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Stressed and distressed opportunities


Special situations strategies see value in European bank NPLs, writes James Williams.

CVC Credit Partners is a global alternative investment manager focused on sub-investment grade debt capital markets in the US and Europe, managing USD14.4 billion of assets under management, as of the first quarter of 2016. 

Recently, the firm completed the final closing of its Global Special Situations Fund. The fund, which focuses on stressed and distressed corporate credit, predominantly across Europe, secured EUR650 million of capital commitments from investors. 

This brings total commitments across all of CVC Credit Partners’ Credit Opportunities vehicles to more than EUR2.5 billion and the scale of its business serves to illustrate the demand for special situations strategies. 

Steve Hickey, Managing Partner and Chief Investment Officer of CVC Credit Partners, recently commented: “CVC’s local office network across the US and Europe provides us with broad access to a wide range of investment opportunities, as well as invaluable market insight and local relationships, as we continue to enhance CVC Credit Partners’ growing platform.”

Mark DeNatale (pictured) is Partner and Global Head of Special Situations. He believes the structural changes across the European banking landscape, potentially impacted by the recent UK referendum result, have created “attractive investment opportunities for disciplined investors, like ourselves. We look forward to investing further in the space, delivering consistent value for our investors.”

The new fund will invest in bank loans, high yield bonds, mezzanine, structured products and, selectively, short positions, other derivative transactions or equity, often created through debt restructuring.

DeNatale says that in terms of the target assets being pursued in Europe: “We believe the market size of opportunity is greater than USD500 billion of non-performing loans.” One only has to look at Italian banks, which alone are estimated to hold EUR360 billion of NPLs, to appreciate the scale of the situation.

“We like to keep the investment philosophy simple,” says DeNatale. “What we are aligned with our LPs on is to deliver private equity-like returns, but in a much better risk-adjusted part of the capital structure. For example, more than 50 per cent of our investments are targeted for loans, which would make sense in so much as the assets coming out of European financial institutions are non-performing loans. Loans often have preferential terms like collateral and covenants that are drivers of recovery.”

Within CVC Partners’ Credit Opportunities and Special Situations strategies there are a number of segregated managed accounts and quarterly redeemable credit opportunity funds (for example CVC Credit Partners European Credit Opportunities Ltd has shares listed on the London Stock Exchange). 

However, these have lower return hurdles and are more liquid products than the CVC Credit Partners Global Special Situations Fund; the only fund that offers a private equity lock-up, targeting 20 per cent gross returns. It has a six-year investment cycle with a three-year reinvestment period.

Back in April, KKR, a global investment firm, announced the final closing of KKR Special Situations Fund II LP (KSSF II), a USD3.35 billion global fund primarily focused on credit-oriented, deep-value investing in distressed or event-driven situations.

That the number of credit assets trading at distressed levels has been increasing steadily for several months, coupled with the wave of redemptions in the distressed and opportunistic credit fund space, the pricing environment for risk is “meaningfully more attractive than in prior years,” according to Jamie Weinstein, Co-Head of Special Situations at KKR. “The size of the distressed opportunity is not the same as it was in 2008. The levels of stress were higher than they are now. The default rates are lower today than they were in 2008.  We think there is a likelihood of an increase in distressed and credit opportunities in the next couple of years although the sourcing and executing of opportunities is actually harder today. That said, we are not as dependent on the liquid secondary market for distressed securities as other firms are.”

KSSF II is the successor fund to KKR Special Situations Fund (KSSF I), KKR’s first dedicated special situations vehicle, which completed fundraising in December 2013 with USD2 billion in capital commitments. KKR’s special situations strategy invests across the capital structure in both privately negotiated transactions and in the secondary markets, seeking to earn strong risk adjusted returns from market dislocations, complex situations and distressed assets. 

Over at CVC Credit Partners, DeNatale explains that GSSF portfolio contains 20 to 30 of the best ideas on the CVC Credit Partners platform. “There are multiple factors involved in the team arriving at those best ideas that involves detailed bottom-up fundamental credit analysis. We are leveraging our European network of 13 offices and also leveraging our proprietary database that has been tracking credit metrics for a decade or more.

“We are one of the largest performing credit managers across Europe and North America, so it’s also about leveraging the CVC infrastructure and the CVC credit team’s expertise managing capital across multiple jurisdictions as well as through multiple cycles of volatility and uncertainty,” he says.

In that sense, GSSF pursues a truly global mandate focused on the best opportunities across the CVC platform. DeNatale says: “We see opportunities in renewables, infrastructure, power generation, as well as in corporates that have been impacted by the Brexit decision due to large FX movements.

“European banks are, of course, the main source of the loans that are getting sold down. For example, we are currently analysing a USD2 billion-plus portfolio of impaired loans out of a UK bank. We believe this opportunity set will grow over the next 24 to 36 months.”

Weinstein says that KKR leverages its relationships and industry expertise to identify opportunities “where we think risk is mispriced”. Sometimes, he says, it comes in the form of buying securities in the secondary market at a steep discount to face value. “Other times it comes from a privately originated new money investment into a company where we get a more than adequate return for stepping into a distressed company’s capital structure and providing a solution.”

He says that while there are attractive opportunities in the market “they are not easy. Situations are complicated. Capital structures and business issues are complicated. QE is making it hard for investors to get paid right now.”

The European Central Bank’s Asset Quality Review programme is pushing European banks to sell impaired loans to the market, all of which plays to the advantage of specialist investors such as KKR and CVC Capital Partners. Weinstein confirms that KKR is active in the European NPL space and refers to a joint venture it has with European banks via its Pillarstone platform. 

Pillarstone was established in 2015 by KKR Credit to partner with European banks to create value by managing their exposure to non-core and underperforming assets on their balance sheets. In May this year, KKR Credit further expanded the Pillarstone platform through the signing of a binding agreement with Alpha Bank and Eurobank in Greece. 

Those who pursue special situations strategies are required to diversify the portfolio as much as possible. The Global Special Situations Fund is not expected to hold positions greater than 7 per cent of the total book value. 

The ability to source the right opportunities across the capital structure is something that CVC Credit Partners prides itself on. The team has been successfully managing returns since the Asia crisis in the late 90s and knows how to build and manage positions appropriately in strong risk-adjusted opportunities. 

DeNatale does not believe there has yet been enough capital raised for the opportunity set in Special Situations over the next two to three years, but he caveats the point by saying:

“We are raising what we think is an appropriate level of capital to be deployed in our strategy. You don’t want to be in a position where you raise so much capital that you are forced to put it to work in lower quality opportunities. That undervalues the proprietary database that we manage here and leverage.” 

Of critical importance when purchasing impaired loans – or mezzanine tranches and high yield bonds for that matter – is focusing on what the recovery rate will be for the asset that is being purchased. For this reason, CVC Credit Partners uses a bottom-up approach. 

“We are constantly balancing the expected asset recovery assumptions versus the offer price coming out of the selling institutions. The majority of the time we are sourcing directly from selling institutions.

“We could see loans priced at 40 cents on the dollar, or 80 cents on the dollar. An asset at 80 cents might not sound exciting but because of the equity stapled to that loan purchase you could be driving returns of 20 to 30 per cent. It’s not all about absolute price. It also comes down to your collateral and what else you are getting with that asset purchase,” explains DeNatale.

As European banks are being forced to sell their impaired loans, over 50 per cent of the GSSF portfolio will be loans. This will help CVC Capital Partners capture private equity-type returns in a more attractive risk-adjusted part of the capital structure as loans get paid before equity. 

There is a carve-out of up to 20 per cent in GSSF for hedging purposes. DeNatale confirms that the team has already been active in terms of deploying capital in the fund. Like GSSF, KSSF II will have a three-year investment period. “It is structured as a long term vehicle so we have many years for value creation and to realise those returns,” says Weinstein.

KKR employs a partnership approach when working with companies and seeks unique opportunities to offer solutions to its various counterparties. The special situations strategy is dynamic and able to deploy capital in multiple ways in order to capture opportunities arising from market dislocation. 

“KSSF II will do distressed for control, rescue financing and secondary opportunistic investments. Those can take the form of loans or bonds or potentially things that become equity investments after a restructuring,” adds Weinstein.

DeNatale concludes by stating that the stressed and distressed market is as interesting “as I’ve seen over the last five years. 

“The credit market is twice the size it was before the financial crash in 2008 and there are significant impacts to the underlying corporates within the credit space. It’s a space where we feel we have the right network and team, and right capital base, to outperform over the next three years of the reinvestment period.

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