Hedge funds and private equity firms continue to circle distressed assets in Europe. Lynn Strongin Dodds looks at the prospects for opportunistic investors

Arecent billion-dollar refinancing deal breathed much needed life into the
 European commercial mortgage-backed securities (CMBS) market. But hedge funds and private equity firms should refrain from breaking out the champagne just yet. Activity is on the increase, but the deal flow is still expected to be muted.

The deal that made the headlines recently was a €750m-plus CMBS backed by a so-called Vitus portfolio of 30,000 residential rental properties and 7,124 parking spaces in Germany. It was priced at just under 4% and the prime participants were mainstream players such as JP Morgan which bought the bulk (€565m of the notes) and M&G Investments which purchased the remaining chunk. The properties underlying the bond were run and co-owned by Round Hill Capital, a pan-European UK investor specialising in student housing and German residential real estate.

The deal was noteworthy in that it was the first issuance of such a transaction in Europe since 2007 when the market peaked with €67bn of issuance. Activity ground to a halt two years later when the world was in the throes of the financial crisis and it has been spluttering ever since due to the lack of bank lending. The jury is out on whether the Vitus deal will kick-start the moribund CMBS industry and provide fertile hunting ground for deal-hungry alternative investment players.

Many industry experts are sceptical. Phillip Burns, chief executive officer at Corestate Capital, a Switzerland-based specialist private equity real estate firm, observes: “This past week saw the Vitus deal but the deal size was not huge relative to the overhang and we are still in challenging times. CMBS is still a dirty word in some places and the returns are not as attractive as in other areas of real estate. You have to pick your sweet spot and I am not sure that is CMBS.”

Cheyne Capital Management, which was one of the first in 2008 to raise a fund for CMBS and to a lesser extent residential-mortgage-backed securities, has expanded its debt strategy. The hedge fund manager just raised $300m (€231m) to provide stretched senior debt, mezzanine loans and equivalent paper in the secondary markets. This takes the firm’s total European real estate debt assets under management to $1.4bn, a substantial hike from a starting $25m allocation three years ago.

Around two-thirds of the new fund is slated for the UK, with the balance earmarked for Germany as well as other select Northern European locations, which are in better financial shape than their Southern counterparts. It has been reported that Cheyne teamed up with private equity firm TPG earlier this year to buy £32m (€39.7m) of junior debt secured against Woolgate Exchange in a bid to take control from Irish Bank Resolution Corporation (IBRC), formerly the Anglo Irish Bank.

“We are the largest CMBS franchise in Europe but our strategy has evolved over time to include a UCITS-compliant European real estate bond fund – and our flagship real estate debt fund, where we invest across the capital structure,” says Shamez Alibhai, head of the real estate debt team at Cheyne. “One of the main problems with CMBS in Europe, is that, compared to the US, it is not as standardised, deal flow is reduced and the market does not have the same liquidity or depth.”

According to Alibhai, the flagship fund invests in European real estate securities, backed by commercial and residential real estate. The objective is to take advantage of structural dislocations in Europe and not simply distressed assets. Typically, the firm employs a barbell approach involving a 65% allocation to senior bonds with a 50% LTV, and a 35% allocation to more junior bonds. Combined, this gives the portfolio downside protection and attractive yields.

Cheyne Capital is far from alone in the space. Alternative investment managers have been rubbing their hands in anticipation ever since Lehman Brothers exploded and property prices plummeted. Banks, though, were not pushed to the brink and, instead, delayed selling off distressed debt and property. Today, hope has been reignited by the euro-zone crisis but, once again, investors might be disappointed.

All told, hedge funds and private equity firms have amassed an unprecedented €60bn to invest in distressed debt, with loans backed by commercial real estate generating the most interest, according to a report by PwC. Apollo Global Management, Oaktree Capital Group, Avenue Capital Group and Davidson Kempner Capital Management are just a few of the mammoth US firms that have recently flocked to Europe, putting down roots and raising funds.

The opportunities should be there for the picking. Starting next year, regulatory changes, including Basel III, will force banks to keep more capital against assets, which should lead to the restructuring of loan portfolios. According to a recent report by KPMG, to improve capital ratios, European banks could shrink their balance sheets by $2.6trn through to the end of 2013. Over €1.5trn of non-performing loans are sitting on their balance sheets, with more than €600bn in the UK, Spain and Ireland alone.

Few, though, expect to see an avalanche of deals and, instead, predict that the flow will be small but steady over the next few years. One reason is that European Central Bank president Mario Draghi has cut interest rates three times, to a record low and flooded the financial system with cash since taking the helm last November. The latest move has been the bond-buying programme that policymakers have said will buy peripheral member states time to get a “very difficult situation” under control.

This has meant that banks do not feel the pressure to sell at heavily discounted prices, which has been highlighted in a recent report by The European Banking Authority. It noted that banks have shored up their balance sheets and increased capital reserves by selling shares, holding on to profits and converting lower-quality capital to common equity, rather than by cutting lending or resorting to fire sales.

“Things are getting easier – or less difficult – but it is still a mixed story,” says Philip Cropper, managing director of CBRE Real Estate Finance. “Deals are taking place but a lot of the stock is controlled indirectly by the banks and they are in the difficult position of having to diffuse the biggest time bomb and de-leverage without eroding their balance sheets. As a result, I don’t think we will see the flood of deals that people keep anticipating, because it would be too damaging.”

Instead, European banks are conducting damage-limitation exercises and trying to dispose of assets at no loss, or at a small discount compared with their book value to help keep capital levels intact. For example, it has been rumoured that Société Générale, France’s second-largest bank, is close to selling an €800m portfolio of mortgage loans to AXA Real Estate, at a sub-10% discount.

It is also disposing of its portfolios in piecemeal fashion. We see the banks selling down their positions bit by bit,” says Keith Breslauer, managing director and founder of Patron Capital. “I do not think we will see large portfolios coming to the market.”

For example, Lloyds has a £16bn portfolio of Irish loans that it is selling in smaller transactions. The most recent transaction for the government-owned bank was the proposed sale of €2bn of Irish loans and £809m worth of Australian corporate real estate loans to a Morgan Stanley and Blackstone joint venture for £388m. In addition, Oaktree Capital Management completed the purchase of its Project Harrogate defaulted UK loan portfolio for around £260m. The most high profile, though, was the so-called Project Royal, where the bank disposed of a £923m portfolio of UK non-performing loans to Lone Star.

Meanwhile, Blackstone snapped up the state-owned Royal Bank of Scotland’s £1.4bn Project Isobel. The deal almost fell apart when the private equity giant failed to secure outside debt financing to fund part of the acquisition. RBS was reported to have rescued the deal by providing £550m in so-called vendor financing.

There has also been some movement on the continent, with Spanish bank Banco Santander recently cementing a €700m sale of non-performing real estate loans to Morgan Stanley, having failed to agree a sale on an initial €3bn portfolio of real estate and land assets. The portfolio is believed to have been sold at a hefty 67.5% discount and is the second such sale by the bank in 2012.

Pricing, though, continues to be a major problem, according to Cropper. “The most important aspects of successful loan sales are an efficient and well-run process, strong bidder track record and realistic pricing expectations between counterparties. We have seen several transactions fall by the wayside during the year due to the complexities of being able to accurately value large and intricate loan portfolios, where there are sometimes large levels of distress.”

Looking ahead, Alibhai believes that mezzanine loans offer the greatest potential although, at the moment, there are a large number of buyers chasing a limited number of deals. By definition, mezzanine finance fills the gap above senior debt and so depends on there being a working senior debt market.

“There is a great deal of capital in the market and funds are focusing more on mezzanine but the reality is, in order to lend mezzanine, you have to assume that there is a senior debt market in place, which is not the case,” says Cropper. “Also, the better quality assets do not need mezzanine. There will be an increased amount of refinancing coming due and it could close the gap, but at the moment I do not see much demand for it.”

Breslauer also believes that “it makes more sense and is less expensive to buy the underlying asset than the loan”. He says: “The discount between the seller and buyer is less as the time to collect the loan, and the associated discount does not need to be taken into account. There are a lot of properties in Europe where the property is good but the seller is distressed, usually because he over-levered the asset and now needs to sell. We see opportunities to add value through asset management and not imposing leverage, or financial engineering.”

The private equity group is set for a shopping spree and has been busy spending the €880m it recently raised from investors. It aims to generate a 17-22% gross internal rate of return over a three-to-five-year investment horizon and has already deployed 15% of the capital in five investments, including the Von Essen properties Luxury Family Hotels, the Motor Fuels Group chain of retail and petrol stations, and the distressed Uni-Invest CMBS transaction in the Netherlands.