Where next for German NPLs?
Companies in Europe's largest economy have traditionally relied on bank financing for their borrowing requirements, rather than the capital markets, giving the German banking system a large pool of loans. A property bubble after the 1990 reunification of the former West and East Germany also led to a massive volume of loans being collateralised against real-estate assets. German banks have been struggling for years with the poor asset quality on their balance sheets, but the approach of Basel II in 2007 has concentrated the minds of German bankers and thrown up opportunities for investors who want to bid for non-performing loans (NPL).
Sankar Krishnan is a managing director at restructuring specialists Alvarez & Marsal. Based in Frankfurt, he is also acting chief executive officer of drug store chain Ihr Platz, which was put into restructuring after Deutsche Bank purchased its debt. He says the time is right for German banks to sell off distressed assets.
"A lot of companies in Germany have non-performing debt, and the banks have held on to these loans for too long. Management has often not been prepared to accept real restructuring and the banks have been too patient, believing time will cure the problem," he says. "Bank capital is tied up with these NPLs at a time when Basel II is coming along, and it's important for them to clean up their balance sheets."
A May 2005 report from rating agency Standard & Poor's recently described Germany as "the land of opportunity" for a few investor groups - but 'few' remains the operative word. A handful of US funds and banks plus an even smaller cadre of European buyers dominate the market, and some observers believe the barriers to new entrants will become more formidable as time goes by.
US players dominate the purchasing side of the NPL business. While a growing number of German banks sell off their own NPLs - the biggest sellers to date being Dresdner Bank and Hypo Real Estate (HRE) - Deutsche Bank is the only German bank that is active in sourcing and buying these assets.
Dominant US firms include Merrill Lynch, Goldman Sachs, Bank of America, Bear Stearns, JPMorgan and Citigroup, while active European firms include Barclays Capital, CSFB and UBS. US fund Lone Star has been active, while US hedge fund Cerberus is attempting to break into the market.
The US interest can be explained by the relative lack of distressed debt opportunities back home. "The US market for distressed situations has peaked," says Joachim Koolman, a managing director for global distressed products at Deutsche Bank. "The big restructurings are behind us now, and the US economy is doing well, so US investors are looking for new markets. They are also looking at Asia, particularly China, but Europe has the advantage of relatively clear-cut bankruptcy laws and processes. As Europe's biggest economy, Germany is an obvious target, and this has been accelerated by the restructuring of the German banking sector over the past few years, as German banks are forced to offload their bad loans."
Like its foreign competitors, Deutsche Bank has broadened its distressed business from a focus on trading distressed assets - buying non-performing assets from German banks and then placing them with investors - to doing more restructuring business. "This typically involves us acquiring up to 100% of the bank pool and then working with the company on a financial restructuring," says Koolman, who adds that a German banking licence is key to being fully involved in the NPL trade. This allows the buyer to restructure and refinance loans in a portfolio they have purchased, rather than simply running down or selling on the loans.
If an investor is only buying terminated NPLs, they do not need a German banking licence. But to extend new money to restructure loans, or to buy diversified loan books where some loans are non-performing but others are still performing or sub-performing (and therefore an ongoing banking relationship exists), a licence is essential.
The most recent example of a foreign firm acquiring a German banking licence was Goldman Sachs' purchase of Delmora, a bank that was originally set up to restructure bad loans from SchmidtBank and Delbruck. Goldman purchased Delmora from the Bundesverband deutscher Banken (Association of German Banks) in May this year.
Robert Clausen is a director of Peters Associates, a Frankfurt-based corporate advisory firm which advised the Bundesverband deutscher Banken on the Delmora sale. He says the sale was different to previous German NPL transactions in that it involved a sale of both servicing capacity and the portfolio to service. "Goldman Sachs purchased not just a EUR2.3 billion portfolio of non-performing loans but also the platform to work out these loans. It gives the bank an entrance to the German market, a banking licence and an up-to-speed working platform."
Similarly, Lone Star has bought Mitteleuropaische Handelsbank (MHB), a subsidiary of Norddeutsche Landesbank (NordLB), in order to get a German banking licence, while WestLB and NordLB have set up a joint venture with Japan's Shinsei Bank (formerly the Long-Term Credit Bank of Japan) and US investment fund J.C. Flowers, called SGK (Servicegesellschaft Kreditmanagement), to buy and restructure non-performing loans. This means Flowers, too, now has a German banking platform.
Other active buyers include Merrill Lynch, which purchased EUR1.4 billion of loans from Dresdner. Merrill is building up an NPL portfolio and will perform a dual role by restructuring the loans on one hand, and acting as a private equity-type buyer on the other (by taking an active loan in the company whose loans it owns, and possibly restructuring it). Elsewhere, Morgan Stanley Real Estate bought a portfolio of non-performing real-estate backed loans from HRE last year, with a notional value of EUR394 million. Marc Chennault, Morgan Stanley's vice-president for non-performing loan portfolios (Europe), says much of the attention so far has been focused on the big portfolio transactions, but there will continue to be plenty of activity on single-name bilateral NPL deals.
Citigroup and JPMorgan have also been active buyers, with Citigroup picking up a EUR394 million portfolio from HRE last year. JPMorgan's European head of credit and rates, Fawzi Kyriakos-Saad, says his firm has purchased five portfolios as a principal investor, with a total of EUR2 billion notional.
With this flood of new entrants, the German NPL market is clearly becoming more competitive at a time when Germany remains a seller's market for distressed loans. So how long will the interest continue?
"Much depends on how successful some of these new entrants are," says Deutsche Bank's Koolman. "When it comes to restructuring portfolios, the easy wins are on the first few deals, but if you have a portfolio you need to run it right down before you can really say you've met your targets for returns." Koolman also predicts that Germany may now see a shift from the big portfolio transactions that have been done by firms such as Dresdner over the past year, to more single-asset bilateral transactions.
As for the likelihood of new companies - US or European - entering the market as buyers, the balance between supply and demand is hard to judge at present. Horst Clemens, head of corporate finance at Dresdner Bank's Institutional Restructuring Unit, says only a few US firms have been successful so far, and some of those who want to break into the market may never do so. "Once a firm has bought one portfolio, it has a track record and so becomes more attractive to the sellers," he says. "Without that track record, it is difficult to become a buyer."
JPMorgan's Kyriakos-Saad predicts that three to five investment banks and two to three funds will come to dominate the market. He says that while Germany may remain a seller's market for NPLs for the time being, it won't be long before the main buyers reach a level of servicing and pricing knowledge which leads to a more efficient and balanced market.
"Buyers still need to get sizeable portfolios on their balance sheet in order to become comfortable with the level of return they can expect," he says. "But once the five to seven big players that we expect to see establish themselves in this market each get to the point of having EUR1 billion and EUR2 billion portfolios in market value, there will be much more efficiency. At that point, it will be even harder for new entrants to get into this market. It's an expensive market to enter, and as returns inevitably go down as the market becomes more efficient, it will become even tougher to enter."
WHY SELL NPLS?
The process by which a bank decides to sell off all or part of its loan book is complex and will vary in each case, but there are a few common factors - whether in Germany or elsewhere.
Jaap Dutry, head of the special assets group for Europe, the Middle East and Africa at Bank of America, says: "The first thing you have to do is determine the viability of the entity, and we use outside consultants to assist in that process - typically the recovery specialists at the big international accountancy firms. Most of our loans are syndicated, with bilateral deals very much in the minority, so this would usually have to be done in conjunction with the other syndicate banks." The banks will look to set up a coordinating committee, and hire accountants and lawyers to carry out due diligence.
The options available to the lenders are to refinance the existing debt - pushing out maturities and adjusting covenants - in cases where the lender has a temporary cashflow problem; or to establish whether the company needs to 'right-size' its balance sheet, perhaps by looking at debt-for-equity exchanges or by converting normal senior debt into mezzanine; or, if neither of these options is feasible, to look at the possibility of insolvency. If refinancing or balance sheet restructuring is chosen, says Dutry, "we need to take a view on the borrower's real repayment capacity, and on our own cost of carrying the loan, which in turn will require us to look at our cost of capital reserves as well as the ongoing management time involved in dealing with it. Our conclusion may well be that we should look to pursue an early exit, for example through a sale of the loan."
Other factors to be taken into account include concentrations of risk in a particular industry or country. It might make sense to sell on an NPL if the bank's overall portfolio was too heavily concentrated in that country or sector. Finally, as mentioned above, it may simply be more expensive to hold on to a loan than to sell it. "We would then do a discounted cashflow calculation to establish the viable price at which to sell," says Dutry. "The secondary loan market in Europe is well-established, offering banks more flexibility in managing their problem loans."
German banks have generally followed much the same pattern when it comes to evaluating and selling off their NPLs. Dresdner Bank, however, has taken a slightly different approach. Its parent group, Allianz, wanted it to move out of non-strategic businesses altogether, and so Dresdner created an Institutional Restructuring Unit (IRU), which was used to get rid of EUR35 billion of assets - not just NPLs, but also its sub-performing and performing but non-core assets, such as private equity investments, for example.
Horst Clemens, head of corporate finance at the Dresdner IRU, says the idea behind setting up the IRU was to shift the bank's management focus to strategic business, allowing the IRU to deal with non-strategic business." The IRU has now virtually completed its work, with its most recent sale of EUR1.4 billion of corporate loans and commercial real-estate assets to Merrill Lynch and Lone Star in June.
HOW BIG IS THE MARKET?
The exact size of the German non-performing loan (NPL) market is surprisingly hard to gauge, partly because of the different types of assets which are collateralised against loans (and the fact that some loans have no collateral against them), and partly because many of the portfolios that are being sold include performing as well as non-performing assets. Estimates of the total volume of NPLs in the banking system range from EUR150 billion to EUR300 billion, but the key figure for credit investors is how much of this volume will actually be made available to purchase.
"Supply is trickling out at present," says Marc Chennault, vice-president for non-performing loan portfolios (Europe) at Morgan Stanley, "but we would expect the supply to increase as Basel II implementation draws closer. This market only really started up in 2004, and only a few assets have been successfully converted."
Fitch estimates that the total volume of impaired loans at the 25 largest German banks was EUR100 billion at the end of 2003. Fitch has used this estimate to extrapolate a total figure of between EUR155 billion and EUR160 billion, but it warns of the dangers of this methodology. And it notes that "since any estimate is based on book values, it does not represent a realisable market value." The average purchase price of NPLs is not known, but clearly investors would expect to buy up impaired loans at well below par.
Joachim Koolman, a managing director for global distressed products at Deutsche Bank, estimates that there are around EUR250 billion of NPLs in Germany at present, but points out that non-performing doesn't necessarily mean insolvent. "It could be, for example, that an interest payment has been postponed," he says. "By no means the entire volume of these loans will come to market. Banks will continue to see restructuring of their clients' loans as part of their core competence. But they will focus more and more on target clients and sell off the non-core ones." Koolman adds that his group saw around EUR10-12 billion of NPL sales in Germany last year, and expects up to EUR15 billion in 2005. Fawzi Kyriakos-Saad, European head of credit and rates at JPMorgan, says that assuming there are total NPLs of around EUR300 billion in Germany, perhaps EUR100 billion will come to market. JPMorgan aims to have picked up about 25% of that volume in the next five to seven years.
One of the big questions is who will be the next seller. The Landesbanks have now lost their state guarantees, a move that will force them to be more disciplined about asset quality in order to protect their credit ratings. This could force many Landesbanks to sell off NPLs, although so far there is little evidence of this happening (the exception is the joint venture between WestLB and NordLB with Flowers and Shinsei). Similarly, the savings banks, or Sparkassen, and cooperative banks which make up most of Germany's banking system have mostly been reluctant to sell their NPLs so far. A big sale by Landesbanks, Sparkassen or cooperative banks could potentially break this logjam and unleash a torrent of new NPL sales onto the market.
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