EUROPEAN NON-PERFORMING LOANS - 2019 www.sterlingvdr.com - Sterling data room
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EUROPEAN NON-PERFORMING LOANS
2019
www.sterlingvdr.com
0EUROPEAN NPLS MAINTAIN MOMENTUM IN 2019
The EU now boasts a stockpile of nearly €780 billion of NPLs, according to the European
Banking Authority. This presents a major opportunity for investors, as the region’s largest
banks continue to clean up their balance sheets, creating a growing market for dealing with
their bad assets.
This figure is down from a peak in 2015, when economic recoveries started to take hold in
hard-hit crisis countries such as Ireland and Spain. But, even as the proportion of NPLs on
banks’ books declines for the EU as a whole (from 7.5% in 2015 to 5% at the end of 2017),
banks in Italy and Greece continue to struggle with rising NPLs amid a continuing flow of
bad loans and faltering economic recoveries.
This has huge implications for bank profitability and the ability of financial institutions to
lend to businesses. And, as we begin 2019 with whispered warnings of recession in the air,
it’s unlikely that distressed-credit managers and investors seeking upside from managing
NPLs will be any less busy in the year ahead.
HOW DID 2008 SHAPE THE NPL MARKET?
The development of a two-way market for buying and selling large portfolios of NPLs is a
relatively recent phenomenon. NPLs are not strictly speaking defaulted loans. They
constitute any borrowed money where scheduled interest or principal payments have not
been made to the lender for at least 90 days for commercial loans, or 180 days in the case of
consumer loans.
The distinction between an NPL and a defaulted loan may vary according to local rules. But
it matters to investors because NPL portfolios can be bought and repackaged with the
expectation of recovering at least some of the borrowed amount.
Prior to the 2008 crisis, banks in Europe had become highly leveraged. Compounding that
risk, the sustained low interest rate environment encouraged banks to lend to high-risk
borrowers to secure higher returns. Predictably, when borrowers started to default on
some of those loans, the banks suffered huge losses because they were legally obliged to
write down their value.
1 1Post-crisis, new rules on capital adequacy and risk reporting created a lower-risk
environment for the banks (or, perhaps, for their investors). They have to show they’re
adequately capitalised and have sufficient ‘bail-in’ capital to withstand a liquidity event or
credit crisis.
But the regulators – including the European Commission (EC) and the European Central
Bank (ECB) – also encouraged the expansion of a European market for NPLs to mitigate the
impact of defaults.
They obliged banks to sell entire portfolios of loans, including many that were not
distressed, at deep discounts. That meant establishing a legal framework for orderly NPL
sales and encouraging governments to enact supportive legislation.
2 2HOW DID THE HUNT FOR YIELD SUPERCHARGE NPLS?
At the same time as European banks were clearing out NPLs, persistently low returns on
traditional fixed income assets elsewhere in the market encouraged investors to seek out
higher yielding assets. For alternative asset managers, private equity and pensions funds in
particular, the NPL market was ideal.
Their enthusiasm for NPLs was heightened by the ECB’s programme of asset purchases,
known as quantitative easing (QE), which removed large swathes of government and highly
rated corporate debt from the market, as well as asset-backed securities and even covered
bonds.
These operations began in 2015 and continued until the end of 2018, with asset purchases
eventually totalling more than €2.5 trillion. The resulting scarcity of high-quality credits in
both government and corporate fixed-income markets sent many investors – especially
those with long-term liabilities, such as pension funds – on a global quest for yield.
Demand from these long-term investors has since become a major driver in the
development of a new class of globally diversified distressed credit fund managers. These
investors buy whole portfolios of NPLs at large discounts to their face value, then manage
the assets back to health, or recombine them and sell them on, providing their backers with
high returns along the way.
The depth of data available on loans, counterparties, related markets, risks and
performance has also transformed the way NPLs can be packaged and marketed.
The EC has done its part to encourage the development of this secondary market in NPLs as
a way to speed the recovery of bank balance sheets, primarily by removing existing legal
and regulatory hurdles for new participants to invest.
3 3WHAT IS EUROPE DOING TO BOOST NPLS?
An even more diverse group of investors – including international distressed credit funds,
family offices and other private institutions – looks set to keep the NPL market busy.
European banks still have an estimated €944 billion of NPLs on their balance sheets – Italy
accounts for €224.2 billion of that, Greece €112.3 billion.
Struggling economies desperately need banks to securitise and sell NPLs to free up lending
capacity for growth businesses – and to keep banks from either tapping equity investors or
the region’s new bail-in regime. And many countries are targeting policy interventions to
boost the NPL market.
In Italy, with its large stock of NPLs, a voluntary government securitisation guarantee
scheme is available to senior tranches of NPLs that banks put up for sale. The GACS
(Garanzia Cartolarizzazione Sofferenze) is likely to play a role in accelerating sales by
supporting reasonable bid/ask spreads in a more competitive market.
Greece is considering a similar plan, in which lenders would unload some bad loans into
special purpose vehicles (SPV) that would then qualify for a state guarantee.
An anticipated rise in European interest rates in the coming year is also motivating banks to
sell their loan portfolios sooner rather than later. Even a small uptick in the rates that
issuers are required to pay on borrowing can exacerbate difficulties they face in meeting
future interest and principal payment schedules.
WHAT’S HAPPENING WITH CORPORATE DEBT?
Beyond the banks, we’ll see more corporate NPL issuance in 2019. The European market for
leveraged loans, for example, has expanded dramatically since 2015 amid growing deal
activity, particularly M&A. In 2018 alone, the number of leveraged loans outstanding
reached a record €150 billion.
The European leveraged bond market has gained traction with investors, too, mirroring the
US junk (high-yield) bond market 20 years earlier. Leveraged buyout deals are driving
market growth across Europe: in 2017, issuance reached a record volume of €110 billion.
4 4One catalyst is that many – if not most – of the leveraged finance deals from 2017 and 2018
were covenant-lite structures, which reduce the legal recourse of investors in the event of a
default. As happened in the US when that market turned sour, many high-yielding
instruments in Europe could fail spectacularly when the interest rate cycle turns.
HOW WILL DEMAND FOR NPLS SHAPE UP IN 2019?
On the buy-side, alternative asset managers such as private equity firms and hedge funds
remain highly liquid, with plenty of cash to invest in higher-returning assets. The recent
pullback in major equity markets could even add to their appetite for European NPLs,
which add diversity to their portfolios and generate a strong internal rate of return (IRR).
While investment demand for leveraged loans and bonds should continue to be robust in
Europe, there are a number of risks surrounding possible changes in monetary policy. In
particular, there are concerns around the combined impact on high-yield debt markets in
Europe from the end of central bank bond purchases and rising yields on higher-rated
corporate and government securities.
Buyers and sellers of NPLs navigating the complexities of this competitive and increasingly
risky landscape need instant access to comprehensive information about individual issues
and programmes. Small changes in policy, economic fundamentals and investor sentiment
demand robust, up-to-date research, modelling and analysis.
HOW IS NPL MODELLING EVOLVING?
Pricing NPL portfolios is always challenging. In Europe, performance varies widely
according to the jurisdiction where the loans originate. Local factors such as current
legislation and past experience can be analysed for clues on what to expect in terms of NPL
performance and recovery rates.
But NPL portfolios in the most distressed countries such as Greece have short and therefore
unreliable track records. This often results in pricing that is characterised by high bid/ask
spreads, making it far more difficult and risky to invest.
5 5Buyers keen to determine the likelihood and the speed at which they can expect the
underlying assets to recover must digest a great deal of portfolio-specific information
ahead of a sale, too.
Many investors have resorted to appointing or acquiring local ‘servicers’ to assess their
risks in different markets. These local providers help investors gain insight into the nature
of potential NPL investments – or leverage the servicer’s database of information about the
borrower.
HOW ARE NPL VENDORS AND INVESTORS MANAGING THIS
DATA?
There is currently no centralised system to provide equal access to all interested parties in
NPL transactions. But virtual data rooms (VDRs) have been providing essential services to
the primary European NPL market almost since its inception. They have a successful track
record of supporting the NPL market through the timely distribution and management of
essential information about specific deals.
It’s not just the value of a centralised and secure channel for communicating details about
offers as they become available. VDRs can support entire teams of analysts and investment
managers as they comb through large amounts of detail about individual loans in an NPL
portfolio, and then model and price investments in real time.
VDRs work well for a wide variety of parties, providing industry standard tools for analysing
investments and helping users quickly identify, organise and structure data in ways that
prioritise the most relevant information for investors. By allowing users to perform tasks
such as asking questions and adding comments, this analysis is made significantly quicker.
Data rooms also drastically reduce the incidence of errors, data losses and opportunities
for unauthorised intrusion.
Whether it’s M&A, equity capital raisings or purchasing NPL loan portfolios, a process-
driven approach can be an invaluable tool for investors with little margin for error or delay.
Using a VDR with specialised information management capabilities is essential to ensure
that data is handled accurately and quickly without compromising the flexibility that
participants in this fast-evolving market require.
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