Just as global credit markets came to terms with the subprime mortgage market collapse of 2007, Lehman Brothers delivered the ultimate blow in autumn 2008. All remnants of market stability were thrown in complete disarray as investors scrambled to grasp the concept of the bank’s demise, a code which will no doubt take years to decipher. Primary activity in the leveraged loan and high yield bond markets faded into the backdrop in late 2008. Bank credit committees froze in action, and cracks started to show as real liquidity needs gripped European business.
As Debtwire’s European Distressed Debt Market Outlook entered its fifth year of production, the report findings presented detailed results of a survey questioning 100 European and US hedge fund managers, prop desk traders and long-only investors on the outlook for the European distressed debt market in 2009. “Market participants appear significantly more pessimistic than the major ratings agencies,” says Richard Nevins, a partner at Cadwalader, Wickersham & Taft. “Last month, for example, S&P predicted some 20% of European speculative credits could default by 2010, whereas fully one third of respondents saw 40% or more of credits needing to restructure.”
With the speed and depth of the global economic downturn taking most market participants by surprise, respondents remained cautious about the prospects of distressed investing in 2009, citing 4Q 2009 as the anticipated peak in financial restructurings. Key findings from the survey included:
• The primary pressure for European business is tightening liquidity, driven by the decline in the wider economic framework.
• Property/construction, auto/auto parts and consumer retail sectors will offer the most opportunities for distressed investors in 2009. Financials, chemicals and media businesses will also likely be pressured in the next 12 months.
• Private equity sponsors admit they are unprepared for the next wave of restructurings.
• Covenant resets and capital injections are expected to be the most likely outcome for creditor negotiations in 2009.
• High yield bonds have replaced mezzanine debt as the second most attractive debt instrument for distressed investment.
• Most respondents anticipate a large number of leveraged companies to face debt restructurings in 2009 with a third expecting at least 40% of these businesses to restructure.
In December 2008, Debtwire interviewed 56 hedge fund managers and long-only investors and 44 prop desk traders in Europe and the US. Interviewees were questioned about their expectations for the European distressed debt market in 2009 and beyond.
The largest proportion of respondents (see Fig.1) do not expect European financial restructurings to peak until the end of 2009, with a further 21% and 17% forecasting a decline in the number of restructurings from Q1 or Q2 2010 respectively. According to a number of respondents, the primary pressure for businesses is tightening liquidity. A number of respondents also suggest covenant-lite, long-dated or PIK toggle paper could delay restructurings. Loan documentation with sponsor-friendly equity cure language could also postpone a restructuring scenario, respondents said.
According to Kevin Hewitt of FTI Consulting, “It doesn’t feel like the peak volume of European financial restructurings is still nine months away. The volume of financial and operational restructuring activities across Europe is already at a very high level. Based on the responses to this question the latter part of 2009 and 2010 are going to put severe pressure on participants in the restructuring market.”
Respondents to Fig 2 were divided on the likely number of insolvency filings in 2009. The downsizing of the economy and high levels of debt will trigger an increase in insolvencies, respondents said. Some noted the volume and complexity of restructurings, and the sheet size of lender syndicates could prevent consensual/out-of-court restructurings.Some respondents question the likelihood of an increase in the number of insolvencies outnumbering restructurings. Insolvency is the last resort for owners, creditors and stakeholders, they noted. Respondents also highlighted that insolvencies are more likely to occur at the lower end of the scale. Larger businesses could face political pressure to restructure.
“2009 could be the year the CLOs crack under the weight of defaults,” says David Resnick, of Rothschildin New York. “Distressed companies are very quickly having payment defaults after covenant breaches. And this is getting worse as a prolonged downturn erodes what little fat companies had on their backs.”
According to 88% of respondents, senior debt offers the highest return on investment, ranking first choice with 66% of those questioned. “Senior is secured and will drive a [restructuring] process,” noted one.
Half of respondents rate high yield bonds as an attractive product, while second lien and mezzanine debt ranks lower in respondents’ favour. Interestingly, mezzanine debt ranked some way ahead of second lien debt in last year’s Debtwire survey, sitting second in line behind senior debt and scoring first place ranking with 9% of respondents.
“The role of the senior lender has never been so powerful,” says Paul Inglis at FTI Consulting. “In a market where asset values are so depressed and value recovery plans so uncertain it is difficult to see why distressed investors would take the risk of investing elsewhere in the structure until at least they have a foothold in the senior and more visibility.”
The UK is expected to produce the most distressed opportunities in 2009, with three quarters of respondents ranking it first. Germany also received a high ranking, followed by France and then Russia (see Fig.4).
Respondents were divided on investment prospects in Spain. Identified by a large number of respondents (43%), only 2% rank the Southern European country as the greatest opportunity for distressed investment. “Spain will be [a] huge [restructuring market], but it’s hard to see how there will be many going concerns or an open debt market,” said one respondent. “It’s mostly non-traded bank debt.”
Macroeconomic imbalances prompt a wealth of opportunities in the UK, with its over-stretched economy, tightening liquidity, and a decrease in private consumption, according to respondents. According to one interviewee, the UK was simply “a bubble waiting to burst.”
For many respondents, insolvency regimes and government intervention shape their views, particularly in Western Europe. “Countries with government influence offering support for private businesses will be attractive,” said one.
Sector-specific factors will also likely influence opportunities (financials in the UK, automotives in Germany and the construction market in Spain). The size of these economies and the tradability of debt will also sway investor sentiment.
“The most severe problem in Europe is the UK, where banks have been hoarding cash since September 2007,” says Alistair Dick, of Rothschild in London. “We do not see much let up, given potential provisioning banks will require as the recession hits their corporate loan books.”
Respondents were near-equally divided on increased asset allocation to distressed opportunities in 2008. Despite 45% opting to increase exposure, many abstaining respondents said the last 12 months were too early to consider distressed investment.Respondents are only slightly more assured of increasing allocations in 2009, with 56% planning to ramp up exposure to distressed investment. In many cases, respondents perceived existing exposure sufficient. A third of respondents said they were actively fund raising for investment in distressed opportunities.
According to Heinrich Kerstien of Rothschild in Frankfurt, “There is a large weight of money looking for investment opportunities, but the flight to quality is making investors reluctant to increase their allocations to distressed assets in the short term.”
ABOUT THE AUTHORS
Andrew Merret is Managing Director, Co-Head of European Restructuring at Rothschild, Richard Nevin is a Partner at Cadwalader, Wickersham & Taft LLP, Carrie-Anne Holt is Managing Editor of Debtwire, and Kevin Hewitt is head of FTI Corporate Finance Europe.
For the full text of this report, readers are encouraged to visit www.mergermarket.com/pdf/European-Distressed-Debt-Market-Outlook-2009.pdf