LONDON Hedge funds stalking distressed assets in Europe may be left with slim pickings after a trillion-euro cash injection from the European Central Bank (ECB) eased the pressure on banks to dump some of their weaker holdings.
Many fund managers, who have been scenting prey since the credit crisis began, had been hoping European banks would sell off assets such as corporate loans and project finance debt to comply with Basel III global capital adequacy rules, the thrust of which comes into force next year.
However, some managers think the opportunity may have gone for now after the ECB flooded markets with 530 billion euros (442 billion pounds) of cheap cash last week, on top of a 489 billion tranche in December, to try and head off a second credit crunch.
Many believe the cheap money, lent via the Long-term Refinancing Operations (LTRO) at 1 percent for three years, will make life easier for banks by allowing them to boost their profits and avoid asset firesales for the moment.
"Distressed opportunities in Europe are further away than the consensus thinks," said Girish Reddy, founder and managing partner at Prisma Capital Partners, which manages around $7.5 billion (4.8 billion pounds) in assets.
"The LTRO is allowing banks to rebuild their balance sheets through profitability. The can is being kicked down the road."
The ECB's actions could signal yet more waiting for distressed funds, which typically buy the bonds and other securities of companies facing tough times and approaching or in bankruptcy.
"Managers fixated on classic distressed (assets) don't have much to do," said one fund of funds manager who spoke on condition of anonymity. "European banks probably feel a bit of breathing space right now ... It (the opportunity) is potentially there but it hasn't happened (on a) large scale."
After enjoying double-digit percentage gains in 2009 and 2010 on the back of rebounding asset prices, distressed funds lost 1.8 percent in 2010 in a tough year for hedge funds, according to Hedge Fund Research.
Some have been sitting on cash levels of as much as 50 percent for a couple of years whilst still charging fees to clients, said one hedge fund investor.
Anecdotal evidence suggests they could find themselves in a similar position for some time to come. According to data from Citi, distressed funds cut their leverage by 6.8 percent between December, when the LTRO was announced, and January, even as other hedge fund strategies increased borrowing.
"Some investors will lose patience with these type of funds," said the investor, who added he was "staying away from the space" for now.
"Investment levels in funds are still not picking up materially," the investor added. "The LTRO definitely adds to that feeling of comfort (for banks)."
Distressed funds account for only a small proportion of the $2 trillion hedge fund industry, and the bulk of the distressed funds operating in Europe are U.S.-based firms with European offices, such as Avenue Capital, Anchorage Advisors and King Street Capital Management.
Managers say such funds can still find opportunities in the U.S. in the wake of the LTRO, but the smaller group of funds focusing solely on Europe may have to make do with smaller restructurings.
"They are trying to do industrial bankruptcies rather than European bank deleveraging. There will be enough to do, but not to the size people expect. It won't be multi-billion, but more like $1-2 billion transactions," said Prisma's Reddy.
Distressed managers were left sorely disappointed by the opportunities on offer from 2008 to 2010, as banks, on the mend from the financial crisis, proved unwilling to take major hits and sell assets at fire-sale levels.
Many funds had also been banking that a much-discussed "wall of maturities," stemming from the enormous debt piles backing the leveraged buyouts of the 2007 boom, would push lenders to become a lot tougher on ailing borrowers, creating a wave of restructurings.
One of the most active funds in this area in Europe, Oaktree Capital, returned money to investors from its distressed investment fund in early 2011, in what many took as the clearest signal that opportunities were thinning.
Many in the industry saw last year's euro zone debt crisis and looming banking regulation as putting fresh pressure on banks to reduce their groaning balance sheets and raised hopes that long-awaited distressed opportunities would finally appear.
Though budget hotelier Travelodge entering talks with its lenders was one such event, Prisma's Reddy said "in Europe it's not happening as much" as in the U.S., where managers were finding opportunities in companies such as American Airlines and Eastman Kodak.
However, the LTRO could yet have a silver lining for distressed investors.
"Somewhat counter-intuitively, the faster that European banks can recover, the quicker they will be able to recognise impairments on their problem loan assets, so distressed investors should want to see banks generate higher profits," said Iain Burnett, Head of Distressed at BlueBay Asset Management.
(Additional reporting by Sarah White and Tommy Wilkes; Editing by Will Waterman)
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