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Aon Retirement and Investment Blog

European bank deleveraging regains momentum

New banking regulations brought about by the financial crisis resulted in banks being forced to take measures to repair their balance sheets, including divesting assets and reducing lending activity. Over the last few years, this trend of bank deleveraging has been more pronounced in Europe, where banks have lagged their U.S. counterparts in selling non-core assets and reducing debt on their balance sheets, and appears likely to accelerate this year. This is producing opportunities for specialist investment managers to purchase attractive assets often at a discount, or to be a provider of finance where the banks were once the lender. We view this as a multiyear investment opportunity.

Focus on Europe
Since the financial crisis in 2008–2009, many banks and financial institutions in Europe have failed and many of those that have not still remain undercapitalized and need to raise capital or shrink their assets. At the same time, many parts of Europe are either still in recession or facing challenging prospects for growth, causing the stock of non-performing loans to continue to grow and add additional pressure on bank balance sheets. In addition, Brexit, the Italian referendum, and other general elections coming up in 2017 are creating further uncertainty and instability in the Eurozone. As a result, banks appear to be divesting assets at a growing pace. A recent study by Deloitte[1] highlights how the rate of loan portfolio sales from banks has been steadily increasing over the last few years and, given the amount outstanding at the end of 2016, looks set to continue this year.

The European banking system remains large relative to its economy. To put this into perspective, it’s estimated that European banks’ assets stand at approximately three times the gross domestic product (GDP). As such, the European Central Bank estimates that there’s an additional trillion euros in non-core assets held within European banks that will need to be disinvested in the coming years. These loan portfolios represent a wide variety of underlying collateral, such as commercial real estate loans, consumer debt, student loans, structured credit, loans to small and medium enterprises, and other corporate loans. Moreover, the stock of assets that are nonperforming loans—where the borrower has already defaulted on payment—is significant. Since banks are under pressure to sell these assets, they will typically do so at a substantial discount to their current or expected value. This is providing a considerable opportunity for specialist managers to help banks remove these often-complex loans from their balance sheets. These opportunities may come in the form of distressed corporate investments in industries that are facing headwinds, such as metals and mining or retail, or industries that banks are less inclined to lend to, such as aircraft, shipping, and energy, where the new owner will be actively involved in an operational turnaround or restructuring.

In addition to purchasing assets directly from the banks, these funds have the ability to enter into privately negotiated lending transactions, essentially filling the void left by banks reducing their lending activity. One area in particular where we’ve seen this is the direct origination of commercial real estate loans, especially in Europe where the impact of banks’ retrenchment has been pronounced. Without the competition of more widely available financing, specialist managers are typically able to charge a premium for these types of loans.

How to Access This Opportunity
Aon Hewitt has identified funds that are seeking to take advantage of the continuing dislocations in capital markets and are uniquely poised to exploit this opportunity in Europe as the pace of banks’ divestment of assets regains momentum. Rather than focus on funds with narrow mandates, the strategies we prefer to  cast a wide net, investing across asset classes, industries, and geographies in both performing and nonperforming loans and securities. This strategy allows investment managers to walk away from areas of the market that appear overheated, while pivoting toward areas where competition is weakest. Having said that, we do find that managers will tend to have superior capabilities in a certain sector—for example, real estate or corporate loans, and a strong local presence in the regions in which they are investing. This latter point is particularly important for sourcing investments as specialist managers will often need existing relationships with local banks.

Overall, we believe that the restrictive effect of post-financial crisis regulatory reform on banks’ ability to lend to the private sector, combined with the pressure to divest assets, is creating an opportunity to earn attractive returns for specialist investment managers who step into that void. These strategies may potentially deliver a net internal rate of return (IRR) in the low to mid-teens[2], and those return prospects look particularly attractive relative to public credit markets. However, investors do need to be prepared to give up liquidity. Given the illiquid nature of many of the underlying investments, investing in a lock-up vehicle that matches the duration of assets is crucial for success.

Alison Trusty is a hedge fund specialist in Aon Hewitt’s Global Investment Manager research team in London.

[1] “The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.”
[2] ‘Uncovering opportunities in 2017’ – Deloitte Deleveraging Europe 2016-2017

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