Stress in Europe Presents Opportunities in Private Markets – Sam Phillips

The latest in a long list of European problems

Eurozone inflation continues to climb to record highs, with Eurostat (the statistical body of the EU) recently announcing that the inflation rate was 9.1% in August 2022. accompanied by an energy inflation rate of 38.6% (as shown in the table below).

With its roots in COVID-19, the energy crisis in Europe and now the growing economic fallout from the conflict in Ukraine are just the latest issues in a long list (think GFC, the ensuing European debt crisis, to Brexit, etc.) which created a climate of stress in Europe. Then, if you add the removal of unprecedented fiscal and monetary interventions, the potential for recession is great.

This presents opportunities for investors with a risk appetite.

What opportunities are available to investors?

For a long time, European banks were content to knit loans at inception and then hold those loans on their balance sheets until they matured. This contrasts with other banking systems, such as the United States and Australia, where banks have adopted an “origin and syndicate” model in which they continue to issue the loan but then organize a syndicate to contract this loan. This led to the European financial system being dominated by banks.

The ECB noted in its Financial Stability Review of June 2012 that the GFC “has revealed a number of unsustainable features of the business models of some EU banks – such as a heavy reliance on funding short-term wholesale markets, overly complex group structures and insufficient capital buffers – which banks need to adjust to ensure their long-term viability”.

Since then, there has been increased pressure on banks and other financial institutions to sell assets in order to optimize their balance sheets and portfolios of existing assets in terms of quality and size, allowing them to freeing up capital to deploy into new higher margins. businesses. The result has been a relatively constant flow of non-performing, non-core, and capital-inefficient whole loans, real assets, and other asset-backed credits and credit-like instruments.

The current inflationary environment will create new vulnerabilities for borrowers most exposed to these pressures, for example in energy, food and other commodity prices. This situation will be further exacerbated by the withdrawal of fiscal and monetary stimulus and by the increase in debt service due to the rise in interest rates. This will ultimately lead to an increasing number of stressed assets, a higher level of non-performing loans and increased pressure on European banks and financial institutions to clean up their balance sheets. As the volume of these distressed assets grows, deals are likely to close at attractive risk-adjusted values ​​for buyers.

Does a strategy focused on investing in stressed assets make sense if a recession is looming?

Whatever the strategy, we are often asked if a strategy makes sense in today’s environment. Our answer will often be “it depends”, because it depends on the particular situation of the investor.

Investors will need to consider (among other things) their investment horizon, how this particular strategy fits into their overall portfolio, will this strategy improve the diversification of their portfolio, will there be enough cash in their total portfolio if they include the strategy, are the expected risks justified by the expected returns, how accessible will this strategy be, etc.

While we cannot answer all of these questions, we can comment on diversification and access considerations:

  • It’s probably safe enough to assume that the majority of Australian investors (outside of any investment through an institutional pension fund) have little or no exposure to the opportunities presented by the troubled European financial system. Indeed, these strategies have been the domain of private market managers, who until recently focused only on institutional investors. Therefore, it is likely that such a strategy could provide valuable diversification benefits to retail portfolios.
  • In terms of access, we believe investors should partner with experienced professionals, especially in areas they are unfamiliar with. We believe that the flexibility and experience of a professional who has navigated the ongoing stresses of the European financial system is needed to build a diversified portfolio of distressed credit oriented assets, structured real estate or to provide asset-backed capital solutions to distressed counterparties. within a risk management framework. Additionally, professionals with the capabilities and know-how can further improve the potential performance of their portfolios through a diligent and disciplined approach to portfolio management (i.e. collection management, collections and resolutions, seizures, etc.).

Therefore, for investors looking for ways to take advantage of the current market environment, it may be worth considering whether the opportunities presented by the latest European issues make sense for their portfolio.

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Mary I. Bruner