Germany 2005 - Funds show commitment
The need for German banks to sell non-performing loans has sparked a flurry of interest from buyers of distressed debt. But with a slower than expected NPL disposal programme in 2004 and some expensive sales, will the same funds remain interested? Kate Haywood reports.
In the past, German banks have been slow to sort out their bad debts, preferring to restructure and extend a loan than foreclose. Over the last two years however, Germany’s bad loan market has seen momentum increase as commercial banks look to improve their balance sheets, free up regulatory capital held against bad loans, and cut costs.
Germany has the largest stockpile of bad loans in Europe, and one of the largest in the world. Value estimates for Germany's NPL market range from €160bn to €300bn. And around 50 principal credit units investment of UK and US investment banks and UK and US opportunity funds are clamouring to pick over the market, despite some expensive sales in 2004. They include Lone Star, Ceberus Capital Management, Citigroup, Goldman Sachs, CSFB, Fortress, GE Capital and Morgan Stanley.
German banks first announced plans to sell down their bad loans in 2002, and the first transaction closed in 2003. Last year, thanks to a number of large transactions, German banks sold €12bn (face value) of non-performing loans, compared with €3bn in 2003. The largest transaction to date has been HypoRealEstate's (HRE) sale of its €3.6bn real estate portfolio to Lone Star. The Texas-based fund was by far the most active last year, acquiring €6.2bn (face-value).
“This deal was regarded as the largest of its kind and contained €2.48bn of non-performing loans,” explained Thilo Hild, insolvency lawyer at Wellensiek Grub and Partner in Frankfurt. “Even in Asia or the US such a size has never been sold in one single transaction.”
Other notable deals included the sale of Dresdner's €1.2bn portfolio to Lone Star and Eurohypo’s sale of a €2.4bn portfolio to Citigroup.
According to Karsten von Koeller, chairman of Lone Star Germany, “2004 was the real opening of the market. To predict what the total volume of sales will be is very difficult, because you have to remember that a number of institutions will decide to work out the loans themselves.”
Hurdles to overcome
While some of last year's deals impressed, the rate of disposals disappointed. "There was always more talk about more deals than actual transactions," said Gerd Bieding, director at boutique bank Freyberg Close Brothers in Frankfurt. "There was a running model elsewhere, and people underestimated the time it would take to transfer this to Germany."
Rumours of failed auctions and failed single-name sales by German banks (due to disagreements on price) highlighted the fact that the difference placed on valuations of the bad loans by each party could hinder the supply of non-performing loans. Deutsche VerkehrsBank had been working on the disposal of a €160m portfolio last year, but was rumoured to have abandoned the sale because it considered the price offered below fair value.
“One particular challenge is the differences placed on the valuation of bad loans by each party. Many banks still talk and think in accounting terms, while investors act in terms of net present value, discounting for time and risk,” said Wolf Waschkuhn, managing director of Kroll Germany in a report. “Therefore many banks mistakenly believe that prices offered by potential buyers are below a ‘fair value’ level.”
Transaction costs are also high. As a result, there is a minimum bad loan size of around €50m for single loans and €500m for portfolio transactions, required to make the trade feasible for all the parties involved. The problem is that only around 50 banks in Germany have portfolios of that size.
“We expect the minimum size for portfolio transactions to decrease to €100m by 2008, and that smaller credit institutions will pool their bad loans in order to achieve the portfolio volumes required,” said Kroll’s Waschkuhn. Pooling bad loans is nothing new. Last year, state banks West LB and NordLB, both of which had been looking at individual sales, joined forces to maximise returns on a sale of their NPL portfolios.
In addition, the absence of market standards in terms of the legal uncertainty surrounding data protection and banking secrecy is an obstacle to increased investor participation. Transaction costs are expected to remain high until market standards are developed, but the pricing gap is expected to disappear as buyers develop a better understanding of the market.
“We fully expect this 'pricing gap' to disappear within the next few years, as bad loan sales are becoming more of a commodity and with the learning process underway on the supplier side," said Finja Carolin Kuetz, director at management consultancy Mercer Oliver Wyman. “Key potential to investors' success will be their awareness of the specifics of the German market, such as protection afforded to employees and customers.”
Small-scale investors are increasingly expected to form joint ventures with larger funds to allow them to compete in the bigger auctions.
"Investors will have to build strong relationships with banks and win their trust as well as tailor their pricing capabilities to the German market," said Kuetz.
"Some of the smaller investors don't want to bid alone in big auctions
because they are expensive and demand a lot of human resources," added Wellensiek's Hild. "However, they participate as back-up financers behind the big investment banks or funds to participate in the up-side of those big transactions, or invest in single loans which are usually traded afterwards.
"Even top players like Deutsche Bank and Lone star formed a joint venture for the bid for Delmora Bank. If investors are not able or willing to cover the risk of such an investment alone, this seems to be a smart idea under the premise of similar investment strategies" said Hild.
Investor returns on total investment for bad loan transactions, currently at 7%–8%, (although the leveraged return is 18%–22% given external financing of 75%) are also below investors’ expectations.
“Proof of investor returns remains to be proven because the German market is still at a very early stage,” said Joachim Koolman, managing director at Deutsche Bank in London. “People want a 15%–25% IRR, but we expect it to be another two years before such returns are realised. The funds need to prove that it is possible to make these returns on a whole portfolio rather than on single names. There is a big question of how long it will take to get some balance into the market. The North American economy is now picking up and as a result we are seeing more and more investors chasing new investment opportunities in the German market as it's the biggest in Europe."
With more and more money entering the market, both Kroll and Mercer Oliver Wyman anticipate that around €20bn (face value) of NPLs could go under the hammer this year, as bank shareholders look to avert further losses and adopt new global accounting standards in anticipation of Basel II coming into force in 2007. The new accord, coupled with the removal of state guarantees for Landesbanks later in 2005, means banks will have to hold more money in reserve to cover their bad loans.
“No one knows whether this [Landesbank NPL sales] will start this year or not. Less than 10% of the deals were from public sector banks last year and until now Landesbanks haven't felt the pressure to sell,” said Lone Star's von Koeller. “However with the fall away of state guarantees for Landesbanks in July, these banks are going to come under increasing pressure to sell.”
There are still a number of banks that are not in a position to offload their distressed debts. "Not all of the banks are ready to sell their loan portfolios. You have to be profitable to sell loans at a discount, and a number of the banks are still not at this stage," said Deutsche’s Koolmann.
Last month however, Commerzbank completed the sale of its €350m portfolio to Goldman Sachs, and as of mid-March, Bayern LB's sale of its €400m portfolio to Cerberus is on the verge of completion. Delmora Bank, which was created to restructure bad loans from Hof-based Schmidtbank, opened a loan book in January with a face value of €2.5bn to a shortlist of bidders, and called for offers in February. The deal is expected to close in either March or April.
And there are a number of deals expected to surface later this year. Dg Hyp announced it would look to sell a portfolio containing over €1bn of bad loans, while Hamburg-based HSH Nordbank has entered into exclusive talks with Oaktree Capital over the €1bn sale of Gehag, a portfolio of real estate loans.
Lone Star and Merrill Lynch are in exclusive negotiations for the Dresdner Institutional Restructuring Unit's €2bn portfolio; Hessische Landesbank is rumoured to be among banks hoping to complete sales before the proposed removal of state support, while due diligence on Munich-based Hypothenbank's circa €500m portfolio started in March. HVB is also expected to have a €2.5bn portfolio up for grabs.
"We also expect 10–15 NPL sales from German savings banks, each with a face value of between €100m and €500m," said Wellensiek's Hild.
In some cases, the bad loans have become such an issue that whole banks have become acquisition targets. Lone Star for example is rumoured to be interested in real estate lender Aareal Bank, which has a hefty NPL portfolio.
“Some of the funds want to or have already bought a bank to help them service the loan portfolios," said Hild. "This gives them a platform to acquire NPLs, and shows a long-term commitment to the German market.”
Von Koeller added: “We still have more appetite and more fire power and would like to build on our market position and enlarge.”