European banks new target for distressed debt

With domestic opportunities shrinking, U.S. private equity and real estate firms are going abroad once more for investments.

While many investors went to Asia following the financial crisis there in the 1990s, now Europe is the target, with alternative investment firms snapping up banks for their distressed debt portfolios, the infrastructure to service these loans and the ability to become lenders themselves.

A dominant player is Lone Star Fund, a real estate opportunity fund manager known for its distressed debt plays. Lone Star is said to be poised to buy Mitteleuropaische Handelsbank AG from Nord/LB, Hanover, Germany. Lone Star previously purchased a €2 billion ($2.59 billion) portfolio from Dresdner Bank AG, Frankfurt. Lone Star also owns banks in Korea and Japan.

Lone Star was one of the first U.S. funds to go after the distressed debt market in Germany, when it bought the shuttered Gontard & Metallbank in 2003. Lone Star executives declined to comment for this story.

Investment firms also are pursuing equity stakes, trying to gain a share of profits from strong European banks. The private equity investment unit of the C$140.3 billion (US$113.39 billion) Caisse de Depot et Placement du Quebec, Montreal, is buying a 10% stake in private bank La Compagnie Financiere Edmond de Rothschild Banque, Paris. And the private equity business of GE Capital Corp. is one of the suitors for NIB Capital NB, Amsterdam, the merchant bank owned by two Dutch pension funds, Stichting Pensioenfonds ABP and PGGM.

"Our investment enables the Caisse to partner with one of the best-performing merchant banks in France," said Henri-Paul Rousseau, chairman and chief executive officer of Caisse de Depot.

Managers are moving abroad because of a double whammy. Less than 1% of U.S. bank debt is non-performing and cheap debt is keeping corporations solvent, insiders say. Yet while investment opportunities at home shrink, institutional investors are inching up their distressed debt allocations, preparing for 2006, when they expect a wave of U.S. buyout fund and real estate deals to go bust.

"In large part, funds looking overseas are driven by the relative lack of value in the U.S., particularly in the distressed market," said Mark Holdsworth, managing partner of Tennenbaum Capital Partners LLC, a Santa Monica, Calif., private equity firm.

"In the U.S., the debt markets continue to be red hot. It reminds me of the Internet bubble of the 1990s: Yields are depressed … and there are new entrants buying up this stuff, including hedge funds and private equity firms just now getting into the game. Banks (and investment banks) are coming back in a big way."

Said Kelly De Ponte, partner in Probitas Partners, a San Francisco private equity placement agent: "A number of limited partners, both in the U.S. and in Europe, are worried that general partners are using higher and higher levels of leverage and that in a year to a year and a half, if the economy falls and interest rates rise, the portfolio companies of these buyout funds will turn distressed."

Increasing distressed debt investments hedges against those possible losses by buyout firms. While the investors might lose money in their buyout funds, they could make money from their distressed managers, who would snap up those companies or properties at a discount.

Currently, the best places to buy distressed debt are Asia and Germany, Mr. De Ponte said. German banks did not fare well in the merger between East and West Germany, which caused a shortage of credit for small to midsized companies. Lone Star and other private equity firms are interested in supplying that capital and in buying up the banks' portfolios of non-performing loans.

There is a relatively small group of real estate and private equity managers that has developed an expertise in monetizing non-performing assets, said Mark Grinis, partner in Ernst & Young LLC's real estate practice, New York. They include Lone Star, Morgan Stanley Real Estate, Goldman Sachs Group Inc., Cerberus Capital Management LP, Ripplewood Holdings LLC, Newbridge Capital Inc., Aries Advisors LLC, TCW Group Inc. and Oaktree Capital Management LLC.

Other private equity firms are investing in overseas banks or the banks' portfolios through subsidiaries or partnerships. For example, Texas Pacific Group and Blum Capital Partners LP are among the co-owners of Newbridge.

Still others aim at restructuring failed businesses, rather than buying debt. Those firms include Littlejohn and Co. LLC and KBS Realty Advisors LLC. These firms buy distressed debt to gain control of a company and then convert the debt to equity in the bankruptcy proceedings.

Despite the shortage of domestic investments, distressed debt players are having no trouble raising large funds. Lone Star just closed a $4.2 billion fund; Tennenbaum Capital Partners closed a $2 billion fund; Oaktree Capital raised $1.4 billion; and Ewing Management Group closed a $1 billion fund in the fourth quarter of 2004.

Investors in those funds include the Teachers' Retirement System of the State of Illinois, Canada Pension Plan Investment Board, Washington State Investment Board, Oregon Investment Council, University of Texas Investment Management Co. and New York State Teachers' Retirement System.

None of the investors would go on the record to discuss their managers' investment strategy.

"I think you will find any time funds are producing strong returns, they continue to get investors to re-invest in subsequent funds," Ernst & Young's Mr. Grinis said. He added that the average return for these funds has been around 20%.

Most of the largest distressed debt money managers began during the savings and loan debacle in the 1980s, helping the Resolution Trust Corp. securitize non-performing loans. They eventually took their expertise to other areas of the world, moving to Japan in 1997, Mr. Grinis said.

For example, Newbridge Capital bought a controlling stake in Korea First Bank at 5,000 won per share in 1999. It then cut the Seoul-based bank's bad debt portfolio and shifted its business to consumer lending from a large commercial lender. Newbridge sold the bank in December for 3.5 trillion won ($34 billion), or about 17,000 won per share.

Now that Asia is beginning a recovery, Germany is the next place distressed managers are beginning to ply their trade, with Lone Star first.

After July, lending banks in Germany — which now enjoy the credit rating of the government — will have to survive on their own ratings, said Geza Toth-Feher, an attorney in the London office of Los Angeles-based law firm Paul, Hastings, Janofsky & Walker LLP. This is forcing them to reorganize and trim some of their non-performing loans. The bank reorganization and a depressed economy are making it easier to buy banks and state-owned residential companies, he said.

According to a report by Ernst & Young, other markets — such as Russia, the Czech Republic, China and India — are ripe for distress debt opportunities.

But the managers shouldn't stray too far from home; many fund managers expect an increase in distressed opportunities in the United States within 18 months.

"It would not surprise me if there were distressed debt opportunities in the U.S. in 2006," Mr. Grinis said. "There are a lot of opportunity funds and a lot of liquidity and low interest rates, and when you see a lot of liquidity and low interest rates, you see a runup in value. The question is: Will it stabilize, drop steadily or drop quickly?"