The German Patient

Central Europe is sitting on a mountain of under-utilised debt

Stuart Fieldhouse
Originally published in the February/March 2006 issue

Stuart Fieldhouse spoke to Roland Berger Strategy Consultants about the evolving market for distressed debt in Central Europe.

Germany has for some time now been a focal point for funds interested in distressed debt. “The German patient” as it was recently referred to in a presentation in London by strategy consultancy Roland Berger, has been looking less than healthy. It has experienced hardly any growth (annual GDP was averaging 0.7% from 2001 to 2004), has seen unemployment on the rise, falling prosperity (per capita GDP is now below the EU15 average), and flagging competitiveness. What happened to the posterboy of European industrial innovation? He now looks tired and old – the average number of patents approved in Germany has been dropping by 2% every year since 1998!

“There’s only been a sluggish shift toward a service economy and knowledge society,” explains Wolfgang Hermann, Head of Corporate Restructurings at Roland Berger. “There’s a need for more financing in this economic environment, there’s a need for more capital to ensure growth. Right now companies can’t finance their capital gains, and the equity ratio is still falling.”

There are many root causes for this development, amongst them the shrinking and ageing German population, low immigration, and sluggish attempts to eliminate bureaucracy. High labour costs, the high cost of unemployment, and a very inflexible job market have also played a role. In addition to this, there remain few foreign capital investments and a poor output-to-capital ratio.

Without a decisive election result, there is also a large question mark over whether a whole slew of much-needed reform initiatives will be implemented, or simply abandoned. Roland Berger has pointed to a series of areas where much needs to be done by the government going forward. Areas already in need of attention include the job market, bureaucracy (e.g. tax reform and deregulation), innovation, education, capital markets, and demographic developments (easing of immigration restrictions). The light at the end of the tunnel is still very dull, and the worry is that it is just going to get darker due to prevailing political uncertainties.

There are, however, some positives in this scenario, as there need to be for an effective distressed debt play to occur. In 2005 there was a reversal of the insolvency hype trend, the first drop since 1999. Exports managed to provide a degree of economic stimulation, and increasing business profits were reported by the DAX 100 companies. Added to this, there have been some indications of economic recovery, and expectations of an increase in economic growth this year are being bandied about. On the downside, Germany still faces significant political uncertainties in the wake of last year’s Bundestag elections, rising prices for raw materials, and a lack of domestic and foreign demand. There are also dire predictions from the likes of the IMF that Germany will be facing slow economic growth in the years ahead.

Graph 1: Reasons for selling distressed debt

Grow or go

Right now, the need for equity to provide stabilisation and new direction is still very high. It is needed to finance corporate restructuring, to stabilise companies, to finance Germany’s next growth stage, and to finance additional adjustment measures. Such requirements cannot currently be met by traditional shareholders. According to Roland Berger, equity ratio development at German companies hasdropped from 32% in 1999 to 17% in 2004. Banks are reluctant to extend new loans: book credit development of German banks to German companies and private individuals fell from a peak of €7.6bn in 1996 to €-0.4bn in2005. Foreign investments have not been a help, as venture capital and profits ploughed back into German firms in 2004 only amounted to €15.2bn, down from €33.1bn the year previously. Credit transactions fell off from €24.9bn in 2002, to €-46.2bn in 2004, according to the Bundesbank.

These dire numbers have raised the question of whether Germany needs a serious rethink on the corporate finance front. There is a dire need for corporate finance in the wake of five crisis years. Banks are hesitant, foreign investors are sitting on the sidelines. There is an opportunity here for specialists in distressed debt, like hedge funds, to play a critical role, and indeed, there is obvious interest in the sector from fund managers, especially in North America, keen to find new opportunities.

Roland Berger Distressed Debt Survey

Strategy consultancy Roland Berger has been able to shed some revealing light on the way the market for distressed debt in central Europe (including Austria and Switzerland) is developing. Right now, the major banks, despite having been selling distressed debt for years, still see themselves as inexperienced participants in the market. They are still handling business in a largely opportunistic manner, and are prepared to accept considerable price discounts.

“Their favoured solution is the classical restructuring of a loan,” says Nils von Kuhlwein, a partner with Roland Berger. “The actual transaction volumes have been much lower than €300bn, more in the region of €20-25bn. The market is moving away from portfolio deals towards single names.”

The distressed debt markets for corporate and mortgage loans each have a nominal value of more than €100bn, and Roland Berger is projecting that transaction volumes will increase considerably in the coming years, settling at approximately €20-25bn.87%

It all looks potentially peachy for distresseddebt experts, but regulatory barriers still remain: without a banking license, investors will not be able to conduct business in Germany, Austria, or Switzerland. “It will be hard for players to be in the market for the long-term,” von Kuhlwein predicts.

The fact that new entrants may face regulatory problems in central Europe has been borne out by some of the feedback received. Banking secrecy and data privacy protection are seen as being major barriers to trading activities going forwards. Seventy per cent of respondents to the Roland Berger survey agreed that because of bank secrecy and data privacy protection laws in Germany, only non-performing loans are being offered, and in some cases only with the debtor’s approval. Opinions on the effect of legal uncertainty remain divided: for example, only 40%of those surveyed agreed that with problematic loans, client contact remains in the hands of the seller, versus 35% in strong disagreement.

For investors that are not licensed banks, many other problems remain to be grappled with. For starters, a bank license is necessary to buy loan commitments that have not been terminated. Without it, there is no fresh capital or cash available in cases of capital reorganisation, nor is it possible to take over servicing for problem clients. Problems could also arise from loans that have not been terminated, and it is not possible to enter balance settlement agreements (e.g. cash collateral). There is also a risk of misuse of unregistered creditor positions.

The solution that seems most widely embraced is that of sub-participation, although selling the idea to the debtor is another common tactic. There is a general view that there is a viable solution to the banking secrecy/data protection conundrum, and that once this is found, the situation will improve considerably for foreign players.

Most banks are selling distressed debt to reduce their risk, according to the study’s findings. Improving the loans portfolio is a secondary factor. The overall share of distressed debt in the credit portfolio for most of the respondents to the firm’s research study is in the range of 0-7.5%, with the bulk at less than or equal to 2.5%. Nominal value, on the other hand, exceeds€100bn for corporate and real estate debt in the majority of cases.

Graph 2: Share of distressed debt in nominal value (%)To identify a loan as potentially distressed debt, most players in central Europe are relying on their internal early warning systems. Credit risk criteria, pursuant to Basel II, is also a favourite for over half. The nominal value of most transactions exceeds €100m, although corporate loans are generally over €1bn. However, close to 40% of distressed debt transactions in the period 200304 fell under the €100m barrier. Significant discounts of up to 40% or more are not unusual.

Looking ahead, Roland Berger postulates strong growth for 2005 and 2006, but a slowdown in this market in 2007. Its respondents forecast an annual transaction volume of between €10-€16bn each over the next couple of years.

The silver lining

Germany, despite its problematic position, has massive potential. The underdeveloped private equity market, a mere fraction of the size ofthe UK’s and even smaller than Italy’s, has plenty of scope for growth. The sheer size of non-performing loans (potentially as much as €300bn) dwarfs the projected nominal transaction value of €25bn for 2006. There is also sizeable participation in the market from the US, albeit from banks only at this stage. Big NPL deals in 2005 included Goldman Sachs (Commerzbank in February, Delmora in May), and Lone Star (a whole series, including €1,400m with Merrill Lynch for a Dresdner Bank NPL in June, and over €4,000m bought off Hypo Real Estate in 2004). Right now Germany remains the favoured destination market for buyers of distressed debt in Europe by a large stretch of the imagination, and bank debt is the favoured type.

For those less likely to be taking delivery of a banking license in the near future, there is already a developing secondary market. Standards of reporting, and the quality of data continue to improve: for example, publication of default rates is now more frequent, and there is more detailed information on receivables available. The volumes of distressed debt being offered on various markets, not just in Central Europe, have been increasing since 1999. In 2002 alone the market volume of defaulted and distressed debt was $942bn globally, with a market value of $512bn. It is a market that has grown up quickly, and as it matures in Central Europe, there will be plenty of opportunities for managers with scale.

In terms of costs, sellers of distressed debt in Central Europe report that information gathering and analysis still makes up over 50% of their expenditure, with information and data processing accounting for 34.9% on average. On the buyside, information gathering is also a large outlay, at 38.5%, although exit costs represent another 35.5%. Legal advice and the definition of the agreement probably remains the single largest cost for buyers of distressed debt.

The study also interestingly discovered that collateral pools and taxes have a huge impact on distressed debt investing. Special loans, syndicated loans, and collateral assignments are also influential factors. By contrast, dismissal protection laws and International Financial Reporting Standards (IFRS) bear no influence for the vast majority of respondents.

Who are the players?

There are a broad range of banks involved in the Central European distressed loans market at the moment: apart from the major banking names, regional banks, Landesbanks, and credit cooperatives are also holders of non-performing debt. Half of those responding to the Roland Berger study reported annual new credit volumes in excess of €10bn. The vast majority (95.7%) are involved in corporate loans, although a large slice of the banks interviewed (87%) also run mortgage and real estate loan books. A much smaller percentage (less than half) provide consumer loans or issue bonds. In terms of overall experience, 31% of the banks surveyed have been involved in the distressed debt segments for more than five years, although even more, nearly 35%, have been in the market for less than three. Seventy per cent are active in sales only, and are therefore mainly interested in cleaning up their credit portfolios. Another 30% can be described as active ‘dealers’, buying and selling distressed debt. In addition to cleaning up their credit portfolios, they also want to earn money through trading in credit commitments. Roland Berger said it had not come across any pure buyers in the firms it polled.

As mentioned above, most banks involved in the market, despite the high proportion with more than a five year track record, still consider themselves to be inexperienced. Investors, they feel, remain the most experienced players in the market, more so even than legal consultancies. Broken down by type of transaction, the banking community in Central Europe still feels most comfortable with bonds and real estate/mortgage loans, and far less comfortable with corporate loans, despite the high level of exposure to the latter. Corporate loan transactions still generate the most difficulty, which probably goes some way towards explaining this. Single name transactions are still the most highly favoured, mainly because they present the least difficulties.

Getting out

For specialist buyers of distressed debt, eventual disposal is a big consideration, and the survey also shed some light on this. Corporate restructuring and full debt payment are seen as the ideal exit strategy, although the firms Roland Berger spoke to also indicated that partially waiving the remaining debt was also appropriate as part of an exit strategy. Least appropriate was liquidation, followed by a liquidation of collateral. Selling off debt, and financial restructuring was viewed with mixed feelings.

Opinions remained divided on whether the different philosophies of US and German law serve to scare investors off: the rare use of insolvency law in Germany is seen as a disadvantage for the market, and in general, the structure of German law is viewed as being anegative influence. From the perspective of a potential US buyer of German distressed debt portfolios, this is a very serious consideration, particularly given that these worries are largely being voiced by potential sellers, rather than a buyer with a bad experience to complain about.

This market is obviously one with huge potential, and independent consultants like Roland Berger are right to be excited about it. Seasoned distressed debt managers, particularly those feeling jaded about opportunities in the US market, are already investing time and money in investigating the market, but many obstacles remain, especially in the sphere of red tape. Should this be removed, and this would require movement at the political level, then there should be plenty of activity in Germany in 2006 and 2007. But this would require a forthright program of reforms from a government that may not yet feel strong enough to deliver.