Value & Strategy

Home » Financial Analysis » A value investor’s perspective on European distressed debt?

A value investor’s perspective on European distressed debt?

European distressed debt for sale

Baupost of value investor Seth Klarman, together with CenterbridgeKennedy Wilson and DE Shaw & Co. is in the running for problematic consumer loans of Spanish and Irish banks, het Financieele Dagblad, a Dutch financial newspaper reported early August.

A KPMG report, on which the article is based, mentions:

  • these US investors have recently transacted for the first time in Spain and Ireland;
  • deal values are within a EUR 400 mln. and EUR 600 mln. range with outliers around EUR 1.5 bn;
  • Spanish banks are expected to shed problematic loans of around EUR 10-15 bn. in the upcoming 12 months alone;
  • There’s still EUR 1.5 trillion of non-performing loans on European bank balance sheets and KPMG expects these amounts to be offloaded under pressure of Basel III regulations;
  • A peak for debt sales is expected around 2014-2015;

According to Reuters, there is a ‘huge’ interest with private equity and hedge funds to buy-up loan portfolios. PWC estimates there’s EUR 65 bn. in capital waiting to be deployed.

Thanks to their continued access to cheap funding (ECB) and hostage to their low capital buffers, European continental banks, until now, have held on to their assets, to avoid the one-off losses selling debt below par.

Baupost and distressed debt experience

So why is this environment interesting to a value investor like Klarman? Aren’t value investors, like Buffett generally interested in low priced stocks to buy and hold?

Well, Seth Klarman is known for his creative approach to value investing and applying its principles in finding any mispriced asset as compared to its intrinsic value. Today Baupost has built up a track-record investing in distressed debt, providing CIT a rescue loan, investing in Lehman’s debt after they filed for bankruptcy and Enron’s bonds after the firm had collapsed. All with extraordinary returns (e.g. Enron: 5 times investment)

Still the news triggered my curiosity as I am relatively unfamiliar with distressed debt markets and Baupost:

  • How would Klarman’s team source these more obscure deep value opportunities?
  • How would Baupost evaluate this as a deep value opportunity?
  • How would Baupost consider the risks and expected returns of this kind of opportunity?

Please note: I am not active in the distressed debt market, nor do I know anyone at Baupost. I did study Klarman’s writings, speeches and interviews, detailing his approach.

How to source these deep value opportunities?

In a 2006 guest lecture at Columbia University Klarman explains how Baupost search strategy is set-up differently than other investment firms. For example Baupost has no telecom or utilities analysts, but has a distressed debt analyst or a post-bankruptcy analyst which evaluate any situation that they come across.

Klarman says, often for distressed debt, Baupost receives calls from Wall street. In 2011 Baupost set-up shop in London to be closer to distressed debt opportunities, however debt sales have failed to materialize, until now.

But is this enough as a search strategy? If the seller hires experienced advisers it is hard to avoid an auction process. Klarman’s ‘Margin of Safety’ philosophy fits better with negotiated sales, so my guessing is, the analysts do not sit around and wait Canary Wharf or ‘The Street’ to call.

How would Baupost evaluate this as a deep value opportunity?

Klarman: “We focus on a bottom-up approach.  Finding specific one-off situations that are undervalued. Undervalued because of a specific reason and there’s a catalyst often enough in place for realizing that value.” 

Now looking at the opportunities in Spain or Ireland, they are quite clear and fit very well into Baupost’s strategy:

  1. It’s a one-off situation: quite uniquely banks are shedding valuable assets beyond rational prices. An example: certain banks are canceling service-fee generating, non-drawn credit lines of triple A multinationals. It sounds irrational and it is, hence a great environment for undervalued opportunities.
  2. The main reasons: an imbalance in supply and demand of capital and liquidity – high demand for capital and liquidity due to Basel III vs. a lack of investor confidence in banks and limited asset sale opportunities.
  3. Especially problematic credit has become a burden on banks’ balance sheets, because the risk weighting of these assets under the Basel accords will increase and the loss given default (LGD) is uncertain, making regulators jumpy.
  4. The catalyst for the loans is straightforward. It is the expiration date or redemption  of the loans.

What are the key risks and expected returns of this kind of opportunity?

Risks

One of Baupost’s key principles is consider the risk first and then the return. Rule #1: don’t lose money. Rule #2: Never forget rule #1. As a follower of Benjamin Graham’s school and as intelligent investors Klarman’s team probably considers three key risks:

  1. Valuation Risk: an inadequate projection of future earnings
  2. Business/Earnings Risk: the danger of a loss of quality and earnings power through economic changes or deterioration in management
  3. Balance sheet/Financial Risk: financial weakness that may detract from the investment merit.

In his seminal work, Margin of Safety, Klarman writes: There are three principal alternatives for an issuer of debt securities that encounters financial distress: continue to pay principal and interest when due, offer to exchange new securities for securities currently outstanding, or default and file for bankruptcy.”   

So the key questions perceiving the risks and grasping potential returns are:

  • how to understand and mitigate valuation/earnings/financial risk sufficiently?
  • what is the price we can buy this for?;
  • what percentage of the debt holders would default or need to be made a restructuring offer?;
  • and what % of loans could be recovered in such case?

Of course, this is not easy to determine for me as an outsider, however even being part of Klarman’s due diligence team there probably is sufficient uncertainty about the outcomes.

As Klarman’s says: “Risk simply cannot be described by a single number”, and uncertainty is not risk. Therefore I will make an attempt to qualitatively understand risk and return potential of doing a distressed debt deal.

Valuation risk

Clearly a price of 2%-20% of nominal loan value is a significant discount. How much of a discount? That depends on ultimate payoff. Putting in 20 cents on the euro and receiving 30 eurocents still provides a 50% return (assuming no interest payments). However the further away the redemption, the less valuable this transaction becomes.

Valuation risk is also a function of buyers and sellers. As there are still some EUR 1.5 trillion of non-performing assets for sale and little deal appetite at strategic investors, the demand and supply side will be unbalanced for a while. Or?

There are some worrying signals suggesting otherwise:

  • KKR (a private equity house): “An insane amount of capital has been chasing the big portfolio sales and the prospective returns will likely be low,”
  • Reuters:
    • When big deals have executed, huge investor interest has, in some cases, forced the prices higher, eating into returns.
    • A recent rally in prices is also forcing funds to turn to leveraging to earn the double-digit gains investors expect.
    • Even hedge funds not traditionally associated with distressed-debt trading are getting in on the act.
  • KPMG indicates that Spain’s market is hottest of all debt sales markets.

Still there is a fundamental an imbalance in demand and supply between EUR 1.5 trillion of assets vs. EUR 65 bn. in capital implying valuations will be favorable eventually, assuming non-performing loans in majority cannot be bought with debt financing.

Earnings Risk

The loss of earnings power is a clear and present danger in Spain and Ireland, with unemployment at record levels. Due diligence will somewhat clarify whether borrowers have reliable income streams. Naturally not all loan files will be in order and some borrowers will look unreliable on paper, but in fact aren’t. These are the loans with high uncertainty and where Baupost could have the significant edge over the competition.

Baupost could work with local experts for a debt recovery strategy. One of the strategies could be offering an advanced repayment discount to the most problematic cases, hence creating a self-induced catalyst and moving the repayment date forward increasing the IRR and reducing uncertainty.

Moving fast, will mitigate the risks of currency devaluation in real terms or through Eurozone departure, so the majority of cash flows is in Euros not Pesetas.

As per Q2 2012 Baupost has hedged it’s Eurozone exposure several blogs report

Financial risk

Due to the abundance of credit many households and companies in Spain have their debt at unsustainable levels (McKinsey reports: 216% of GDP excl. financial institutions), with all increased risks of default and restructuring.

Again, stimulating firms and households to redeem debts to Baupost first and fast, could mitigate the risk and advance cash flows.

Expected return

Prices, Returns and Safety Margins

Generally a value investors doesn’t go to work for margins of safety less than 30%. Including the price range (2%-20% of nominal) mentioned in het Financieele Dagblad, this implies recovery rates should be minimally at 30% if investors are to pay 20 cents on the euro. SM: 33% = 1-20%/30%

If Baupost would like to make similar returns as on their Enron investment the average recovery should be around 5x above prices paid, implying realized recoveries of 10 cents for the 2 cent deals. Increasing the recoverability of these loans will have major impact on returns. Vice versa, just as much.

Local expertise

The local experts can detail expected recovery best of course, based on their local data on debt repayments. Of course these databases are based on historical data and correlations change through spillover effects, however it could give a range of probable payoffs.

Time to maturity

If a debt portfolio consists of debt maturing on average between now and 2.5 yrs, the target 5x return would be around 200% p.a. excluding interest payments. However would the payment be moved forward, the IRR (internal rate of return) will increase substantially.

Baupost could even offer debtors restructuring at a higher discount to nominal the faster they respond, taking into account the time value of cash flows and the higher riskiness and uncertainty of cash flows further in the future.

Note the importance of a low price and a rapid and high debt recovery as both risk mitigators, return optimizers and uncertainty reducers.

Conclusion

The current European distressed debt sales indeed offer a good fit with Baupost’s investment strategy. In the competitive European environment sourcing strategy and patience is key to avoid valuation risk.

The EUR 1.5 trillion of assets vs. EUR 65 bn. in capital imply an imbalance in demand and supply, so it still looks like an attractive market in less popular debt segments, leaving room for price negotiations.

The inherent earnings and financial risks can be mitigated by moving fast in restructuring and hiring local recovery experts. Making the eventual returns higher en less risky.

For the interested reader, many great blogs are available on Baupost’s and Klarman’s investments and strategy, a selection:

A summary of Klarman’s guest lecture is available at: http://seekingalpha.com/article/81024-seth-klarman-comments-on-money-management-and-baupost-s-approach

A great blog (unfortunately only in Dutch) on Basel III and risk management is available at:

http://folpmers.wordpress.com/

If you care to buy Klarman’s book. Take a look at:

//ws-na.amazon-adsystem.com/widgets/q?ServiceVersion=20070822&OneJS=1&Operation=GetAdHtml&MarketPlace=US&source=ac&ref=qf_sp_asin_til&ad_type=product_link&tracking_id=finaandstrath-20&marketplace=amazon&region=US&placement=0887305105&asins=0887305105&linkId=PNSVU3Y7SNSNNCXE&show_border=true&link_opens_in_new_window=true


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Follow Value & Strategy on WordPress.com

Follow me on Twitter