European debt market faces restructuring: report

Excessive leverage, aggressive business plans and the rising cost of raw materials will power a wave of corporate debt restructuring in Europe this year, according to one survey of investors on both sides of the Atlantic.

Released by international law firm Cadwalader, Wickersham & Taft LLP and investment banking group Rothschild, the third annual European Distressed Debt Market Outlook sounds a cautiously optimistic note.

The report is based on a survey of U.S. and European investors who target corporate restructuring plays, but the study offers insights into the broader European debt market picture.

While none of the respondents foresee any significant slowdown in the European economy, half of them do see significant increases in corporate failure and restructuring for 2007.

The report found 83% of private equity sponsors expect to play an active role in a restructuring in 2007, while 60% of private equity investors expect between 11% and 20% of the “typical” portfolio to be hit by covenant amendments or debt restructurings.

The majority of corporate restructuring is the purview of relationship banking and American hedge funds, the study reports. However, it is no longer their exclusive domain. Companies in the study highlighted the importance of maintaining support from other stakeholders, such as customers, suppliers, employees and pension scheme trustees, to ensure a successful restructuring.

Richard Millward, managing director, Rothschild, emphasizes this development. “The clear message from this survey is that the restructuring wave is yet to break, but activity is definitely intensifying. The impact of non-bank institutions as holders of debt will make the next round of restructurings more complex.”

The impact of these increasingly “complex” restructuring plans on Canadian investors should be minimal, according to Brian O’Neill, senior analyst at Morningstar Canada.

With average European market returns almost double those of Canada, it’s understandable why fund sales data for December show 2006 was a banner year for foreign equity funds. O’Neill said he and his colleagues at Morningstar don’t see anything that would make them think this will stop, so Europe should continue to be one of the hottest markets.

“I think there is a relatively positive outlook for Europe this year. It was certainly very strong last year. We’ve been saying to investors to consider moving some of their Canadian heavy investments and diversifying into foreign assets, particularly Europe and East Asia,” O’Neill says. “When you’re dealing with companies that are going to restructure their debt, you’re dealing with companies that are distressed, which is alternative to bankruptcy. For the most part, people who invest in European equity funds will invest in large-cap and high quality assets that are not affected.”

O’Neill points out that the results from the study may have some impact on investment funds that specialize in distressed companies. But even these face minimal risk due to the way they traditionally diversify their holdings.

The only segment of investors, he said, that might want to be cautious are those with holdings in high yield bond funds with exposure to European companies, which may have an increased risk of forfeiture.

O’Neill says the European Distressed Debt Market Outlook report is optimistic because it points to investor confidence to take risks. He said many companies will risk restructuring to take advantage of strong market conditions.

“One of the gists of the report is that they are anticipating more debt restructuring because of liquidity in the market,” he said. “Sometimes this means that people are more willing to take on risk that they wouldn’t have in the past. This is generally good for investing.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com