HOT STRATEGIESDISTRESSEDDistressed debt: An
expanding opportunity set
Continued selling by European banks and a possible negative turn in the economic cyclein the US suggest opportunities could be rife. Rich McKinney and Marianna Fassinotti
of the D. E. Shaw group discuss various factors driving these developments

Q

associated with complex, esoteric, structured products. Prior to the credit crisis,bank proprietary trading desks would
have seized most of these opportunities,
but that was no longer possible given theevolving regulatory landscape for banks
that followed the crisis. As a result, welaunched the first in our series of intermediate-duration distressed credit funds
specifically to target these assets.

We are now over 10 years out from thecredit crisis that began in 2007, and yet

it continues to reshape markets and economies. What’s your sense of investor appetite
for private debt given the evolving landscape?

Rich McKinney: In both the US andEurope, we see investor flows increasingly
shifting to distressed private debt strategies, but for different reasons in eachmarket.The post-crisis clean-up in the UShas largely been complete for some timeand corporate defaults now are subduedby historical standards, so the flows designated for the States feel more anticipatory in nature. Put simply, investors seemto be positioning themselves for a negative turn in the economic cycle.The flows
earmarked for Europe, on the other hand,continue to target the clean-up of legacybank assets and business units, a processthat has lagged for a combination of structural and temporal reasons.
Marianna Fassinotti: That’s right; todate, non-performing loans (NPLs) havebeen the main focus of the European
banking sector’s divestment activities
post financial crisis. However, addressing NPLs will not address all that ails
the region’s banks. We believe they face
regulatory and market pressures to divesta broader universe of assets in order toimprove profitability. Accordingly, market
participants – governments, banks, regulators, shareholders, and investors – now

“PUT SIMPLY, INVESTORSSEEM TO BE POSITIONING
THEMSELVES FOR A
NEGATIVE TURN IN THE
ECONOMIC CYCLE”			
Rich McKinney

MF: We have always looked for opportunities that lend themselves to our dataintensive, systematic approach. Given thecurrent landscape, we find that many suchopportunities exist in distressed bank loans
and related assets in Europe. To address
this, we have significantly expanded ourteam in order to operate more locally inthe region while leveraging the firm’s proprietary analytics systems.

QHow do investment approaches vary
among distressed debt players in thespace?

increasingly refer to these legacy assets as
non-core assets (NCAs), which includes
NPLs as well as loans and other assets that
may be performing but are now peripheral
to banks’ core businesses.

Q

What motivated the D. E. Shaw groupto enter the space?

RM: Many of the trades we were looking at when I arrived here in 2008 were

RM: Many participants in the space are
seeking higher exposure to operating company risk – in general, we would characterise this approach as having more desire
for various forms of financial leverage andprobably more active use of liability management. By comparison, we believe ourbackground in analysing asset behaviours
and measuring asset risks lead us to a different set of objectives and exposures.

S eptem ber 2018 | Private Debt Investor 41

HOT STRATEGIESDISTRESSED
MF:Yes, we believe it’s possible to identify
asset-specific mispricings related to asset
complexity, market opacity, or localised
dislocations that can generate attractive
returns not reliant on general economic
improvement or an illiquidity premium perse. We attribute our proficiency in assetbacked loans to the same distinguishing
characteristics that established us in assetbacked securities: (1) our ability to quickly
reconcile collateral-level insights with adeep understanding of secondary market
dynamics and capital structuring and (2)the strength of our local sourcing network.
To support the former, we have developed
a set of bespoke technology platforms toanalyse and manage these holdings.

Q

Does the restructuring process for
European banks still present interest-ing distressed investing opportunities or has
it mostly played out?

RM: It’s important to note that banking
crises generally play out over long timelines(as long as eight to 15 years) and that therange of asset sales and business consolidations can be substantially greater thanin more asset-specific crises.The situationin the European Union is exacerbated by
the fact that the banking sector consists ofmore than 6,000 banks spread across 28
countries, all of which have varying rules
and customs for resolving bad debts, notto mention differing levels of willpower
for enforcing them. In short, despite positive developments, especially for the largest banks in the sector, the overall asset
quality of the EU banking sector remains
problematic, and NCAs will not get backto pre-crisis levels anytime soon at the current rate of reduction.

Q

What else do investors need to know
about the European debt markets?

RM: The size and scope of the issues
facing the European banking system arein Europe should function through a more
expansionary credit cycle. Ultimately, webelieve that European capital markets willneed to evolve and grow to support theEuropean economy and to provide bettersources of funding for businesses rather
than banks growing their balance sheets
again.

Q“MANY QUESTIONS REMAINUNANSWERED REGARDING
HOW THE BANKINGSYSTEM IN EUROPESHOULD FUNCTIONTHROUGH A MORE
EXPANSIONARY CREDITCYCLE”			Marianna Fassinotti

much more significant than is generally
appreciated. While approximately €600
billion worth of deals have concluded in
the 2010-17 timeframe, banks still holdan estimated €2 trillion in NCA balances.
Some of these assets will be resolved
internally by the institutions, but mostof this risk will need to be transferredto the private markets. This makes thiscrisis equal to or even larger than similarcrises that we have seen in other developed
economies.
MF: In addition to solving for adequatelevels of capital and risk in the current
market, many questions remain unanswered regarding how the banking system

42 Private Debt Investor | Sep t emb er 2018 	Where do you think growth in distressed
debt will come from?

MF: The overall stock of non-core assets inthe European financial system remains substantial, suggesting these assets will play a
prominent role in secondary debt markets
for the next few years. More specifically, wethink Southern Europe will continue to bea primary source of distressed debt activity
given that, as of 2017 year-end, banks inthat region continued to hold a disproportionate amount of the region’s NCA
exposure. Also, while small- and mediumsized banks have steadily improved asset
quality, their NPL ratios lag those of largebanks and are materially above the targeted
threshold set by banking supervisors, suggesting that this non-Single Supervisory
Mechanism segment of the banking sector
will profile more prominently in asset dispositions. Lastly, we believe the emphasisof NCA sales will shift from commercial
and residential real estate loans to a mixof smaller and more complex assets that
more closely resembles the balance sheetsof Southern European banks and of smallerbanks in general. nThis article was sponsored by the D. E. Shaw group and does notconvey investment advice or an offer of any type with respect
to any securities or other financial products. No assurances
can be given that any aims, assumptions, and/or expectations
expressed or implied in this article were or will be realised, orthat the activities described in this article have continued or willcontinue at all or in the same manner as described.

Sponsored byTHE D. E. SHAW GROUP

Since our founding in 1988, we’ve developed an investment
approach that combines quantitative analysis and scientificresearch with the deep domain expertise and qualitative insights
of experienced practitioners.
Today, we apply this robust approach across a broad range ofsystematic, discretionary, and hybrid investment strategies touncover independent, hard-to-find sources of return acrossglobal public and private markets.
We are the D. E. Shaw group, a global investment andtechnology development firm with 30 years of experience andmore than $50 billion in investment capital as of July 1, 2018.

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