With no lasting resolution to the European financial crisis in sight, the question for many investors is how to invest given the potential macroeconomic and political instability for the foreseeable future in the world's largest economic bloc.
We use the term “demerging” Europe both in the literal sense that the currency union may break apart and as a play on the idea that, from a political and sovereign credit risk standpoint, Europe reflects emerging markets of old. Many investors hope to capitalize on depressed asset prices in the fragile eurozone by investing in those assets associated with beleaguered financial entities fraught with regulatory pressures. But attractive valuations alone may not warrant a directional long position in the region given the possibility of further downside from political indecision and economic stagnation. Furthermore, the timing of and catalysts for asset sales remain uncertain, and the liquidity profile of the most discounted assets may not suit investors seeking to remain nimble in a volatile market environment.
What are the most important factors when considering investments in European distressed assets?
We expect to see a rise in corporate default rates in Europe as macro/political instability leads to further economic strain (and likely recession). This should generate considerable distressed opportunities in the credit market. However, it may be unwise to take directionally long positions in less-liquid assets (as traditional distressed managers tend to orient their portfolios) in an environment reminiscent of classic emerging markets (e.g., high volatility and significant political intervention in markets). We expect volatility to remain elevated as piecemeal policy responses cause short-term rallies followed by sell-offs upon the realization that fundamental issues remain. If investors can stomach the volatility and choose to access the opportunity in less-liquid European distressed assets, the underlying funds should have access to the most attractive deals and the ability to invest through longer lockup vehicles.
How can investors get access to the most attractive deals?
Hedge funds generally aim to get the first look at new deals. However, this is easier said than done, particularly in Europe where long-standing relationships remain a key driver of the banking business. As such, sourcing will be one of the key advantages for investors with a real European presence and established network with the banks. Furthermore, the speed and magnitude of the asset sales is expected to stretch over what could be a multiple-year period. Last year, investors were expecting a large wave of additional supply of loans to be coming from the banks' balance sheets. They are still waiting, and the selling period is expected to be slow. Some distressed funds have dipped their toes into the market; however, actual buying opportunities were less than expected due to wide bid-ask spreads and European banks' inability to withstand large realized losses on their stressed balance sheets.
What kind of liquidity should investors expect?
Regulatory pressure may accelerate bank asset sales as Tier 1 ratios are meant to reach 9% by next summer (this may be revised), but many of the assets that European banks are currently trying to shed may not suit a fund with monthly or even quarterly liquidity. Portfolio asset sales include real estate and infrastructure projects that will require time and patience. Longer-term investors may be able to profit from their ability to withstand near-term volatility while managing these lower-liquidity investments.
What other opportunities are you seeing in European markets currently?
Fortunately, there are other ways to profit from European credit markets without investing in less-liquid portfolio asset sales from struggling banks. Some credit hedge funds with a long/short high-yield orientation have managed to generate attractive returns in the volatile market environment by pairing credit and equity hedges against their long exposure to larger, more-liquid credit names. Funds with expertise in financials may more directly benefit — both on the long and short side — from the opportunities that arise as stressed European financial institutions reshape the nature of their liabilities to meet the requirements of the sovereign rescue package and the upcoming regulatory changes. However, other funds may trade the effects of this trend on corporate borrowers, likely with less volatility.
What developments are you expecting to shape markets in the near term?
Over the next six months, banks may be pressured to sell more attractive liquid assets to meet new capital requirements as well as limit credit to corporate borrowers. This may increase the supply of attractive loans for sale by banks and should continue to push borrowers to issue high-yield bonds if their loans are not refinanced. Indeed, 2010 was a record year in European high-yield issuance as corporate borrowers continued to shift their financing from loans to bonds; the trend continued for much of this year.
The prevalence of new issuers and the rapid expansion of the European bond market may provide increasing opportunities for long/short high-yield funds. For example, the worst-performing names in European high yield have been first-time issuers, particularly family-owned businesses with limited financial transparency. This has created a profile for short selling opportunities when combined with tight pricing and/or high leverage. On the long side, managers are finding opportunities in senior secured bonds of high-quality, utility-like credits in Europe recently providing low-teen yields to maturity.
Dislocations are present in European credit because of the relatively small number of investors in a growing high-yield market (see chart), refinancing pressures, and the complexities of the many jurisdictions. Investors do not have to entirely sacrifice liquidity to gain access to investments in these markets. We believe that a less-directional approach to European credit markets that remains at the more-liquid end of the spectrum is the most prudent approach for many institutional hedge fund investors.
Carl Ludwigson, MBA, CFA, CQF, is an associate director working in portfolio and account management at Pacific Alternative Asset Management Co. LLC. Based in London, he is responsible for manager research in Europe, particularly in credit strategies, as well as client servicing in the region.
Putri Pascualy, MBA, CFA, CQF, is the firm's credit strategist and an associate director in portfolio management. Ms. Pascualy specializes in finding and evaluating global opportunities in credit and distressed strategies on behalf of leading institutional investors.