The practice of distressed investing in Europe only dates back a decade or so but that relative novelty means that the strategy is primed to deliver some big gains for investors who succeed in targeting the best managers. Though distressed and high yield came of age in the US in the early 1980s, in Europe the current juncture is really only the second time that a turn in the economic cycle has made the strategy applicable.

It means that the opportunities for GLG Partners distressed manager Galia Velimukhametova are plentiful. When the corporate distressed market first happened in Europe after the 2000 boom the big opportunities were often in telecoms or cable system operators featuring names like NTL. The distressed opportunity in traditional high yield and so-called fallen angels (see Fig.1) has re-emerged but in this version of the credit cycle it is being dwarfed by opportunities in new areas tied to leveraged loans and hybrid capital, the latter most often present in subordinated financials. Indeed, an analysis by GLG suggests that the size of the distressed opportunity in leveraged loans and hybrid capital mainly in the financials sector is close to $500 billion (see Fig 1).

Perhaps most compelling is that leveraged loan and hybrid capital are relatively new markets in Europe. This implies lots of low hanging fruit and an investment opportunity that should last several years. The distressed strategy launched in July 2008 as part of the GLG Market Neutral Fund and was spun out as the GLG European Distressed Fund in September 2009. There remains a distressed pocket accounting for about 10% of the Market Neutral Fund, which has a broader multi-strategy remit and exposure to different geographies. Across both funds, the distressed strategy has assets of $150 million.

“We focus on corporate distressed in Europe where we believe there are huge opportunities which will continue to exist for several years,” Velimukhametova told The Hedge Fund Journal in a recent interview at GLG’s Curzon Street offices in Mayfair. “The view of serious economists is that there is a long-term problem. Our macro view is that the euro zone in particular will go through quite an extended period of stagnation. Will there be a double-dip recession? Perhaps, perhaps not. But there will definitely be a period of very low growth given structural problems like the exchange rate and the government deficits, which will have to be addressed at some point.”

Leveraged loans ballooned
Research done by GLG suggests that the leverage loan market, fuelled by the buyout boom, went from $100 billion in 2002 at the time of the last distressed cycle to $700 billion now. High yield lending didn’t have such explosive growth but that is starting to change as the market is seeing some refinancing of leveraged loans. What drove the financial engineering were forecasts that long-term economic growth would tick over at 3-4% per year, allowing companies to generate cash and use it to pay down debt. But the economic implosion of 2008-09 instead saw earnings and free cash flows in many companies fall heavily – 40% and more in some cases. The result is that reducing debt is virtually impossible at a time when many capital structures are highly levered.

“We think growth will be subdued,” Velimukhametova says. “At the same time we have a huge amount of sub-investment grade debt in Europe. It’s absolutely historically unprecedented. I’ve been doing high yield for 10 years and at the beginning of the market there was some $30-50 billion in sub-investment grade in Europe, mainly high yield with a little of bilateral loans. But in the last five years we’ve seen an enormous explosion of leveraged buyouts. We have massive maturities and amortisation in this market from 2011 and that is when we believe default rates will pick up and there will be more distressed opportunities.”

Focus on liquid securities
In the distressed universe, the long/short strategy focuses on the most liquid securities of big company balance sheets rather than acquiring loans with a view to restructuring a company and turning the loans into equity. The long/short discipline gives Velimukhametova the flexibility to trade securities through a restructuring or reduce a position and short a play if events warrant it. “That’s the distinguishing feature,” she says. “In a good market we lose money on the premium. On a risk adjusted basis it is a higher quality return.” There is a limit of 10% of the portfolio in any one company and leverage is capped at 150%. On a geographic basis, short side exposure is mainly in southern Europe and Ireland with the long side more heavily exposed to Germany and France and a slight net-long bias on the UK.

Invariably a distressed cycle is ignited by a particular cause. The current distressed cycle is of course a product of excessive mortgage and LBO lending which has ensnared many commercial banks. As banks restructure their balance sheets to raise capital, distressed investors get the opportunity to buy securities from the banks at a discount. The severity of the credit crunch has seen a lot of banks in Europe do these exchanges. It is one good investment opportunity that Velimukhametova has seized. Now the portfolio is moving more and more into late cycle opportunities and becoming more diversified with plays in telecoms/cable and manufacturing sectors such as paper, chemicals and steel which are hurting from the strong euro and over-capacity.

Velimukhametova and Ide Kearney joined GLG in 2008 and 2009 respectively to run the European distressed team. They have an eight year track record of working together, including earlier stints at King Street Capital Europe and before that JP Morgan where Velimukhametova invested in distressed situations and Kearney was a high yield/special situations analyst. Other team members include Till Heimlich who focuses on relative value investment opportunities in loans, bonds and credit derivatives and Christophe Akel who has traded credit with GLG since 2005.

Since the portfolio began trading in the GLG Market Neutral Fund in July 2008, the returns have exceeded 140% (See Fig.2). In 2008, the short book was up 35% but losses on the long side led to a 1.11% drawdown. In 2009, the short book lost 15%, but the long book made 135%.

Velimukhametova aims to hedge long exposure with a big short book. Notional net exposure generated by buying securities is hedged on the short side by buying credit default swaps or short-bonds. Historically, the portfolio has been short since inception. The short exposure as a percentage of capital has varied between 200% and a peak of 400%.

Hedging exposure
“Obviously it is an unusual way to look at it,” Velimukhametova says. “On the short side you cannot lose as much as on the long side. At par, all you can lose is on the interest – if you buy CDS the biggest amount you can lose is the premium. So we look at shorts as a net present value of the premiums which we will lose over the time of the contract as a percentage of capital and it is usually about 20% of capital that is net short exposure versus net long exposure. The notional basis is always short between 100-200% of capital. It is a bit heavy but we are in a very uncertain economic environment.”

The uncertainty is fed by the riddled balance sheets of many banks and the sizeable opportunity now unfolding in hybrid capital and leveraged loans. Velimukhametova estimates that over one-third of the bank hybrid capital market remains below investment grade. “This market was trading at very distressed levels,” she says. “It has come off the bottom but there are still some very interesting opportunities.”

The fund expects to soft close at €300 million. If default rates do pick up substantially into 2012 the fund could open again to new money to take advantage of the opportunity. The sheer scale of the bad debt swelling bank balance sheets means that the fund is looking for a life cycle that could extend beyond the next three years. With economic growth in Europe anaemic there looks to be little hope for banks and companies to get ahead of their debt curves.

Reckless lending
“Our view is that the crisis was caused largely by financial institutions,” Velimukhametova. “They became reckless and lending standards became loose and there was an explosion in derivatives and asset backed securities. That created massive opportunities on the liability side of bank balance sheets because the bank securities were trading at very distressed levels. Until the banking system gets sorted out nothing can actually recover.”

A key macro variable in the European distressed opportunity is the over valuation of the euro, but it is not the only factor. “The euro is one of the very important factors because it makes Europe less competitive,” Velimukhametova says. “Lots of calculations of default rates seek to determine the driving factor. A couple of studies suggest it is GDP growth. If you have high GDP growth default rates drop because you can outgrow your leverage capital structure. But if GDP is falling default rates spike because it becomes really difficult – there is over capacity and pressure on margins – for companies with a lot of debt to outgrow this capitalstructure. So GDP is the main driving factor for distressed.”

Playing house builders
With one UK home builder, the distressed play featured buying bonds and hedging by shorting the equity. The reason for this was straightforward: from a valuation standpoint the bonds outstanding were less than the market value of the equity. In addition, the debt declined sooner and faster than the equity as equity investors took a more long term and thus optimistic view of the housing market and debt repayment prospects. When the builder breached convents on its bank debt and bonds, creditors, including GLG, got involved in negotiating the restructuring. Uncertainty about whether the restructuring would be completed pushed the equity price close to 0. With the equity effectively priced as an option, the fund bought it back. When bonds rallied from a low of 25 (they are now at 100) on the successful restructuring, the equity also rallied and fuelled healthy returns on both plays.

For Velimukhametova and the distressed team there are real benefits to being on the GLG platform. The market neutral fund, of course, included the portfolio in its multi-strategy offering. But the discipline and breadth of GLG is a constant factor in the fund’s research, investment decisions and due diligence. There are informational benefits, too. GLG has a weekly meeting drawing in personnel from the macro, emerging markets, credit, equity and convertibles teams where the focus is on changes in different markets. There is also a weekly macro meeting that gauges investment themes ranging from sovereign issues to currencies and the economic outlook. The GLG equity team, for example, was closely involved with the trading strategy on the home builder and could explain how it performed in the last UK housing market price cycle.

“The nature of distressed is that you don’t know whether a company will default or not,” says Velimukhametova. “We do our own analysis. We look at the downside and in the worst case scenario how much money we will lose. It’s a science, but an art as well as there are a lot of components to decisions. Judgement is needed about legal protection, management, the business and its sector. We need to be comfortable with the valuation, too. So there are lots of inputs to the investment decision.”