European Bank Distress Requires Investor Patience

Chidem Kurdas

Much touted for several years, the trade on European distressed finance looked like a rare opportunity. Buy the drastically under-priced debt of troubled yet inherently valuable European banks or other financial businesses. Then wait for prices to recover.

On the other hand, you can still be waiting after several years with no idea when the wait will end. Faced with on-the-other-hand arguments, you may find it easy to sympathize with Harry Truman who quipped that he needed a one-handed economist.

Here’s an example—not of Truman’s one-handed economist but rather of a European distress play gone long in the tooth.

Fortelus Special Situations Fund invests in distressed debt and credit. It was started in 2007 by Tim Babich, an alumnus of Silver Point Capital and Goldman Sachs. The 2008 crisis created opportunities for Mr. Babich, who made the correct call on the downfall of British bank stocks.

The fund did well until 2011 but that year lost 14.5%. Then customers started to pull out, according to news reports.

At that point Mr. Babich followed a precedent set by certain managers during the crisis.  He moved hard-to-sell assets to a separate portfolio called a side pocket, from which clients cannot withdraw by request but are paid as the assets are liquidated. This was in 2012.

At the time he was quoted as saying he wanted a secure capital base to take advantage of “exceptional” opportunities in Europe in the next few years. Investors who wanted to redeem were given a chance to get back 75% of their money that year, but the rest of it became untouchable in the side pocket.

Those side pockets tend to have long lives. Successful distressed investing does require time. If you’re in a hurry, you lose. Selling the debt of troubled financial businesses under roller coaster conditions can’t be done expeditiously, especially as trading in such securities is thin to non-existent. Meanwhile, the value of the sequestered investments fluctuates with markets.

Do people making the investment decision correctly factor in how long it may take to get back the money? For some it comes as a surprise, and not a happy one. They respond by swearing never to invest again with that manager. But not everybody has the same reaction. There are investors willing to be very patient and stay with the European distress trade.

The real question is, will the return justify the length of time that capital had to be committed? If you did this with Japanese banks 20 years ago, you’d receive very little for your wait. European finance industries are different from Japan’s, of course. But are the circumstances really that different?

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