Alcentra’s Credit Alternatives Vision

Extraordinary European opportunities in stressed, distressed and special situations

HAMLIN LOVELL

The Alcentra Group (“Alcentra”) is one of the largest non-bank lenders to European corporates, and the only one of the top credit managers globally that is headquartered in Europe. Yet the firm’s reach is very much global, with an even split of assets and the 64 credit investment professionals (of 12 nationalities) between the US and Europe. Alcentra’s offices span London, New York, Boston, and Düsseldorf with representative offices in Singapore and Hong Kong. THFJ visited Alcentra’s London headquarters and met several senior team members including two 2015 hires and co-founder, Chairman and Chief Executive David Forbes-Nixon, who also manages the special situations and distressed strategies.

His ambition to “create a tier one global sub-investment grade credit manager which can deliver solutions to clients across the capital structure”, has now been attained – but it has taken 15 years to get there. In 2000, Forbes-Nixon set up Barclays Capital Asset Management. In 2003, backed by private equity firm Alchemy Partners, he spun it out to create Alcentra. Starting with $2bn of assets, mainly in four Collateralised Loan Obligations (“CLOs”), and 20 staff, Alcentra now has assets of $26.8bn, across 70 funds, and 131 staff. The CLO proportion of assets is down from 85% three years ago, to below 45% today (included under Secured Loans below), but Forbes-Nixon still views CLOs as “an important foundation stone”. Growth has been almost entirely organic (bar the 2013 acquisition of Chris Barris’s top quartile High Yield business from Standish). Credit alternatives, including structured credit, direct lending, distressed debt and multi-strategy credit have provided the greatest growth – and “these will continue to be fundamental growth areas over the next 5-10 years” as investors reassess their asset allocation, expects Forbes-Nixon.

Comprehensive Coverage
Alcentra’s asset breakdown appears above. It offers traditional and alternative strategies working across the whole continuum of sub-investment grade credit, which cultivates a culture that enables analysts, who average 15 years’ experience, to choose the optimal instrument to express their views and deliver the best risk-adjusted returns.

“We have merged our High Yield and Loan analysts to create a team of industry-focused analysts who are product-neutral and who the portfolio managers can leverage off” explains Forbes-Nixon. He sees the firm’s comprehensive coverage as a source of competitive edge. For instance, “we are deeply embedded in the primary and secondary markets in Loans and High Yield in Europe and US and have committed capital to one in three deals in Europe. The library of proprietary data we have on individual credits is vast and how we leverage off that information that is key” he mentioned.

Alcentra has been adept at preserving capital and avoiding defaults. For instance “our default rate of 1.5% is a fraction of the market and our loss rate of 0.59% is a third of the market in European loans (source: Alcentra)” Forbes-Nixon claims. He reckons that some competitors, including US ones, would need to buy information positions from dealers or syndicate members, in order to get up to speed on some companies; but even then Alcentra has seen US rivals get burnt by insufficient intimacy with, and knowledge of, European corporates. Forbes-Nixon thinks that Alcentra’s 15 years of experience in European leveraged finance is one of the longest track records in the space – and the firm also has huge experience in actively driving restructurings and turnarounds that can drag on for years.

This omnipresent footprint has forged strong relationships, and “there is no substitute for experience; you simply cannot buy the relationships we have with corporate CEOs,  CFOs, and treasury management, who view Alcentra as a tier one lender” asserts Forbes-Nixon.  Relationships are crucial in Europe because some 95% of leveraged loans come from sponsor-driven LBOs. “Access to management is essential and you have to be non-hostile to open doors” says Forbes-Nixon, who adds “we get exceptional treatment from the street”. Alcentra is seen as being firm but fair in negotiations. In theory Alcentra could pursue hostile tactics, but in practice has very rarely done so. Working with companies, as opposed to against them, throughout the cycle, is the Alcentra philosophy; however, sometimes as a consequence of a restructuring where senior management have failed to execute strategies and service their debt appropriately, “we may upgrade the senior team running the company” explains Forbes-Nixon.

Why Alternative Credit?
Alternative credit globally has a vital function for institutional investors, as Alcentra sees sophisticated investors radically re-assessing their asset allocation in order to meet return targets. “The past 40 years of declining rates provided a free lunch from holding government bonds but now the classic 60% equities, 40% bonds, split will not come close to hitting the 7-8% return target of many pensions and endowments” opines Forbes-Nixon, adding that some strategists are forecasting returns of only 2-3% net from that asset mix. “Sovereign wealth funds, pension funds, insurance companies, endowments, foundations, private banks and family offices are increasing their alternatives bucket in general and alternative credit in particular” Forbes-Nixon is pleased to report. The simplest switch could be from fixed to floating rate debt, and Alcentra targets senior loans to return 6% net of fees, mainly from income. Reaching further out the liquidity curve, direct lending targets 8-10% net according to Alcentra, which has raised assets for direct lending strategies that will help plug “the middle market funding gap to European corporates that Standard & Poors estimate at between €2.7 to €3.1 trillion over the next five years. (Source: S&P Banking Disintermediation in Europe, 15 October 2015.)” states Forbes-Nixon. Investors that are seeking double digit returns, of 10-15% or more, will in Alcentra’s view, need to look at structured, stressed, distressed and special situations credit. Alcentra’s stressed, distressed and special situations strategy has returned 24.4% net in the first ten months of 2015, exceeding its 15% net[1] IRR target and making it a top performer among stressed, distressed and special situations funds globally. Both Alcentra as a firm, and the investment team on a personal level, have invested in the distressed and special situations credit strategy.

Why Europe?
Though Alcentra runs the gamut of corporate credit markets globally, stressed, distressed, and special situations credits in Europe are currently where the manager sees the most compelling opportunities. This is, perhaps, contrarian if many global investors remain underweight of Europe. Though Alcentra has as many investment professionals, assets under management, and strong performance in the US as in Europe, Alcentra presently feels most confident about harnessing its acumen in Europe: “Europe is our back-yard; we are one of the most experienced investors in Europe” reiterates Forbes-Nixon. He adds “Europe is a less mature market where risk is priced much less efficiently because of the complexity of investing in this market – different jurisdictions, accounting regimes, corporate cultures – are all far more clandestine and opaque than the US which makes it more difficult to understand situations as well. That is an environment where we have a huge competitive advantage and will thrive.”

If capital markets are less developed in Europe – partly because the continent’s corporate bond markets were only created in the early 1990s – the post-2008 economic cycle is also at an earlier stage. So, Alcentra expects QE in Europe to be extended to last 3-4 years, does not expect interest rate rises in the Eurozone in the short-term, and would not rule out negative interest rates, but the big macro picture is much less important than individual investment opportunities. “The marginal effectiveness of QE is falling all the time” says Forbes-Nixon, and ultimately he thinks more QE could result in asset bubbles that, when they burst, will provide another distressed cycle.

But nascent distressed opportunities are already apparent in Europe. If some US funds struggled to deploy capital in Europe a few years ago, the opportunity set now looks substantial with the supply of investible credit assets set to surpass trillions. In public markets Alcentra may see advantages in being the biggest player but distressed is quite different. “We would not want to run $10 billion given the typical clip sizes in European distressed. We do not want to be the largest holder of an issue here” explains Forbes-Nixon. So Alcentra intends to cap assets in its new locked up distressed strategy at around one billion in order to remain highly selective.  

Alcentra is sifting through opportunities emanating from three main event-driven sources in Europe which cause stressed and distressed leveraged loan supply to come to market: bank deleveraging; the High Yield maturity wall coupled with record levels of CCC rated issuance, and pending CLO maturities which will lead to more CLO deals being called.

Bank Deleveraging
“The bank deleveraging theme is enormous” foresees Forbes-Nixon, who thinks European banks are years behind those in the US. “After four years of QE in the US, their banks have been very disciplined about cleaning up and shrinking their balance sheets and improving capital ratios. But European banks have not addressed the issue properly”. Europe’s banks need to take on board the ECB’s Asset Quality Review (“AQR”), and comply with Basel III. The challenges are swelled by the scale of balance sheets. European banks’ assets of $42 trillion are about 2.5 times the size of US bank assets, yet the US and European economies are of similar size at $17-18 trillion” Forbes-Nixon illustrates. Little wonder that the European banks need years to work through their books.

The first wave of bank deleveraging focused on real, hard assets including real estate, shipping and aircraft related debt. The next wave is corporate loans and non-performing loans (“NPLs”), and is already underway with sales of €150 billion so far in 2015. Alcentra is of the opinion that hundreds of billions of Euros worth of loans still being marked at par should be provided for as recommended by the AQR. Provisioning, however, is a blunt instrument and if loans are currently marked above fair value, Forbes-Nixon’s experience makes him believe that some banks will over-provision and mark the loans down below their true value. This could provide rich pickings for Alcentra to step in and buy the loans at discounted prices below intrinsic value. “Our job is to identify good businesses with over-levered balance sheets that will trade through problems (or in some cases need a reduction of their debt levels) and will eventually get re-rated by the market. We have a deep team of high quality, experienced, professionals to assess this opportunity set” Forbes-Nixon expects. PWC state NPLs held by banks could amount to €1.1 trillion (source: PWC Portfolio Advisory Group Market Update Q2 2015). Deloitte research indicates over €800bn of NPLs reside on the balance sheets of European banks. (source: Deloitte Deleveraging Europe Market Update H1 2015) But PWC and Deloitte agree that 2015 will be another record-breaking year for loan sales in Europe with both firms forecasting EUR 150bn of transactions. Alcentra sees circa EUR 2 trillion of NPLs and other non-core assets and projects the run rate of bank asset sales will accelerate to EUR 200bn a year, providing a huge source of opportunities. As part of this process, some banks have started taking provisions on balance sheets and other countries may copy the UK and Irish model of setting up ‘bad banks’ such as National Asset Management Agency (“NAMA”). The key catalyst for this catharsis is QE in Europe, finally allowing European banks to recapitalise, sell portfolios and shrink balance sheets.

Maturity Walls and Cliffs
However, non-financial companies may not want to contract their own balance sheets. A maturity wall of EUR 345bn, of mainly bonds and some loans, will need refinancing over the next six years, according to the S&P European High Yield Weekly Review from May 2015. Alcentra expects some healthy companies will grow into their capital structures, and get refinanced or extended. But for some issuers the maturity wall will become a cliff. Following record CCC issuance in 2013 and 2014, some of the lower quality CCC issuers will default, forcing selling by many lenders and investors, playing into the hands of stressed and distressed investors. The US has already seen a significant increase in default rates from lows of 1.4%, with S&P forecasting a doubling of US defaults by 2016. Europe should follow suit in 2016 or 2017 as “the historical pattern is that Europe lags the US by 12 to 18 months” Forbes-Nixon expects.

Stress and Volatility
Performing paper can also offer potential returns high enough for the distressed credit strategy. On an ongoing basis, Alcentra has a ‘work in progress list’ of 122 European leveraged loans or High Yield bonds, with issue sizes of €100mm or more outstanding, that are trading at yields to maturity above 12% or bond prices below 80 cents. This is partly a consequence of market volatility, which has recently reached equity market levels in High Yield, with September 2015 seeing a huge surge in the number of bonds dropping by more than ten points in the month. Forbes-Nixon seems genuinely excited by escalating volatility in 2015. “The third quarter was the worst in 4.5 years for the public equity markets, with $10 trillion wiped off public company valuations, and emerging markets and commodities particularly hard hit” he observes.

The stressed watch-list is valued at around EUR 63.8 billion, and some of the names are still performing. “We are conducting a ton of work in the energy space and are being very patient, waiting for the right price point” Forbes-Nixon mentions. Stressed credits are widely misunderstood by the market. They tend to be at a crossroads, in that within a year “two thirds of them continue to perform and migrate into a sustainably tighter spread range while one third become distressed and need to be restructured” Alcentra has observed. The volatility of stressed names creates good opportunities but Forbes-Nixon warns “those who are not close to company management, have a tenuous relationship with the sponsor and have little history on the organisation have often subsequently been burnt”.
Moving down to distressed names, “This is one of the most exciting times for European distressed since the market started  in 1992” enthuses Forbes-Nixon and again different outcomes will ensue: historically, roughly one in five CCC rated credits defaults, so this will provide further supply.

CLO Calls
First generation, 1.0, pre-crisis CLOs from between 2000 and2007 are past their re-investment periods and are de-leveraging quite fast which tends to increase their financing costs as tranches amortise from the top down. This results in them becoming called, and then sold in a Bids Wanted In Competition (“BWIC”) process that can allow the nimble and cash-rich investor to pick up paper at discounted prices. In fact the 2000-2003 maturities have all been called and Alcentra expects a continuing acceleration of deal calls from the 2004-2007 period, when Alcentra itself issued five CLOs in Europe. Already in 2015, some 20 1.0 CLOs have been called compared with six in 2014 and five in 2013.

Jurisdictional Differences and Forum Shopping
In late 2015, corporate distressed situations are attracting Alcentra’s attention and Forbes-Nixon argues that probably only a handful of players in Europe have the analytical resources to take full advantage of the opportunity set. “Specialists with a track record of distressed investing in Europe, who can analyse and price credits, and understand the different bankruptcy regimes, and have raised enough capital to take advantage of the opportunities” are the ones well positioned to pick off the anomalies from the cascading avalanche of paper.

Some managers are buying large portfolios of hundreds of loans, but Alcentra generally prefers to pick individual loans – and is also picky when it comes to jurisdictions. “The UK and Ireland are strongest for senior secured lenders and creditors, with very high recovery rates” says Forbes-Nixon, who adds that 35% of loan market issuance has come from the UK. PWC’s Portfolio Advisory Group Market Update for 2Q 2015 claims 60% of European loan transactions have come from the UK and Ireland. The next tier is Germany, Austria, Switzerland, the Scandinavian countries and Benelux, which have “reasonably strong creditor processes” in Alcentra’s experience. Then “France is getting better but still has some issues while Spain, Portugal, Italy and Greece pose additional risks for senior secured lenders”. Southern Europe is not out of the question but discounts would need to be very deep and the same applies to Eastern Europe.

A wrinkle here is that companies in Southern Europe can sometimes make use of legal forums in Northern Europe. English courts are sought after by estranged spouses seeking divorce settlements, by offended oligarchs wanting to silence critics – and by senior creditors after their pound of flesh. Alcentra’s Deputy Distressed Portfolio Manager, Laurence Raven, who was previously an analyst in the proprietary trading group at Merrill Lynch, has sat on multiple creditor committees. Raven, who joined Alcentra in 2008, observes “Schemes of Arrangement continue to assist in the restructuring of debts of a number of European companies.” He explains that this can arise from shifting the domicile or headquarters of a company, or by proving some alternative nexus with the UK, such as the presence of an English obligor or by having finance documents governed under English law.  Some Southern European companies, which also have US law governed High Yield bonds are making amendments to their bankruptcy processes in response to domestic borrowers choosing to restructure debts abroad.  For instance, Raven points out that “Spain last year developed homologation as an equivalent to a Scheme of Arrangement. This can allow for a cram down process with majority lender support, which is certainly now more creditor friendly than before”. Raven foresees a steady improvement in creditor rights in France, where he thinks courts want to streamline restructuring processes; though he regrets “France is one country that does not permit companies to forum-shop and re-domicile or move abroad to take advantage of more efficient and creditor friendly regimes to consummate processes, so the blessing of a domestic court is still needed”.

The legal side is so important that Forbes-Nixon says “we spend as much time looking at legal and bankruptcy processes as we do on fundamental credit analysis”. Documentation and execution specialist David Wallace joined in 2015 from law firm Linklaters where he spent seven years on restructuring deals. He elaborates “there is no one size fits all approach. It is not easy to predict what happens in a restructuring process and sometimes it is not even easy to predict which jurisdiction will oversee the completion of a financial restructuring”. Indeed some deals are multi-jurisdictional. A UK advertising publication which was UK-headquartered, but which had a large US business and a Spanish-headquartered business used a UK Scheme of Arrangement to bind dissenting creditors, but also needed to obtain Chapter 15 recognition in the US and get approval from the Spanish authorities as well, recalls Wallace.

Alcentra’s legal eagles, including Wallace, have to explore whether senior creditors will take all or if junior ones could hold out. There are judgements to be made about the estimated cost and duration of the restructuring, which are “easily determined in more predictable jurisdictions but less so elsewhere”. Among many influencing factors Wallace considers whether the management team has the expertise to carry on running the business, who the advisers are, and how different classes of creditors may be impacted. “Every case is different with its own idiosyncracies” Wallace reveals.

Alcentra invests in all parts of the capital structure, and in October 2015 the disconnect between secondary market pricing of bonds compared with loans caught Wallace’s attention. Loans have hardly flinched in the third quarter and there are several reasons to think bonds will soon provide a supply of distressed opportunities. Wallace doubts if companies that easily raised covenant-lite finance four or five years ago would be able to pull off the same trick today. “Amend and extend is much harder in bond markets because it is difficult to identify who owns the bonds. There is far more process risk for bond restructurings, and prices can fall for pernicious technical reasons. Bondholders are ratings driven which results in forced sellers after a downgrade”. Added to these factors is simple market volatility: High Yield bonds have recently been gyrating with equity-like volatility, and have been harshly punished for profits warnings. Market over-reactions can create opportunities for Alcentra, even without events such as defaults or failed attempts at refinancing.

Sectors in Play and Recent Trades  
Alcentra can invest in all industries, and after the oil price crash, Deputy Distressed Portfolio Manager Eric Larsson, who joined Alcentra in 2015 from Mount Kellet Capital Management,  finds oil and gas has a big presence in his watch-list of names, and “October saw the first large default on an oil and gas issuer” he points out. Wallace agrees that oil and gas is rich in opportunities with “the UK still a very big driver and many Norwegian issuers suffering”. The second biggest source of opportunities is financials, where “there are some interesting situations for example in Austria and Portugal, which show how huge bank balance sheets can drive the market”. Spanish construction is still another hot spot for distressed deals, years after that property bubble burst. Away from broad sector dynamics, in most industrial segments “there are more idiosyncratic situations of companies levered too much” notes Larsson.

Though it sounds as if a deep pool of opportunities is materialising very rapidly, 28 years of experience tells Forbes-Nixon that patience can be needed to harvest returns from some credit stories. “The three biggest drivers of our returns this year were all classic, distressedsituations where we planted the seeds several years ago, and they came to fruition this year” says Forbes-Nixon, who adds that Alcentra had been following the firms for up to 10 years. All of them also involved equity exposure, underscoring how Alcentra invests over the entire capital structure; but Alcentra’s route into the equity was different in each case.

Forbes-Nixon recalls how five years ago his teams identified that value broke in the mezzanine paper for a UK gaming company, and also had confidence in the management team. Alcentra bought mezzanine in the 20s, which converted into equity at a valuation of six times EBITDA versus competitors on eight times. “Management executed well, including an internet roll-out, and a takeover bid from a listed competitor is now going through competition clearance” Forbes-Nixon says.

Senior, secured debt can sometimes meet the return target for the distressed credit strategy – when there is equity attached. A French retailer defaulted in 2014 after what Forbes-Nixon views as a ‘perfect storm’ cut its EBITDA by 90% to €50mm, enumerating “There were management missteps, a weak French economy which hit the retail sector hard, combined with the fact that last autumn was the warmest in years, and the Charlie Hebdo terrorist attack also discouraged shopping”. But today Alcentra is excited about the turnaround story, has good visibility on earnings, and sees upside in the equity attached to the super-senior and reinstated loans.

Another example of how senior creditors gained ownership was an Irish telecoms group. Alcentra owned €150mm of senior debt and a restructuring committee was formed with financial advisers and lawyers to provide assistance. Junior creditors were ‘crammed down’ to a de minimis amount, with the second lien getting about 9 cents recovery while the senior got 85 cents, as well as the equity upside.  “This was an asymmetric situation where we had downside protection of the senior debt plus unlimited upside from the equity” says Forbes-Nixon. Indeed as Ireland’s economic resurgence gathers steam, the company has seen a tremendous re-rating to seven times EBITDA – and the de-stapled equity could even be listed.

If some hedge fund strategies have found 2015 to be their worst year since 2008, Alcentra is animated by the extraordinary opportunities on offer in Europe.

Footnote

1. Performance is shown net of fees and expenses, and includes the reinvestment of dividends and capital gain distributions.  Many factors affect performance including changes in market conditions and interest rates and in response to other economic, political, or financial developments. Investment return and principal value of your investment will fluctuate, so that when your investment is sold, the amount you receive could be less than what you originally invested.