Stress in Europe presents private markets opportunities – Sam Phillips

Stress in Europe presents private markets opportunities – Sam Phillips

The latest in Europe’s long list of issues

Eurozone inflation is continuing to soar to record highs, with Eurostat (the EU’s statistics body) recently announcing that the inflation rate was 9.1 per cent in August 2022. Embedded in that result, is a 38.6 per cent energy inflation rate (as shown in the chart 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, Brexit etc.) that have created a climate of stress in Europe. Then, when you add the removal of the unprecedented fiscal and monetary interventions, the potential for recession looms large.

This presents opportunities for investors with an appetite for risk.

What opportunities are available to investors?

For a long time, European banks have stuck to their knitting of originating loans, and then holding those loans on their balance sheets until maturity. This is in contrast to other banking systems, like the US and Australia, where banks have adopted an ‘originate and syndicate’ model in which they continue to originate the loan but then arrange a syndicate to take on that loan. This has led to the European financial system being dominated by banks.

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

Since that time there has been increased pressure on banks and other financial institutions to sell-off assets in order to optimise their balance sheets and existing asset portfolios in terms of quality and size allowing them to free up capital to be deployed into new, higher margin businesses. This has resulted in a relatively consistent flow of non-performing, non-core and capital inefficient whole loans, real assets and other asset-backed credit and credit-like instruments being offloaded.

The current inflationary environment will create new vulnerabilities for borrowers most exposed to those pressures, for instance in relation to energy prices, food and other raw materials. This will be further exacerbated by the withdrawal of fiscal and monetary stimulus, and an increasing debt servicing burden with rising interest rates. This will ultimately lead to a growing 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 such stressed assets increases, deals are likely to be struck at attractive risk-adjusted values to purchasers.

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

Whatever the strategy may be we’re often asked whether a strategy makes sense in the current environment. Our response will often be “it depends”, because it does depend on an investor’s specific circumstances.

Investors will need to consider (amongst others) their investment horizon, how that particular strategy fits into their overall portfolio, will that strategy improve the diversification of their portfolio, will there be sufficient liquidity in their total portfolio if they include the strategy, are the expected risks justified by the expected returns, how will that strategy be accessed etc.

While we can’t answer all of those questions we can comment on the diversification and access considerations:

  • It is probably quite safe to assume that the majority of Australian investors (outside of any investment through an institutional superannuation fund) have very little if any exposure to the opportunities presented by the stressed European financial system. This is because such strategies have been the domain of private markets managers, who until recently have been solely focused on institutional investors. Therefore, it is likely that such a strategy could offer valuable diversification benefits to the portfolios of individuals.
  • In terms of access, our view is that investors should partner with experienced professionals, particularly in areas that they are not familiar with. We believe that the flexibility and experience of a professional that has navigated the ongoing stresses of the European financial system, is necessary to construct a diverse portfolio of distressed credit-oriented assets, structured real estate, or provide asset-backed capital solutions to stressed counterparties within a risk controlled framework. Additionally, professionals with the capabilities and know how can further enhance the potential performance of their portfolios through a diligent and disciplined approach to portfolio servicing (i.e. collection management, recovery and resolutions, foreclosure etc).

Therefore, for investors seeking ways to take advantage of the current market environment, it may be worth considering whether the opportunities presented by Europe’s latest issues makes sense for their portfolio.

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