Even though banks are maintaining efforts to clean up their balance sheets, a stockpile of nearly €780bn worth of non-performing loans (NPLs) still weighs on the European economy, according to the European Banking Authority (EBA).
The figure has fallen significantly over the past three years, partly thanks to regulators. But much credit should go to international distressed credit managers. They have made significant efforts to rid European banks of these bad assets and reward their backers with high returns. The European NPL market is up-and-running, and the ways in which yield-starved pension funds can get involved are multiplying.
Once a source of apprehension for investors, owing to their impact on the banking system, NPLs today are an attractive investment opportunity in the South European countries. The European bank bail-in regime, introduced in 2015, was also instrumental in this market’s development. It means, among other things, that banks have to take losses on NPLs before they can access public money to avoid bankruptcy. Indeed, a bank’s decision to write down or write off the value of a portfolio of loans is the starting point of any NPL transaction.
In theory, the process is simple. When banks are ready to dispose of a portfolio of NPLs, they negotiate with potential buyers. Once the deal goes through, the buyer of the NPLs employs a credit-servicing business to realise the value of the loans. The spread between the ask and bid price represents the return for the buyer. The buyer, however, assumes several kinds of risks.
Francisco Milone, partner and head of real estate for Europe at alternative manager Värde Partners, explains: «There’s a risk to the value of the assets that were used as loan collateral, which investors come to own once they enforce the loan. Then there is a legal risk, because you are betting on your ability to convert a loan into an assets, and you are making an assumption on how long it’s going to take you to go from being a creditor to actually owning the collateral. These two risks are tied to your servicing ability». “Finally, there is financing risk because in the majority of these transactions there is leverage involved,” he says.
For these reasons, NPL expertise lies firmly in the hands of alternative managers or funds with credit-servicing capacity and strong familiarity with local markets. In fact, most significant players in the market have partnered with or acquired a local credit-servicing business. Värde is a good example, as Tim Mooney, its global head of real estate, says: «We have purchased or partnered with specialised servicers in these markets. If you don’t have that specialist skill set, you can’t compete, because you can’t really bear the risks associated with investing in these assets or really understand how to price them»
The difference between NPLs and other alternative credit investment types, such as direct lending, is that with the latter there is potentially more certainty about the evolution of these loans. This is because the capacity of the borrower to repay the loan has been tested, and plenty of data exists on the collateral.
Distressed credit funds are increasingly turning their attention towards UTP assets, according to Marco D’Arrò, founder and managing partners of Real Asset Partners, a London-based advisory business in the alternative assets sector. Banks often offer UTP portfolios following the disposal of NPLs, and existing buyers are often at the front of the line. So while the stock of NPLs is falling the opportunities are growing.
Original Story: IPE | Carlo Svaluto Moreolo
Edition: Prime-Yield