When we visit clients and prospective investors we try to leave them with one clear message: In Europe there is still a significant risk-adjusted opportunity to make money buying assets that need to be recapitalized, refurbished and released. We suggest that this opportunity remains cheap because the cost of an impaired asset still remains well below the value of a repaired asset. We also say that there are now modest tailwinds from improvements in the European economy that may further support performance.
Investors often push back, concerned that capital flows are accelerating and that growth could change the window of opportunity. Inevitably this leads us into a debate centered on ‘the nature and dynamics of the opportunity’ and ‘the degree of difficulty associated with successful execution’. We believe this debate is important as it goes to the heart of why Europe is an interesting investment opportunity right now.
The supply of capital is, in of itself, a major driver of the way in which any opportunity pans out. The prevalence of creditor control and banking distress blew the window of opportunity wide open for investors, but it has been extended for much of the last five years by the way in which in-bound capital has been carefully rationed. Incoming investors have been relatively cautious and as a result capital has been drip-fed into the small group of ‘non-core’ managers that distinguished themselves as prudent fiduciaries in the last cycle. As a result, the aggregate sums raised have been far short of the levels required to clear the capital-intensive opportunities that exist at the value-added and opportunistic end of the market.
LPs that are concerned about the window of opportunity closing, frequently cite increased capital formation as a reason to hold back. We think that the space is better capitalized, but far from crowded. In our view, there are persistent barriers to entry that will slow the pace at which the opportunity plays out. This is because long term rationing has induced some permanent changes to industrial capacity that will slow the pace at which capital can be formed. A major change is that the multi-strategy managers will find it hard to reboot back into the space, as they abandoned value-add and fully re-tooled their businesses to focus on core strategies and debt products. At the same time the regulatory environment in Europe has significantly increased the operating cost and time investment required to be a new entrant niche GP.
The nature of the opportunity is also governed by the quality and condition of the asset base. As we all know, real estate needs constant care and attention to preserve its tenant appeal and long-term value. Capital rationing and seven years of slow-low GDP growth have pushed many assets into a cycle of poor leasing velocity and deferred maintenance liability that has become tough to break. This is why non-core prices and core prices remain widely diverged and, equally, why breaking this cycle is clearly where the opportunity lies. If the capacity to break this cycle and close the spread between impaired and repaired assets is the nexus of the opportunity, then the key to understanding the execution risks is centered on the GP’s ability to manage the creation of ‘core’. GPs that focus on manufacturing an asset that fits neatly into the institutional definition of core, will be among the most successful of this extended vintage.
The final dimension to the non-core opportunity is the debate over growth. The return dynamics of non-core investing continue to allow managers to hit their targets and collect significant leveraged cash flow, without underwriting ‘market improvement’. However, it is very apparent that when GDP growth does come through in an economy, it can provide a dramatic upside boost to returns. This leads us to believe that, even if we don’t have to underwrite growth to make our returns, growth’s catalyzing effect on values should be part of the calculation that investors make when allocating capital. Right now, low growth expectations in Europe don’t seem to be consistent with low rates, cheap euros, lower energy costs, more QE and big current account surpluses. In our view, this embeds a low cost option on the upside into an investment proposition that is already very attractive.