Financial institutions across the EU are redoubling their efforts to excise large volumes of non-performing loans (NPLs) from their balance sheets. So far, their attempts to wind-down NPL holdings have largely been quite successful. According to European Central Bank (ECB) data, European banks are currently sitting on approximately EUR714.3bn worth of NPLs, although this is still a sharp drop-off from 2016 when that number stood at EUR1.12trn.¹ As a result, the NPL ratio across European banks fell to 4.81% (at Q1 2018) down from 5.90% in 2017, denoting a year-on-year decline of 1.09%.²

Given the interconnectedness of the European banking system, regulators including the ECB and European Commission (EC) have been actively pushing for banks to de-risk and remove NPLs entirely from their balance sheets.  Most recently, the EC proposed a series of revisions to the Capital Requirements Regulation including one provision stipulating banks have sufficient loss coverage for any future NPL originations³.  As banks continue to deleverage, the overall supply of NPLs - especially those that have originated in Southern European markets such as Portugal, Italy, Spain, Greece and Cyprus is likely to remain buoyant.

European NPL sales have been strong with completed transactions topping EUR205bnin 2018 alone, while there are another EUR45bnof deals in the pipeline (as of January 2019)⁴. The lion’s share of activity is concentrated in Italy, a country whose NPL market is so sizeable that it is widely considered to be a systemic risk to the entire eurozone. For example, NPL transactions in Italy last year totalled EUR103.6bn, putting it ahead of Spain (EUR43.2bn), Greece (EUR13.9bn), Ireland (EUR14.3bn) Portugal (EUR8bn), Germany (EUR7.6bn), the UK (EUR7.3bn) and Cyprus (EUR2.9bn)⁵.

The reduction of non-performing bank debt in Italy has been abetted by the government’s GACs programme (Garanzia Cartolarizzazione Sofferenze, also known as the NPL Securitisation Guarantee). Launched in 2016, GACs is designed to incentivise domestic banks to sell their NPLs into securitisation vehicles (SPVs) by providing a state guarantee on the senior debt tranches⁶. While GACs expired in March 2019, the government has implemented another broadly similar initiative⁷ for another two years with the the possibility of a further 12 month extension after that⁸. The government is optimistic this scheme will enable local banks to finally shift the EUR200bn of NPLs weighing down on their balance sheets⁹.

The programme has been reasonably effective with 14 GACs-guaranteed securitisations of NPLs taking place in 2018. These transactions included Banco BPM SpA’s EUR9.5bn securitisation of borrower loans in Sicily and Banco di Sardegna SpA’s EUR1bn securitisation of business and personal loans – mostly originating out of Sardinia.¹⁰ GACs has also prompted a spike in multi-bank securitisations, whereby multiple smaller regional providers club together in order to obtain scale so they can sell their bad debts in the capital markets.¹¹ Most notably, the Banca Popolare di Spoleto SpA and Banco di Desio e della Brianza SpA recently collaborated to partake in a EUR1bn securitisation issuance¹²

With such an abundance of deals, institutional investors – principally US-based private equity and asset management companies – have piled into NPL opportunities. NPLs offer excellent double digit returns¹³ at a time when performance in the active asset management industry has been subdued, something that has not been helped by the below-zero/very low interest rates. While private equity has posted strong performance when benchmarked against public market returns, investors have voiced concerns that managers are overpaying on some transactions. Investors are also becoming impatient with the US$1.20trn of dry powder¹⁴, the amount of deployable capital which private equity has accumulated, and they are insisting it be put to use. As a result, this is prompting some private equity managers to chase returns in the NPL market.

High-profile buyers of European NPLs over the last few years have included institutional investors such as Cerberus (EUR29.7bn), SGA (EUR18.3bn), Lone Star (EUR15.1bn), Intrum (EUR13.7bn) and Barclays (EUR10bn)¹⁵. Interest in European NPLs shows no sign of waning either. According to a report produced by law firm Ashurst, more than half of the investors surveyed said they were either “certain” or “very likely” to buy Italian NPLs in the next two years, whereas 40% said the same for Greece and 37% for Spain¹⁶.

While European NPLs have traditionally been acquired by large institutions, Deutsche Bank has observed that a growing number of smaller buy-side firms are increasingly entering the market. These investors are not solely US centric either, but hail from the UK, Nordics, Switzerland, Poland, as well as Asia-Pacific (APAC). As is to be expected, these smaller distressed debt specialists are targeting lower value – albeit more niche - transactions. Even though many of the large European banks have effectively offloaded some of their more attractive assets to major investors, smaller providers have identified a number of NPL opportunities across CEE (Central and Eastern Europe) economies including Bulgaria, Slovenia, Hungary, Romania and Croatia, where bank deleveraging has been slower off the mark¹⁷. In addition, experts are convinced that other untapped CEE markets could yet see increased deal flows, including Ukraine, Albania along with Bosnia and Herzegovina¹⁸.

Elsewhere, specialist asset managers are bullish on the potential returns available through investing into Italian UTPs (unlikely-to-pay), namely sub-performing loans which are yet to enter into default, a market which is estimated to be worth around EUR350bn.¹⁹ While UTPs have not been incorporated into the latest GACs programme²⁰, smaller fund managers are confident that some of these debts can be successfully restructured. So much so that sales in UTPs are scaling new heights. For example, UTPs accounted for 80% or EUR24.2bn of all total loan portfolio sales recorded in Italy up until May 2019, representing a massive jump from 2018, when UTPs comprised just 8% of all sales.²¹ However, caution does need to be exercised as the data is distorted by one very dominant UTP transaction.²²

Moving forward, there are a growing number of new investment opportunities emerging, especially in the Italian market. For instance, amendments were recently introduced to the country’s Securitisation Law in what should make it easier for market participants to securitise NPLs collateralised by real assets such as real estate, automobiles and other registered assets²³. These significant legislative changes are being closely monitored by institutional investors in the region, who are looking to diversify beyond traditional NPLs.

Servicing platforms fall into two camps, namely special servicers who are involved in the recovery and collection process, and master servicers who coordinate the special servicers in their activities, prepare portfolio performance reports and provide support in performing due diligence on the portfolios. Both types of servicers play an integral role in ensuring that the NPL market functions as it should.  It is also a sector that is rapidly evolving, illustrated by the growing number of major investors – who have exposure to NPLs – obtaining majority stakes in servicers so as to streamline and expedite the entire NPL acquisition procedure. Recent transactions include Davidson Kempner Asset Management’s decision to purchase a 44.9% stake in Prelios for US$64m back in 2017 and Arrow Group’s acquisition of Zenith Service SpA in the same year for €17m.

Providers of corporate trust services such as Deutsche Bank are integral to the entire securitisation process. Their expertise in this area, combined with banking services capabilities are ever more important to ensure the smooth facilitation of these transactions. Typically, these services include accounts administration reporting, regulatory compliance checks, helping end investors achieve their investment strategies.

In addition, the bank’s branch network and local geographical reach can also facilitate clients’ portfolio collection activity, which is essential given the substantial use of specific instruments such as Cambiali, which are Italian bills of exchange, within NPL portfolios. As NPL activity continues to expand across Europe, investors should look to utilise the knowledge of industry leading service providers such as Deutsche Bank so as to help maximizing their return opportunities.

Sources

¹ See https://bit.ly/2LzJMzk at eba.europa.eu
² See https://bit.ly/3dK4jNx at eba.europa.eu
³ White & Case (October 24, 2018) New measures of the EU for NPLs
⁴ Ashurst (March 5, 2019) A global NPL perspective
⁵ Ashurst (March 5, 2019) A global NPL perspective
⁶ Deutsche Bank (May 2018) NPLs in Italy
⁷ This has been already implemented with Decree Law 22/2019 converted into Law 41/2019
⁸ Reuters (March 19, 2019) Italy to renew GACs bad loan scheme for up to 3yrs
⁹ Global Capital (March 20, 2019) Italy to renew GACs for two years without UTP clause
¹⁰ S&P Global (March 22, 2019) Italian securitisation wave may have peaked but GACs remains a helpful tool
¹¹ S&P Global (March 22, 2019) Italian securitisation wave may have peaked but GACs remains a helpful tool
¹² S&P Global (March 22, 2019) Italian securitisation wave may have peaked but GACs remains a helpful tool
¹³ See https://bit.ly/39LdREv at ashurst.com
¹⁴ Preqin (January 28, 2019) Alternatives in 2019: Private capital dry powder reaches $2 trillion
¹⁵ Ashurst (March 5, 2019) A global NPL perspective
¹⁶ Ashurst (March 5, 2019) A global NPL perspective
¹⁷ Private Debt Investor (October 1, 2018) Making sense of Europe’s fractured NPL market
¹⁸ Deloitte – NPL Study 2019
¹⁹ Financial Times (July 23, 2018) Veteran financier sees opportunity in Italy’s banking sector
²⁰ Global Capital (March 20, 2019) Italy to renew GACs for two years without UTP clause
²¹ Debtwire – Italy expects record UTP sales in 2019, restructuring market peaks
²² Debtwire – Italy expects record UTP sales in 2019, restructuring market peaks
²³ Fieldfisher (May 15, 2019) Recent changes to Italian securitisation law to make monetisation of real estate and registered assets easier and disposal of non performing loans