Selling out in Germany

Foreign investors are rushing to buy distressed German loans, and sparking political controversy. Despite the protests, this market is poised for strong growth.

After opening its first dry-goods store in the small Baltic Sea port of Wismar in 1881, KarstadtQuelle expanded steadily, with the support of its banks, to become Germany’s biggest department store and mail-order house. So when the company ran into serious problems last year, racking up a massive E1.6 billion ($1.98 billion) loss because of tumbling sales, it turned to its lenders for help. Under political pressure to assist a troubled client at a time of high and rising unemployment, the company’s 16 banks, led by Bayerische Landesbank and ABN Amro, duly obliged in November by extending a new, E1.75 billion short-term credit facility.

The deal seemed to hark back to the glory days of Germany’s postwar economic miracle, when banks worked hand in glove with the country’s leading companies to power the growth of Deutschland AG. But the ink had barely dried on the new loan when several of KarstadtQuelle’s creditors began scrambling to off-load their commitments. On January 28, Landesbank Baden-Württemberg (LBBW) agreed to sell its share of the loan, roughly E110 million, to Goldman, Sachs & Co. for an estimated 92 cents on the euro. Within hours Dresdner Bank and HVB Group had agreed to sell their exposures, worth a combined E300 million, at similar discounts to Barclays Capital and Deutsche Bank, respectively. Subsequently, three more landesbanks sold their exposures, bringing the total amount of the loan sold off to about E460 million.

The sale of KarstadtQuelle’s loans reflects a sea change in German banking that is giving rise to a fast-growing market for distressed or underperforming debt. Years of economic stagnation caused the level of bad and doubtful loans to soar to E160 billion, or 6.4 percent of loans outstanding at German banks, in 2004, according to consulting firm Mercer Oliver Wyman. The pressure of those dubious loans, combined with the imminent introduction of international accounting standards and the Basel II capital adequacy regime -- both of which require loans to be marked to market -- are prompting lenders to cut their exposure, even if that means severing long-standing relationships.

This new hardheaded approach hasn’t come a moment too soon. The weakened state of Germany’s banks was underscored dramatically last month when HVB, the nation’s second-largest lender, agreed to be acquired by Italian bank UniCredit for E19.2 billion. The deal drove home the need for German banks to boost profitability or risk becoming bit players in the consolidation of Europe’s banking industry.

“As bankers, we have to change our ways if we want to play an international role, if we want to have international meaning,” says Bernhard Walter, a member of the management board of Stuttgart-based LBBW. Selling off underperforming loans is vital for the health of his bank and will free up capital for making new loans, he says.

International investment banks, private equity funds and hedge funds, meanwhile, are rushing into the market, confident that Germany’s distressed and underperforming debt will provide pickings as rich as that of Japan and South Korea in recent years. Lone Star Funds, the Dallas-based private equity firm, has been the biggest player to date, purchasing distressed and bad loans with a face value of more than E7 billion over the past two years. In May, Goldman Sachs agreed to acquire Frankfurt-based Delmora Bank, which holds E2.1 billion in sub- and nonperforming loans.

“Why shouldn’t a bank sell a loan at a market price?” asks Karsten von Köller, chairman of Lone Star Deutschland, the Frankfurt-based subsidiary of the U.S. firm. “Debt is more easily traded. This is a natural development that happens over time.”

The growing influence of foreign investors like Lone Star and Goldman Sachs has sparked a political backlash of sorts. Private equity funds aren’t just buying distressed debt, after all -- they are also pursuing leveraged buyouts of ailing companies with the aim of restructuring them through asset sales and layoffs. Foreign investors are also throwing their weight around in other ways. Two hedge funds, London-based Children’s Investment Fund and New Yorkbased Atticus Capital, effectively forced the resignation in May of Werner Seifert as chief executive of Deutsche Börse over his aborted bid for the London Stock Exchange.

These activities have created a sense among many Germans that the country is under siege from speculative financial interests, just as Americans worried about the spate of leveraged buyouts and Japanese real estate purchases in the U.S. in the 1980s and the Japanese complained about U.S. buyouts of their distressed loans and banks in the 1990s. Franz Müntefering, head of the ruling Social Democratic Party (SPD), notoriously gave voice to these worries recently when he attacked private equity firms as a “swarm of locusts” that were razing German companies and destroying jobs.

Such anticapitalist rhetoric is unlikely to affect policy, however. The SPD suffered a humiliating electoral defeat in May in its traditional industrial stronghold of North RhineWestphalia. That prompted Chancellor Gerhard Schröder to call for national elections in September, one year ahead of schedule, saying his government needed a fresh mandate to pursue economic reforms. Opinion polls suggest that the SPD’s center-right opposition, the Christian Democratic Union and its Bavarian sister party, the Christian Socialist Union, will sweep to victory this fall. CDU leader Angela Merkel promises to deepen market-oriented reforms in Germany, and other party officials have opposed any regulation of hedge funds, something Schröder has favored. And interestingly, UniCredit’s bid for HVB hasn’t sparked any nationalist backlash within Germany.

It isn’t just German politicians who deplore the activities of some foreign investors. Many savings and cooperative banks, nonprofit institutions that rely on relationships with local companies and consumers, are also critical of the growing market in distressed debt. Given that they hold an estimated 40 percent of Germany’s distressed debt, their aversion to trading debt represents one of the biggest obstacles to the market’s growth.

“These arrangers, these investment bankers, these Lone Stars, they take these loans and say, ‘We’ll graze these fields and leave when there’s nothing left to eat,’ and after six or seven years, they’ll leave Germany,” says Axel Kraft, a member of the management board at Kreissparkasse Köln, a savings bank in Cologne. “We have to live with our reputation.”

Notwithstanding the views of politicians like Müntefering and bankers like Kraft, the market for distressed debt appears destined to grow because of the sheer volume of underperforming loans outstanding and the need for banks to bolster their returns, bankers say.

Sales of bad and underperforming loans have mushroomed from virtually nothing two years ago to an estimated E12 billion in 2004 and are expected to swell to E20 billion in 2005 and 2006 before leveling off at E15 billion a year, according to a recent report by Mercer Oliver Wyman and Kroll Associates. That would make Germany the world’s second-biggest market for distressed debt, behind Japan and just ahead of the U.S.

Until recently, the bulk of activity has been in real estate loans, reflecting the depressed state of Germany’s property market after the binge of postunification development. The sale of KarstadtQuelle’s debt represented a dramatic new opening, in two respects. The borrower was a blue-chip company, not an empty office park, and although KarstadtQuelle faces serious financial difficulties, it continues to service its debt. The willingness of banks to sell such exposures should fuel the growth of debt trading, bankers say.

The other notable fact about the sale was the involvement of four landesbanks -- Bayerische Landesbank, Landesbank Hessen-Thüringen Girozentrale, LBBW and WestLB. These state-owned institutions have traditionally viewed themselves as public utilities with a duty to serve the businesses and people in their states. Today’s rapidly changing regulatory environment, including the removal of the landesbanks’ state guarantees this month, means they must operate increasingly like commercial banks.

WestLB and NordLB last month announced a joint venture with Japan’s Shinsei Bank and U.S. private equity firm J.C. Flowers & Co. to service E400 million of bad loans; they invited other savings banks and landesbanks to join in; so far none has.

“Public banks are still reluctant, but I expect them also to change with regard to the disappearance of the state guarantees. We are approaching banks we believe have an NPL of a particular size,” says Lone Star’s von Köller, referring to nonperforming loans.

Meanwhile, demand for German debt among foreign institutions continues to grow. More than a dozen U.S. and European hedge funds and private equity funds, including such names as Citadel Investment Group and Cargill Investor Services as well as Lone Star, are looking to buy distressed debt, attracted by potential returns of 20 percent or more. Investment banks including Citigroup, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs and J.P. Morgan are involved as both principals and dealers.

The competition among buyers is already weighing on margins. “There is a sense of frustration among investors, especially latecomers, who face a seemingly cramped marketplace with few available investment opportunities and reduced spreads,” says Finja Carolin Kütz, director of Mercer Oliver Wyman’s operations in Germany.

“Clearly, we have a seller’s market,” says David Abrams, who heads CSFB’s global distressed-debt unit. “The pricings have been aggressive. If you’re looking to sell something, everything is lining up for you.”

Fresh evidence of the strong demand for distressed German assets came in May when Deutsche Annington Immobilien, a subsidiary of Terra Firma Capital Partners, the vehicle of U.K. private equity investor Guy Hands, agreed to pay E7 billion for Viterra, the property arm of German utility E.ON. The deal consisted of E4 billion of equity in 150,000 apartments and E3 billion in debt. Analysts had expected Viterra to fetch between E5.5 billion and E6 billion, but competing bids from U.S. hedge funds Cerberus Capital Management and Fortress Investment Group drove up the price. E.ON will post a cool E2.4 billion gain on the sale.

Distressed-debt sales have been accelerating in recent months. Goldman Sachs spent an undisclosed amount to buy Delmora, which holds sub- and nonperforming loans from two failed banks, Delbrück & Co. and SchmidtBank. The acquisition strengthens Goldman’s ability to pursue more deals by giving it a German banking license, which should allow the firm to refinance distressed debt more easily, as well as Delmora’s 200-strong loan workout department.

HVB will begin selling off E15 billion in bad and underperforming loans later this year. The bank’s January announcement of the planned sales, along with a decision to take a E2.5 billion write-off on the loans, facilitated the merger discussions with UniCredit by signaling that HVB was finally coming to grips with its bad-loan problems, bankers involved in the transaction say.

Wiesbaden-based Aareal Bank began off-loading its E2.8 billion debt portfolio last month by selling E690 million of loans, mostly on commercial real estate, to Lone Star.

The market for distressed debt took off two years ago after Dresdner Bank, a unit of Allianz, set up an institutional restructuring unit to work off a E35.5 billion mountain of bad loans, including E9.2 billion of German real estate and corporate loans. The bank sold its last major German asset, a E1.4 billion portfolio of corporate and real estate loans, to Lone Star and Merrill Lynch Investment Managers last month. The deal, terms of which weren’t disclosed, will enable Dresdner to close its restructuring unit by the end of this year.

Dresdner is also seeking to convert underperforming loans into equity and push for corporate restructurings. Dresdner and a consortium of three other banks agreed in May to swap E27.9 million of debt with Nordex, a German maker of wind turbines, for an equity stake valued at E20 million.

These actions have reduced Dresdner’s stock of underperforming loans by more than three quarters, to E8.6 billion at the end of the first quarter, and allowed the bank to reduce the amount of capital tied up in bad loans by E2.4 billion.

Lone Star’s German headquarters, across the street from the Frankfurt Convention Center, is in a modern office building whose vacant lower floors are a reminder of the excesses that debt traders are trying to work off. Many of the loans in the firm’s eight disclosed distressed-debt transactions involve real estate, mostly in Eastern Germany, a region von Köller fled as a child to escape the Communist regime.

The 65-year-old von Köller knows the market well. A veteran mortgage banker, he was named chairman of Eurohypo in 2002 when the firm was formed by the merger of the mortgage arms of Commerzbank, Deutsche Bank and Dresdner. After integrating the three businesses, von Köller retired from Eurohypo last year and was promptly recruited by Lone Star to head its German operation. He arranged the biggest loan purchase so far in Germany, teaming up with J.P. Morgan last year to buy E3.6 billion in loans -- of which E2.48 billion were nonperforming -- from Hypo Real Estate Bank.

“Germany is seen with different eyes from the outside,” von Köller says, explaining the foreign interest in its distressed debt. “Both sides profit from that.”

By buying debt at a discount and taking a more aggressive stance on workouts than German banks do, Lone Star aims to achieve annual returns of 20 percent on its investments, von Köller says. The firm’s loan-servicing subsidiary, Hudson Advisors, employs 250 people in Germany whose pay is linked to the speed of recoveries they achieve on their loans.

Von Köller is negotiating the E50 million purchase of Mitteleuropäische Handelsbank from Hannover-based NordLB. The deal is small, but it will give Lone Star a banking license, allowing the firm to refinance distressed mortgages more efficiently.

Deutsche Bank’s 45-person distressed-debt team has acted as a principal alongside a group of hedge funds to buy up the debt of several companies, swap it for equity and then carry out restructurings. In one case, Deutsche and its partners bought 69 percent of a E75 million convertible bond of Augusta Technologie, a communications and information technology concern, that the company had defaulted on. The investors persuaded other bondholders to agree to a debt-equity swap and ended up owning 62 percent of the company. Deutsche aims to sell its stake, probably to a private equity firm, later this year.

“Our goal is to restructure a business out of court,” says Joachim Koolmann, who heads Deutsche’s distressed-debt unit. That’s essential because German law requires an immediate liquidation of assets after a company goes bankrupt.

Despite the latest burst of activity, Kütz of Mercer Oliver Wyman warns that Germany’s secondhand debt market could cool off unless the country’s big nonprofit banking sector sheds its inhibitions and joins the trend. The country’s deeply conservative savings banks and cooperative banks remain reluctant to sell loans, regarding that as tantamount to a betrayal of their long-standing clients. “We have a public contract,” says Kreissparkasse Köln’s Kraft. “We will not take away the umbrella when it’s raining. That’s not our duty.”

The only savings bank known to have broken ranks, Niederschlesische Sparkasse in Görlitz in northern Germany, sold E100 million face value of real estate loans to Lone Star and J.P. Morgan in the first quarter of 2004.

Notwithstanding the obstacles, the sheer size of Germany’s underperforming loan pools and the regulatory pressure on banks to reduce their exposures should ensure a bright future for debt traders. “Over the next 18 months, we’ll see some big portfolios, and the market will continue to open up,” says Deutsche’s Koolmann. “Once these large portfolios are done, there will be a more normalized business. There will always be stressed or distressed loans.”