Media headlines often reinforce the perception that only the biggest investors are buying distressed debt. The names that most commonly arise include Fortress Investment Group, Cerberus, LoneStar, Blackstone, TPG, and Apollo Real Estate Advisors.
But a new survey by Boston-based global loan purchase advisor DebtX has discovered strong interest from a broad range of firms, including many with modest balance sheets. The company polled 50 firms with €150bn of funds and found that 60% of the respondents indicated that they were seeking to invest in opportunities requiring less than €100m in equity.
And 12% of the survey group had the resources to bid on opportunities requiring greater than €250m.
Barred from participation
Smaller funds have become frustrated. Having raised funds to invest, investors are being barred from participating in the few transactions that occurred in Europe last year and so far this year due to the prohibitive size of the deals.
For example, the structure of Project Isobel, Royal Bank of Scotland’s £1.36bn (€1.69bn) sale of UK commercial real estate loans completed last December, precluded all but the very largest funds from participating.
DebtX says that the European distressed market is perceived by some as an “invitation-only” market favouring the very largest private equity funds.
Gifford West, head of European operations at the company, says: “We have a bit of gridlock here. Banks are failing to maximise loan sale proceeds, as they are selling too much in bulk. If they engage in smaller lot sizes, they will see higher prices and a faster throughput.
“A deal is taking six months from start to finish, taking vast amounts of time. Focusing on smaller pools and more buyers can streamline the process, which can then be as short as three months.”
West says: “In the US there are between 70 and 100 portfolio sales per quarter and in Europe it’s a big quarter if there’s two across the whole region. Why is that? Partially because of the banks’ sale model. Isobel took over a year to complete.”
The survey also found that, surprisingly, investors showed little preference for the size of assets being sold in loan pools. As long as the aggregate pool did not exceed a fund’s absolute targets, the composition of the underlying pool did not appear to be a factor. Investors were equally interested in bidding on a pool containing 25 €2m loans as on as a pool consisting of five €10m loans.
Respondents indicated a strong preference for distressed debt secured by German real estate. DebtX thinks that this reflects both the stronger German economy as well as the greater liquidity of German non-performing loans.
Outside Germany, demand is high across all geographies, with the exception of Greece. Spain remains a strong focus of interest, even with the present market volatility. Interestingly, investors’ appetites differed little between the core market of some countries and the less developed secondary cities – for example, Dublin versus the rest of Ireland, London versus the rest of the UK, and so on. Greece is notable for the low level of interest.
Distressed retail, multifamily, office, and residential property loans dominated investors’ interest in the DebtX survey. Distressed hospitality, logistics, and industrial loans were the next most popular types of assets.
Land loans were the least favoured category. In DebtX’s follow-up interviews, investors overwhelmingly preferred assets with existing cash flow. Retail, multifamily, and office were seen as the sectors with the greatest stability and prospects in most markets.
Distressed loan investors typically are purchasing loans with the intent of taking control of the real estate. As a result, investors had a greater interest in bilateral loans compared to other loan structures.
DebtX’s interviews found that investors were frustrated with more structured loan facilities. Less-than-clear documentation and the need for super majorities in case of default made investors more hesitant to bid for these types of loans.
Most investors have the capital to finance the purchase of distressed debt. While investors will not refuse vendor financing, it was not seen as a critical component to a sale structure. Investors have funds that they are seeking to place; the priority at this juncture is to invest.
With North American banks increasingly offering financing for distressed debt purchases, vendor finance is likely becoming less of an issue. Despite the growing amount of capital being raised to buy distressed European real estate loans, too little product is being brought to market in a manner that allows all interested investors to participate.
Market imbalance
DebtX found that there is a clear market imbalance for small- and mid-sized funds – far less supply for the existing demand. The majority of funds ready to invest are being shut out of the few transactions that have taken place owing to the size of the investment required.
To build liquidity, European sellers need to begin regular sales with smaller loan pools to encourage bidding from many investors, says West. He adds: “As more liquidity develops, additional funds will be created to absorb the debt currently held by European banks. Any sale that is transparent and fair should successfully generate bids.”
As the Federal Deposit Insurance Corporation has demonstrated in the US, greater liquidity can be achieved through multiple loan sales of moderately sized transactions, rather than large but infrequent sales. Liquidity will build liquidity, says West.
