European Distressed Debt Market

Today, Bloomberg posted an article on Oaktree Capital's intent to purchased distressed debt investments in the EU as opportunities for distressed debt in the United States are slim to nil"

"March 3 (Bloomberg) -- Oaktree Capital Management LLC, an $82 billion investment firm, plans to purchase more distressed assets in Europe as a price rally eroded the return outlook for U.S. corporate debt, according to Chairman Howard Marks.

'The better opportunities lie in Europe because banks have some purification job to do on their portfolios, and in mid-cap deals and also in debt related to commercial real estate,' Marks said in an interview in Berlin yesterday. 'We indicated to our investors in 2008 that a return before fees of more than 25 percent is possible. Today, you can’t get that level of returns from traditional U.S. distressed debt.'"

As I have done in the past, I will layout a graph of the number of traced distressed issuers traded over the past year:

As one can see, the index has effectively grinded tighter on the whole since QE2 was hinted by Ben Bernake in the late summer of 2010.

In past cycles, distressed debt returns have held up a few years after default spike. But looking back in history, one can see that not only has annualized returns dropped, but the length of the "comeback" if you will has gotten shorter. For example, distressed produced fantastic results over 6 years in the period following the 90/91' recession (through 97'). In 2003, distressed had a fantastic year as well, and was followed by strong returns in the following 3 years. That being said, these returns were no were near the length or the magnitude of the previous cycle. Why is this?

In my estimation, there is simply a whole lot of capital in the distressed debt world. Bonds may not fall far enough and are snapped back at a precariously fast rate. And admittedly, we should have had more defaults in the 2008/2009 period, but massive fiscal and monetary stimulus turned off that spigot quickly. Of course, some players, like Oaktree, made absolute bank from the cycle: The fund that Howard Marks began marketing in 2007/2008, returned 31% gross to investors - and they are returning the capital because a lack of opportunities.

Now, to get back to the original point of this post, Howard Marks thinks the European distressed debt market offers a better opportunity set than the US. While my mandate professionally does not allow me to invest in non-dollar denominated assets, the potential risk/reward does look better than the distressed market domestically. Here are some things to consider:

1. Research analysts estimate that banks in the EU will have to shed more assets than US banks: Typically, and as played out by this cycle, public distressed securities rally over the course of a few years then banks and other financial institutions begin to shed assets that will probably sell at a more reasonable valuation. Banks can get away with this because historically they marked to model and did not have to take capital charges for unrealized losses on the balance sheet. Domestically, banks will begin to sell off their CRE loan portfolio (and equity positions) - This morning Sam Zell noted, regarding CRE: "...because of zero interest rates, there is an awful lot of assets that in another arena would have already been REO. And so the result is, there is very little supply. The banks are feeding their distressed assets into the market very slowly, so the supply of new stuff is low." But then Zell went on to say that capital domestically is sky high and that prices probably will not drop to make real juicy returns (here's the video: http://www.cnbc.com/id/15840232?video=3000008432&play=1). In Europe though, banks are under significantly more pressure due to a variety of issues (cross ownership of sovereign bonds for instance). Net / Net more "forced" sellers in Europe, especially considering Basel III implementation
2. The amount of capital chasing distressed debt in Europe is less than that in the United States: I do not have figured in front of me, so you will have to take my word for it. The list of dedicated distressed debt funds in Europe numbers about 40, whereas in the United States its a little less than 300.
3. Complexity. In the EU, bankruptcy leads itself more to liquidation than restructuring. Furthermore, while cross-nation rehabilitation rules have been somewhat standardized, the fact remains that many of these rules have not been tested in an actual restructuring proceeding. In my opinion, complexity leads to more opportunity

When looking at dealer runs for European distressed debt I am greeted by a list of opportunities I have never heard of. In the coming weeks, I am going to try to find 2-3 managers playing in the distressed space in Europe and conduct an interview with them (if you know of any, please contact me). To me, when the competition is less, and their are more forced sellers, good things are bound to happen for your investors.

I will do my best in the coming months to add to my coverage of the EU distressed debt market - if you would like to help, contact me at hunter [at] distressed-debt-investing.com