The global hunt for yield in restructuring markets has seen a slew of hedge funds converge on Germany over the past two years, in a gold rush that has brought treasures for many. But activity is now retreating to more sensible levels as the less prepared funds find themselves conceding defeat to a successful few. Richard Jory and Chris Bourke report.
Overzealous hedge funds that piled into German distressed credits are cutting their exposure to that market after reaching the harsh conclusion that they lack the skill-sets necessary to run a business. The country's creditor-unfriendly insolvency law is also scaring funds from Europe's most promising distressed draw, leaving the better pickings to an elite handful.
"Several years ago, no one in Germany knew what a hedge fund was," said Marcel Laehn, director at BHF-Bank in Frankfurt. "There has been more activity in the hedge fund business in the last three to four years, although those involved suffered losses when the funds did not do what those that set them up said they would do," said Laehn.
What a different mood it was two years ago. Germany was heralded as the promised land, the land of opportunity for distressed investors that found their own backyard lacking in much that resembled return. This was in spite of the fact that Germany was only slowly coming around to the concept of corporate restructuring.
"There was a huge perception that hedge funds would present a new asset class," said Laehn. "Also, everybody wanted to be in hedge funds for their private clients."
In the last 1990s and early 2000s, private investors wanted hedge funds but no one was offering them on a public basis. This led to developments in 2002–2003 that saw hedge funds brought into the German market by banks in two ways. First, for institutional investors; and secondly, for semi-institutional investors, which are generally families although they act more like institutional investors. The latter have been investing in hedge funds for the last 20–30 years, although in the hedge fund business outside Germany.
The foreign investment banks that entered the German market with hedge fund products offered investors the opportunity to buy into certificates of hedge funds or funds of funds. The product offering was good for the banks, who were charging healthy fees, but not so good for investors, who were burdened with a lot of fees and costs.
Negative press followed, based on the costs, and also a misunderstanding from investors over what they should be expecting. "Investment banks had been taking too much of a cut as intermediaries," said Laehn. "Some of the money made by investment banks was stupid money as the private investors knew nothing, or little."
"Investors were told they could expect double-digit returns, which is not the strategy for hedge funds, which are all about getting high returns from bonds but taking less risk than equity. The market fell and managers of these funds were not so often seen, with many failing to fulfil their promises."
Since then some of the legislative constraints have been relieved. "Since 2004/2005, there are get new ways of investing in hedge funds, such as managed accounts and new certificates or fund of funds strategies," said Laehn.
"There are more funds of funds; investors know more about hidden fees, with prices coming down for certificates and funds of funds; and a more managed account strategy has been developed, pooling, say, 15 investors in one managed account, which has high transparency and only one or two main investments," said Laehn.
Optimism
The main reason for optimism in the early 2000s was the changing landscape for German banks, which were stripping non-performing company loans from their balance sheets after losing state guarantees and facing Basel II rules on capital adequacy.
Despite much of that market being real estate loans, there was also widespread hope that a more liberal German insolvency market would rub off on to the classic distressed debt plays.
For many, that hope has dulled. Some of the arrivals in distressed Germany are realising that sourcing deals there can be a tedious, thankless process that demands investor patience. Recent examples of "deals from hell" said to be scaring off some investors include the drawn-out auto plays Kiekert and TMD Friction.
The companies becoming stressed are generally either those that have grown beyond the capacity of the founder to want to keep up with its development, or those that have failed to introduce proper financial reporting systems, something that they typically fail to discover until it is too late.
Similarly, the country has a stream of companies currently struggling with sales and financial reporting. "It is a Germany issue," said Heike Munro, head of Deutsche Bank's distressed debt business in Germany. "It was OK when Germany was a growth market, but once you grow bigger as a company you need to develop things such as financial reporting." Succession for many of these companies is also a key issue.
The bigger companies that have been in trouble are automotive, but there have been a few retailers, although the construction industry has apparently turned around. Those banks that are involved are often providing refinancing funds as the company capital structures are reworked.
Hiring outside Germany has been limited, further exacerbating the problems and depriving these companies of expertise and experience from other financiers and accountants from outside Germany.
Initial outlay
Those building stakes in distressed companies' debt are finding the initial outlay is just the beginning, and that further investment is required prior to a successful sale of the restructured company. Certainly, the smaller funds are wont to concentrate their resources and so find it tough to justify such longer-term commitment.
"Many of the hedge funds have stopped looking at Germany as a potential market," said Wolf Waschkun from restructuring advisory group Kroll. "The deals you see are increasingly with a limited number of funds, with fewer getting involved on a regular basis."
"Anyone with an exposure to management is finding this market far more difficult than originally thought," said the European head of a US private equity group with huge exposure to Germany.
A sense of deja vu prevails. Back in the late 1990s, a flood of private equity capital poured into Germany, only to see the unprepared funds withdraw. Is the new breed of investors now starting to regret that same herd-like exuberance?
"Funnily enough, people make the same mistakes," said a German-based restructuring adviser. "Investors forget they aren't in London, they're in Germany. The legislature is much more difficult, the business culture's different – all these factors counted in the late 90s, but people have short memories."
Some are investing for the longer term. "The line between hedge funds and private equity is blurring. The business is not driven by sector, and now the arbitrage possibilities have gone away. But these companies may take a stake in a business for a few years," said Laehn.
Insolvency snag
The insolvency law remains a snag. One major drawback for creditors is the inability to select their own administrator, which reduces the control they have over workouts. The inability to cram down bondholders – and the superior rights of German shareholders – are also obstacles to creditors seeking a quick debt-equity conversion.
A new insolvency code (the German insolvency stature - InsO) came into force on January 1 1999, and brought with it changes to the German restructuring law adopting features from the US chapter 11 procedure. From the US legislation, Germany has adopted the insolvency plan procedure and also the self management procedure.
Following that, the European Insolvency Regulation came into force on May 31 2002, although Germany resisted introducing the EU regulation lock, stock and barrel and decided to create its own wide-ranging autonomous German international insolvency law.
Germany's insolvency act is very different from that of the UK. First and foremost, the fact that you as a creditor – or the company itself – cannot choose who the administrator will be makes for enormous uncertainty surrounding insolvency. If a company goes into insolvency in an uncontrolled manner, the loss of control scares investors away.
The number of insolvency proceedings that have been opened continues to increase significantly, although at the moment this is due to the increase in consumer insolvency proceedings. In
fact, the number of opened business insolvency proceedings has been declining since 2005, "a trend which was particularly marked in the first half of 2006," said Ferdinand Kiessner, a German lawyer and accountant in an article in the Insolvency and Restructuring in Germany Yearbook 2007.
But not everyone is complaining. "For us, as financial advisers, we can use that to our benefit," said a source from one German-based restructuring house. "In cases we've been involved in, we bring parties right to the edge of the cliff and say: 'This is what will happen if we don't agree'. It's effectively a gun to the head."
So the unexpected pressure on ambitious investors means the usual suspects such as Cerberus, SVP and Kingsbridge are dominating the market. The most successful funds have a local presence.
"Those who are successful invest in local resource, then build up a network over time to source deals," said Waschkun. "You can't do this from an office in New York or London."