European non-performing loan (NPL) portfolio deal flow is expected to peak this year with global private equity funds increasingly turning their focus to this side of the Atlantic following lacklustre NPL deal flow in the US.
With magnitude of distress in Europe outstripping the US – at an estimated €1trn of commercial real estate, residential and consumer NPLs on banks’ balance sheets, according to Ernst & Young – a broadening universe of global NPL investors are competing for UK, Irish, Spanish and German deals.
The NPL market in Europe is still considered nascent and, indeed, with investment opportunities expected to endure, at the current rate, for up to another five years.
But some investors have not given up hope for a rapid acceleration of the current trajectory, with the European Central Bank clearly capable of fast accelerating the pace of legacy commercial real estate loan disposals.
In an interview carried out by Ernst & Young for its fifth NPL investor survey published today, entitled Flocking to Europe, Donald Sheets, senior principal in the New York office of Square Mile Capital Management (SMCM), said: “We presently are exploring opportunities in Europe, which is in the early stages of NPL portfolio sales.
“To use a baseball analogy: the fans are just taking their seats. Once there’s a mandate from the European Central Bank for banks to start winding down their NPL portfolios, there will be more product coming out of banks, but I don’t know what they will look like since we are just beginning to investigate the marketplace.
“Which loans will come out of banks first? Better quality? Worse quality? Small balance? It remains fluid.”
Germany, the market which has resolutely opted to play the long game through the creation of government-sponsored bad banks, would experience the greatest seismic shift, in the event of such an ECB mandate, for which there is no palpable expectation in the near-term.
Indeed, the ECB’s continued provision of cheap finance to banks, and the now separate bad bank legal entities, to some of the Europe’s largest banks has reduced the pressure for NPL sales.
But a more gradual uptick in NPL sales this year is expected, driven by increased regulatory requirements and banks’ increased focus on profitability, motivating banks to unload more of their bad loans.
In a second interview published in E&Y’s report, Lee Millstein, head of European and Asian distressed and real estate investments and senior managing director of Cerberus Capital Management, said: “Europe represents the biggest NPL opportunity worldwide. In my view, European NPLs are one of the best investment opportunities of any asset class globally.”
This is borne out by a survey of global NPL investors in Ernst & Young’s report, with almost one-third of respondents reporting increased activity on 12 months ago and Europe now accounting for almost one-third of focus, for a survey dominated by US-based respondents.
“Banks will continue to focus on strengthening their balance sheets and cutting costs in 2013, and they will try to sell NPLs as part of the process of de-leveraging and improving their financial position,” wrote Ernst & Young’s Mathieu Roland-Billecart, a partner in the real estate corporate finance team.
“Like any great opportunity,” continued Millstein in the interview with E&Y, “the European NPL pipeline isn’t growing as big as investors likely prefer today, but it is moving in the right direction. Banks and regulators realise that NPL deals are the only solutions that work for everyone.
“The pressure in Europe is coming from several fronts. First, banks will have to gradually meet the new Basel III minimum international capital requirements, which make it very capital intensive to hold NPLs.
“Second, it’s costly for banks to keep NPLs on their balance sheets. NPLs generate zero income, and the banks typically don’t have experienced workout platforms.
“So it’s better for the banks, better for us since we know how to do workouts, and it’s better for the underlying market. It’s a win-win.
“Third, regulators in Europe and elsewhere realise that banks aren’t the best holders and servicers of NPLs.”
Germany was the most popular single market in this year’s E&Y survey, voted by 46.3% of respondents, followed by UK, Spain and Ireland, at 38.9%, 33.3% and 28.6%, respectively.
Roland-Billecart added: “NPLs collateralised by commercial properties in Germany, the UK, Ireland and Spain are currently attracting the greatest interest from investors.
“German and UK banks have already experienced a fair amount of distress but clearly investors anticipate more product is waiting in the wings and these remain highly popular investment markets.”
The interested investor base chasing NPL deals is broadening – to include smaller private equity firms and sovereign wealth funds, wealthy individuals, family offices and US and UK real estate investment trusts (REITs) – and with this comes a lower cost of capital chasing, typically, smaller deals.
In some cases, these investors have offered higher prices than the big firms, writes Ernst & Young in its report.
The recent turmoil in Cyprus has undoubtedly knocked that confidence but given the relatively benign reaction by the markets little permanent damage appears to have been done so far.