the restructuring business in the next few years?

That's a very interesting question. When we went through what was a very credit expansionary phase, I guess, in the early and mid-2000s, the availability of finance was a global phenomenon, not just a US phenomenon, and so yes, in Europe we do have the same form of maturity wall through what I would call the teenage years of the 2000s. It's been referred to as a shark's fin. If you look at the shape of it on a chart, it very much resembles a shark's fin at the moment, although it is being dealt with from time to time. The maturity wall is across the leverage loan space, the infrastructure loan space and the property loan space. Slightly different shapes in terms of where it is at its peak, but what is happening at the moment in the next few years is that there's refinancing currently ongoing, and especially at the moment in the high-yield capital markets, which have become very open for business through periods of this year.

Although the bankers of the world have talked about windows of opportunity, the volatility in the markets is still there. And what we have, effectively, is periods of time when there is excessively busy activity in the high-yield markets versus quieter periods. May of this year was a very good example of a quieter period. People, I think, got a little bit jittery again. The net result of that is that there will be a lower refinancing risk when we get to the maturity wall, 2014-2016 is kind of where we’ll see peak activity.

But what you do have at the moment, obviously, is adverse selection. So what's going on is that the better companies are finding themselves capable of refinancing their maturity issues, and those that are less well in terms of a credit rating are effectively finding themselves with difficulties. So the way in which that's likely to affect the restructuring business from a leverage loan perspective is that we expect there to be a steady stream of new business, steady but not massively busy.

If we look at the world as being flat to slightly down in the developed world for a period of time, the type of things we're getting from the leverage loan side is some second-time offenders and possibly third-time offenders, old covenant reset deals, and candidates that were part of the big ‘kick the can down the road’ experience that occurred in 2008 or late 2008 and through the period of 2009. Plus there will be some new offenders. Despite the fact that I think prospects have stabilised, business pipelines remain with a lack of visibility and so what we have, I think, is going to be some new offenders coming through.

From the property side, the CMBS market has lagged the restructuring cycle quite significantly. The CMBS, it's a securitisation vehicle, it's designed not to be unwound and not to fall apart. And it does create some complexity in the property markets. You've got loan maturities, but you also have CMBS structures which have been bolted on top of that, creating complexity. And that, I think, is going to be busy for restructuring and also a complicated arena in that you will find that you've got people who are unaccustomed to distress sitting in the capital structure, and it will make it more difficult to get deals done.

We know the European restructuring process can sometimes be challenging to investors given the various legal regimes across the continent. Do you foresee a move to better standardise the bankruptcy process in Europe? Will that open the market to more willing capital, if that happens?

I think it's unlikely that there'll be more standardisation, and why do I think that? If we look back at history through difficult phases following financial crisis, most of the steps lead towards disjointed behaviour rather than joined-up behaviour, and an awful lot of what goes on is that people talk very nicely about finding global solutions and then national pride takes hold and we end up with thoughts in the press around currency wars, and people trying to competitively devalue their currencies in order to make their economies more competitive on a relative basis. But what you end up with is protectionism and an inward looking point of view and perspective.

I think that probably talks against standardisation of bankruptcy regimes. However, what we are seeing is people seeking to provide more streamlined processes in different jurisdictions. What has not been popular, I think, in certain areas of Europe is the whole debate around centre of main interest (COMI) shifting, in order to take advantage of a different bankruptcy regime within Europe. And given the insolvency regulations and how that governs insolvency processes from an overarching perspective above the national legal frameworks that are in place, that has obviously led to the reports of the insolvency brothel being the UK with its prepacked administration process having been used on a number of occasions. And what you've seen is countries trying to help streamline their own bankruptcy processes to allow for a fast - rack process to prevent the business distress that attaches to a company being in an insolvent situation for a period of time. That's been seen most recently in France, where they are now looking to develop and put a track record in place for a streamlined safeguard process.

I think the second part of your question was: will that open up avenues for more willing capital? I think the capital is there. I think the opportunity is more difficult to take advantage of at the moment in that there aren't quite as many sellers as people had hoped there would be of loan assets in distress and/or lending opportunities to companies that are in a certain amount of business distress. The equity markets have supported public companies to an extent through their rights offerings and there has been some new lending done, but what we have found is a general unwillingness for companies that have borrowed too much money to seek and be successful in seeking outside capital, in that the people who are currently invested in their capital structure either find it a better ideal for them to do the deals themselves, or they will effectively resist change, which became the whole ‘kicking the can down the road’ problem.

And what we saw, I think, for the last couple of years, which is still fairly prevalent, is that if a business is not strictly just running out of money, but it does have financial distress attached to it, people attach less attention to that, and they have bigger problems to have to deal with, so it goes to the back of the queue.

The distressed debt market is definitely a crowded one in the United States. Is that the case in the UK and Europe? Can you talk about some of the important differences between the two markets?

Yes, sure. The market is not quite as crowded in Europe. Like any form of a capital market, we seem to have followed, rather than led, and so the distressed debt market is no different in that the hedge fund community has largely grown up and matured at an earlier stage in the US than in Europe and a lot of the participants in Europe are part of a larger US umbrella group. But it is a very different investing environment.

In the US, you have a wonderful track record, a tried and tested method for fundamental restructuring, using Chapter 11 bankruptcy. Its track record, the process that it drives, the fact that it's in court, people get good visibility on what is going to happen and when it's going to happen, it gives people certainty as to the process and likely outcome and the things they're going to have to prepare and the way in which they will be able to deal or not deal with the stress as the case may be. It is a very debtor-friendly regime, but it is fundamentally a very

good way for businesses to restructure.

In Europe there's no equivalent in almost every jurisdiction, so you have, within the EU, 27 different regimes. And the most important differences that that, I guess, brings along are within all those different regimes, many of them are in their infancy. There are very few that have quite as good a track record or are as well-developed as the US Chapter 11 process. Chapter 11 has been around for quite a long time. Safeguard is a fairly recent phenomenon and the first high profile one, I think, was Eurotunnel, which was still only a handful of years ago.

And the second important difference, I think, is that it creates process risk for an investor. And that process risk becomes a far more important part of the valuation debate and the value debate when you're looking to make an investment. What you need to do, I think, in Europe, is very different to the US. There's a lot of forensic analysis around process risk in the advance of making that investment decision. There's greater risk in the type of jurisdiction you're in and how that affects that bankruptcy process should it be required, the ability to lend to a company in distress, and the likely investment duration, how long you may have to be an investor, whether you're in part of the debt capital structure or not of a particular business.

And so the differences very much revolve around a lack of track record to process and the risk that that then creates for the investor.

We know you have participated in a number of very high-profile restructurings over the past few years. We would like to know which has been the most interesting to you? The most challenging? And why?

As restructuring goes, no two deals are the same. But interesting tends to come out of complexity and it being a little different. And I think I could probably answer the two parts, interesting and challenging, just with one transaction, and that was the restructuring of Northern Rock.

Northern Rock had, I think, probably a number of fascinating pieces to it. Obviously there was the drama that is created by a run on the bank, pictures in the press and probably more stories in newspapers than I have ever seen on any single deal that I've worked on. But people standing outside branches of Northern Rock talking about trying to get their money back. And then, obviously, the first forced government intervention.

And this came, obviously, at a time before the whole of Europe had had to guarantee its banking system in one fashion or another, and the scandal attached to the government treating Northern Rock with a different brush than that with which it painted the other banks was phenomenally complicated for them, in that the European Union had not reduced its criteria around giving state aid to companies in times of financial and systemic distress. So there was a far greater risk that actually the European Union was going to come in and try to outlaw what was going on, together with the whole government intervention, together with the fact, I think, the most important thing… and the most interesting thing about Northern Rock is that everybody could relate to it, because everyone's got a bank account. And so it touched the lives of every single person who lives in the UK. Not because they had a Northern Rock bank account, but because they were interested in something that was effectively an early indicator for the market activity to come in restructurings, and they got a perspective on what happens when things go wrong. But no, Northern Rock is definitely the most recent, most interesting, most challenging one for us.

What is your outlook for the restructuring and reorganisation market over the next few years? Do sovereign issues begin to spill into the outlook for private enterprises and their access to capital?

A difficult one to answer, because the pipeline lacks visibility at the moment. However, having said that, deals do keep coming out of the woodwork, and we're not quiet here. We are actually quite busy. What we've seen recently, I think, have been some fairly esoteric types of activity.

There's still a structured finance fallout going on, so people who have disputes in relation to structured deals that were put together, sometimes just between two parties, sometimes as a package deal basis. And across the structured finance market, I think there will continue to be activity. People will seek to exit the restructurings that they've already executed, so structured investment vehicles have restructured, but people haven't exited their investment. They've restructured it in order to create a stable position and then to choose when to exit. But the things that are coming down the structured finance pipeline, I think, are bilateral deals where people have got large exposures to each other in an argument, and the mortgage-backed securities market on a commercial basis, so the CMBS market. We think they'll be very active areas.

As we move through 11 into 12 and 13, I think that the restructuring market will continue to provide its fair share of leveraged loan workouts and infrastructure loan workouts, and then you will come to, obviously, the restructuring wall, the refinancing wall that we have coming in 13, 14, and then a little bit in 15 as well. That, I think, paints a fairly rosy picture from, I guess,

a non-sovereign perspective.

From a sovereign perspective, I think there will actually be sovereign activity to come, and that's not just around countries going bust, but every country has got the word austerity in its budget now, especially across southern Europe and we do in the UK. And one of the things that that will require, as well as the raising of taxes and the reduction of the size of the public sectors in order to bring budget deficits down, it's going to be the sale of part of the state's assets, whatever's left.

I think the Greeks have been very forthcoming in terms of publicising exactly what they're looking to privatise. And that list is fairly long and will need to be put together into packages that are valuable to investors. And there'll need to be a story told and advice given on how best to do that.

Equally, just looking at the second half of the question, you have the sovereign issues spilling into private enterprises, I think there is a risk that it does that, and there are a number of different fallout potentials from the sovereign issues that are being felt in Greece and also in Ireland and Portugal, and to an extent, in Spain and Italy, and then across the world, to an extent.

But if you look at the extreme cases, as a sovereign gets downgraded, it has knock-on effects in that obviously, if we look at what happened in Ireland, for instance. The Irish turned round, some couple of years ago now, and guaranteed all of the deposits in all of their bank accounts. Now while Ireland is still a favourably rated nation for the purposes of credit quality, that guarantee is worth something. But what happens when that guarantee is worth less, because the credit rating of Ireland is dropping, is that actually people attach less value to that guarantee and you may find, whether it's in the financial institution space or in the corporate space, government backing doesn't really count for that much anymore. And there are likely to be issues that do come out on a corporate basis and a financial institution basis from a continuing sovereign issue thing.

DDI: Thanks, Simon. You will be speaking at the IQPC European Investing in Distressed Debt Forum in October. Can you give us a preview of what you will be discussing?

S Davies: Certainly. I will be helping to, I guess, give direction to a panel, talking about the response of the banks and other lenders to financial crisis. That will cover a number of different points, in particular the way in which banks have either recognised or not recognised loss when assets have gone south, crisis management of those banks and institutions. Their new capital requirements, the impact potentially, of BASEL III on those capital requirements and whether that is a good tool for helping create confidence in the sustainability and stability of financial institutions, and the structural position of banks and other institutional funds that do general lending within the markets. We'll also talk a little bit about incentive structures and potential improvements that could be made to those.

One of the things, I think, that's interesting is that incentive structures have been somewhat skewed to the outside, and in downside scenarios as we found, in the last two or three years, they have created some slightly odd behavioural patterns, which have been difficult to deal with when doing restructurings. I'll talk a little bit about that in more detail at the forum.

What we'll also talk a little bit about is recovery, the recovery phase. So there are two aspects, I think, that are interesting there. One is lending volumes in the recovery of lending volumes and there has been an awful lot of press written about that, which will be interesting to discuss. But also the response of institutions to change in regulation. Change, usually, is met with resistance, whether it's somebody's own wage packet or the ability of an institution to do business on a regulated or unregulated basis. And hopefully the discussion there will be interesting also.

Thank you for your time today Simon