Falling pricing makes it hard to hit returns promised to investors, writes David Hatcher
A staggering €54.9bn of non-performing real estate loan portfolios have been traded in Europe so far this year, more than the whole of 2012 and 2013 combined.
Cushman & Wakefield estimates that another €30.8bn of deals are ongoing. Non-performing loans (NPLs) are coming not just from familiar sellers such as Lloyds Banking Group and Ireland’s bad bank NAMA, but also from institutions under pressure to shore up balance sheets due to regulatory pressure, such as Spanish bad bank Sareb and Bank of Cyprus.
The ECB’s Asset Quality Review may also put more banks under further pressure to flush out their bad books.
However, NPL investors complain that competition is still fierce on most deals with more new names making shortlists. This means pricing has been sharp, making the target returns private equity buyers have promised fund investors harder to hit.
“With the prices being paid now, the market needs to keep on improving for deals to work,” says one major investor in European NPLs. “Most of the deals done in 2012-13 were better than the ones being done now. The [more recent deals] can still be good but they require a lot of work.”
The revival of Europe’s real estate markets has led NPL investors to buy on the assumption that the rise in values will continue until they exit the investment. With pricing forecast to rise, there is an urge to deploy as much capital as quickly as possible. “The thinking is you’ve got to get it while you can. The number of portfolios available will eventually decrease; the market is not forever,” the investor says.
Private equity funds say that while NPL purchases have so far largely hit the “mid-to-high-teen” returns promised to investors, competition is making this harder to achieve.
Limited partners in giant funds raised by the likes of Blackstone, Lone Star and Cerberus generally classify their investment as real estate, rather than debt, as they are usually putting cash into funds that have a broader remit than strictly distressed debt.
European loans still in play
Karl Koch, chief investment officer of Iowa Public Employees Retirement Scheme, says: “This type of opportunity is nearing its end in the US, but Europe is viewed as still in play, as European banks are forced to reduce non-performing assets to meet stringent new minimum capital requirements.”
This steady demand for new stock has allowed NPL sellers to come out relatively well from their distressed positions.
Another investor says: “There has been an increased weight of money for NPLs and a trend towards larger pools, as some banks near the end of liquidation programmes. It’s fair to say that pricing has increased over the past couple of years and sellers have done a good job of capitalising on that.”
Higher prices are fuelling increased deal volumes, with sellers more willing to market portfolios as they have greater confidence in a positive outcome.
“In the early days after we were established and Europe’s loan sale market wasn’t particularly mature, US buyers were looking to pay 25 to 30 cents in the dollar,” says NAMA portfolio manager Hugh MacNish Porter. “We were reticent to sell at that discount, so largely followed more of an asset sell-down strategy.
“As the UK, Irish and European markets become more sophisticated, the deep discounts originally sought are narrowing. In many cases we can sell loans pretty much for what we think we’d get for the assets. That’s attracting us to sell loans; we can sell large amounts quickly and get good pricing.”
Arguably, the NPL portfolios on offer are also falling in quality, so that while sellers can take advantage of increased demand, buyers may find it tougher to negotiate a profitable exit. Putting in place the infrastructure required to work through bigger portfolios, including the right technology, asset management and legal expertise in each jurisdiction, can be expensive and time-consuming.
One big, experienced NPL investor says new entrants may come unstuck. “It’s getting competitive and we have lost bids to people with much less experience than us,” he says. “It’s very complicated; I think some newer players don’t realise how hard it is and won’t hit the targets they have been promising as it gets more competitive.”
Some buyers have increased their gearing to hit funds’ return targets, allowing them to put less equity into deals. The likes of Citi, Wells Fargo, Royal Bank of Canada, Nomura and Credit Suisse are all looking to increase loan-on-loan lending. “The debt market’s improvement has definitely made it easier for us to keep buying,” one investor says.
However, some believe a higher-leverage approach to what are already relatively high-risk investments is imprudent. “We are gearing to moderate 60-65% levels; we just don’t see increasing leveraging above that level as a ‘good risk’,” says one. “ You can add leverage for lower-risk situations but it’s not appropriate for NPLs.”
Broader structuring capabilities and availability of finance in new markets is also making trades viable. “We are not gearing more aggressively but debt availability has increased,” one investor says. “When we put debt in place, it is less about gearing levels and more about how we can use it, investing in assets and negotiating future potential income variations from the portfolio.”
One obvious way to counter rising NPL pricing in ‘early’ markets such as the UK and Ireland is to target new markets where recovery is less advanced and pricing lower. In July, Deutsche Bank, Bayside Capital and AnaCap Financial Partners bought a €495m Romanian loan portfolio from Volksbank Romania.
No rush into new markets
“We are not seeing a massive rush yet into new areas – Irish banks will have done the most deleveraging this year – but we are slowly seeing more investors looking in new jurisdictions,” says Alex Rowbottom, director at European loan portfolio asset manager CR Investment Management.
“A Spanish market has started to emerge but with few large deals yet. There has been talk about Italy, but the enforcement process and structuring is yet to be understood.”
Entering new jurisdictions can bring challenges in taking control of distressed assets and heightened risk when executing business plans, with a potential impact on pricing. “UK and Ireland have quite lender-friendly legislation; France is very difficult, Italy worse, Germany not great, and neither is Spain,” says NAMA’s MacNish Porter.
“If you fall out with your borrower and have substantial amounts of loans you will spend hundreds of thousands to sort it out. It’s a lengthy, judicial process, you are not in control and non-secure creditors can get in front of you – a consensual route is particularly beneficial.”
Such risks are epitomised by the legal wrangle between Blackstone and Michael O’Flynn, whose €1.8bn of loans held against Irish and UK assets were bought by the private equity firm from NAMA in May.
Such challenges in less mature NPL markets may lead to lower pricing and there is an expectation that the AQR may cause some new institutions, particularly those with weaker banking systems, such as Italy, to have to sell portfolios next year.
However, CR’s Rowbottom doubts that there will be a flood of NPL sales. “It could be slightly overplayed,” he says. “Some banks have worked hard in the past two years to make sure they are better placed to deal with it. Some have issues, but these organisations generally know they have problems and are trying to address them, sometimes dealing with them in a more discreet, bilateral way, not so in the public domain.”
As investors venture out into less mature European NPL markets, analysing the real estate held against the loans and carrying out thorough due diligence becomes even more important. One investor says: “We are more than happy to consider mainstream European economies and look for value in more distressed economies, but it’s about liquidity – it’s not just going in, it’s about determining the way back out.” N
Rush of deals raises oversupply fears
For the first time since the financial crisis, participants in NPL trades have been wondering whether there could be an oversupply in certain markets.
In Ireland a rush of portfolios have come to the market: RBS’s Ulster Bank agreed sales from its €1.2bn Project Achill in October, including €600m of NPLs to Lone Star, and is selling the €1.7bn Project Aran. Lloyds is selling its €2bn Project Parasol and €1.1bn Project Paris and Danske Bank is expected to sell an Irish portfolio.
“A massive volume of loans is coming to the market in Ireland and the big question is are there are enough buyers?” says one investor. “There is a danger of oversupply and everyone is looking at pricing very carefully. There may end up being one deal too many and a seller late to the game could be really disappointed with the price.”
From a seller’s perspective this has yet to happen. “Our recent sales indicate a depth of capital is there, including new entrants,” says NAMA portfolio manager Hugh MacNish Porter.