Old world distressed debt has become a significant opportunity for investment in the UK and Europe in 2012. Shearman's Solomon Noh reports

For the past few years a group – composed primarily of US-based hedge funds – has focused with keen interest on potential distressed investment opportunities arising out of the UK and Europe. A number of key players within that group have dedicated an increasing amount of their resources to the UK/European strategy, such as by increasing or reallocating staff. Some have even gone so far as to open offices in London recently in preparation for what many expect will be a flood of distressed bank loans coming to market.

For a variety of capital and regulatory reasons, since the onset of the 2008 financial crisis, US banks have been given incentive to sell off a chunk of their holdings to distressed hedge funds, even at a substantial discount to par, rather than hold the loans with reserves or other impairments to their capital. By contrast, banks in the UK and Europe do not appear to have faced the same sort of pressures or incentives and, in fact, still tend to attribute full value to loans that by most reasonable accounts are severely distressed.

Because many underperforming loans remain marked at par, the market thus far has witnessed a mismatch in expectations between UK/European banks, on the one hand, and distressed investment funds, on the other. Because hedge funds typically only buy assets at a steeply discounted price so as to ensure an acceptable rate of return, the distressed investment activity in the UK/Europe remained stagnant through much of 2011.

Many expect the tide to turn in 2012. For various reasons – including the implementation of Basel III (a global regulatory standard on bank capital adequacy, among other things), which will require banks to hold higher quality capital – analysts anticipate that UK/European banks will need to downsize their balance sheets over the next 18 to 24 months by an astonishing sum, somewhere in the order of €1.5trn (£1.2trn) to €2.5trn (£2trn). It is widely expected that banks will respond with a series (or a rash) of asset sales involving distressed loans as well as non-core assets.

If a spate of loan sales indeed were to materialise, distressed investment funds – estimated to have approximately $150bn (or approximately €200bn (£97bn)) devoted to European 'special situation' strategies – should have an abundant supply of distressed assets from which to choose.

In addition to this inventory of legacy distressed debt, it is expected that fresh supplies of underperforming loans and bonds will continue to surface in the UK/Europe due to the vicious combination of stagnating growth, lack of high-yield financing and a looming wall of debt maturities this year (totalling well in excess of €100bn (£83bn)), all against the backdrop of the sovereign debt crisis. Indeed, some analysts predict that high-yield default rates will more than double, from 2.6% at the end of 2011 to 5.6% in 2012.

Types of distressed 
investment strategies

This unusual confluence of circumstances may well lead to a wide array of investment opportunities in the UK/Europe for distressed funds. For one, a surge in distressed loan sales would provide fertile ground for distressed debt trading – for funds seeking to purchase at a discount with a view to holding the assets for the long term (with the expectation that the underlying value will recover over time) or those who have no interest other than to buy at a favourable price and flip their investments for a quick profit.

Others may favour so-called loan-to-own strategies, whereby an investor acquires distressed debt with a view to ultimately owning all or a portion of the equity in the borrower/issuer through a debt-for-equity exchange. A debt-for-equity swap can occur through a court process – involving a formal bankruptcy/insolvency filing in which the presiding court would force the exchange upon dissenting creditors so long as certain voting thresholds are met – or a consensual out-of-court restructuring.

Another form of distressed investment which has become more prevalent recently is a synthetic asset transfer. In a synthetic transfer, the transacting parties use derivatives documentation (such as a total return swap) to transfer the value (as well as the risk) underlying the assets without the actual title being transferred between them. Transactions of this type – which can be simple or immensely complicated, depending on the business deal and structure – may be appealing to banks that may be sensitive to appearing to have offloaded their assets to opportunistic hedge funds.

Although the expected surge in distressed investment opportunities in the UK and Europe may appear at first blush to be boundless, there is a caveat: in order to be successful, fund managers likely will need to be well-versed in local law, particularly local insolvency law. Insolvency law tends to be a trap for the unwary, as it often provides for the unwinding of contracts and transfers, renders certain contract provisions unenforceable and imposes sometimes unforeseen risks and burdens (such as through a forced clawback of previously-transferred assets).

Hedge funds making distressed investments will need to be cognisant of the relevant risks. This is true not only in situations involving a formal bankruptcy/insolvency process, but also where the borrower or issuer is insolvent (on a balance sheet basis or is otherwise unable to pay its debts as they come due) or is approaching insolvency, during which time certain transactions with the borrower/issuer are subject to special ex post scrutiny.

There is good news, however, for hedge fund managers seeking to delve into UK/European special situations. First, it is expected that as the involvement of US-based hedge funds becomes more prevalent, restructurings increasingly will take on a US style (meaning restructurings are likely to become more aggressive and fast-paced, among other things).

Moreover, it is likely that these hedge funds more often will be working alongside or negotiating against the same group of players with whom they had dealt in the past in relation to US strategies. As a result, distressed fund managers should feel quickly at home in managing UK or European situations.

Second, an increasing number of European jurisdictions are enacting insolvency laws moulded in large part from the US Bankruptcy Code. Therefore, insolvency laws have generally become more predictable than in the past, especially from the perspective of US-based distressed fund managers who are used to dealing with US bankruptcy law. Nonetheless, rules vary in meaningful ways from jurisdiction to jurisdiction.

What does this mean for law firms?

This unique market climate demands a law firm that:

• has restructuring professionals with substantial experience in US-style restructuring assignments and who speak the language of the US Bankruptcy Code and thus are able to translate foreign insolvency concepts in ways that US hedge fund managers can readily digest;

• has local insolvency law capability so that clients can get their questions answered without having to retain multiple counsel;

• can combine multiple practice disciplines (such as derivatives, structured finance, M&A as well as bankruptcy/insolvency) to tackle the complexity of some of the transactions being put in place (of the synthetic asset transfer variety, for example); and

• perhaps most importantly, has all of those resources available on a real-time basis in London or elsewhere in Europe so that issues can be addressed and resolved quickly without the need to wait for the work day to start in New York.

The year 2012 has the potential to present a historic opportunity for hedge funds seeking to profit from distressed debt. Law firms that are able to guide their clients through unfamiliar legal regimes in quick, efficient and creative ways will be best placed to advise hedge funds on this expected wave of activity.

Solomon Noh (pictured) is a partner in the finance practice at Shearman & Sterling and recently transferred from the US to London.

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