EUROZONE: Profit in the tail

Need it be said that private equity real estate is a competitive business. Indeed, there is a legion of firms out there marketing their point of difference to limited partners. Some of these general partners are a bit unrealistic in their self-appraisal, while some correctly analyze their strengths. Therefore, when a GP says it is good at X, one needs a healthy dose of skepticism on hand. Likewise, when market players point out a weakness in others, the same bottle of cynicism is required in the jacket pocket.

From time to time, a theme emerges where that bottle needs to be permanently in hand, and one such moment has arrived in relation to nonperforming loans (NPLs). In Europe, I detect there currently is a kind of white noise around the theme that NPL buyers may struggle to make the returns they have promised investors – namely  20 percent or better.

The thrust of the argument being made, mainly by firms not pursuing large NPLs, seems to be that profits in NPLs are made in the ‘tail’ – loosely defined as the assets that remain in a portfolio after the sale of the better quality ones, those that can be refinanced and those with the best credit rating. While it may be easier selling the first tranche of assets, the real kicker is in selling the more challenging assets.

The problem, however, is that Europe is a low or no growth environment. Is it really possible that buyers will be able to exit the tail successfully, ask naysayers.

One answer to this tends to be to look at the other end of the equation. The most important factor in distressed debt investing is the ability to invest when buying opportunities are special. In other words, when the entry price is below intrinsic value. There are plenty of times when it is not optimal for the purchaser of distressed debt to be investing, such as when sellers are not under much pressure – real or psychological – to sell. The investment results can be lackluster in such a market.

In mainstream private equity, Oaktree Capital Management chairman Howard Marks suggests that there have only been two periods out of 18 years when it was possible to access highly outstanding returns through bargain basement purchases. In the Guide to Distressed Debt and Turnaround Investing, published by PERE’s parent company PEI Media in 2007, Marks said one episode was in 1990, when a recession, a credit crunch, the Gulf War, the meltdown of many prominent leveraged buyouts of the 1980s and the government’s war on junk bonds enabled optimal conditions. The other was in 2002, when there also was a recession and a credit crunch, the invasion of Afghanistan and – for good measure – the bursting of the dot-com bubble, as well as financial scandals such as Enron.

On paper at least, it looks like 2012 and onwards in Europe should be added to that list, given the confluence of events. Still, one problem seems to be a lack of willingness or necessity on the part of sellers to take a haircut. In addition, lenders seem like they are chasing up prices, making it harder to enter a transaction at a low basis.
Even when conditions are good for distressed debt investing, performance cannot be achieved without good management and expertise. This is where it is worth dwelling on the small number of protagonists in Europe, including Cerberus Capital Management, The Blackstone Group, Lone Star Funds, Westbrook Partners, Starwood Capital Group and Kennedy Wilson.

An interesting question is to ask how many of these firms have an in-house special servicing arm. The ones that don’t find it harder to finance their bids than the ones that do, which is why it was smart of Starwood to buy LNR Property, which has a European special servicing unit. Furthermore, the ones that have large teams on the ground with comprehensive experience in the target countries have a particular advantage in being able to make a NPL portfolio really profitable.

Those with experience say they acknowledge the argument about not being able to make money from the tail, but they maintain their expertise is in underwriting and pricing correctly and selling aggressively. If, for example, a portfolio contains a residential block in a Spanish coastal town, they might price 20 of the 200 units at zero value. Those 20 apartments might be facing the motorway instead of the sea or in the basement of a block where there is hardly any light. Caveat emptor.

In Germany, one of these firms currently is dealing with a tail from a loan backed by retail assets. The sponsor of the original investment went insolvent and one of the firms above acquired the loan. Even though the retailer got into difficulty, it kept paying the rent and apparently even extended some leases. The NPL buyer is in no rush to sell the tail of the assets because cash is coming in, and therefore distributions are being made to limited partners. The firm is concentrating on the equity multiple back to the limited partners and things look good – and that is in a low-growth environment.

There is no way to generalise the potential success of NPL buyers in Europe. Some will make mistakes and fail to make money, while others will see lackluster returns. The best, however, will achieve alpha returns.