Study on distressed debt

• In the next two years, transaction volumes for corporate distressed debt will drop from EUR 21 billion to EUR 7.5-10 billion
• Differing price expectations of buyers and sellers are the biggest obstacle to trade
• Banks would like to see a credit exchange for organized distressed debt trading

According to a Roland Berger Strategy Consultants study on distressed debt in Germany from the banks' perspective, the corporate distressed debt market will see a downward trend in the coming years. Banks expect transaction volumes to drop from EUR 21 billion EUR 7.5 billion in 2007 and EUR 10 billion the following year. Study respondents said that the differing price expectations of buyers and sellers are the biggest obstacle to trade. For this reason, more than half of the managers interviewed would like to see an organized credit exchange for distressed debt. This would make trading simpler and more transparent.

In 2006, Roland Berger Strategy Consultants interviewed 47 distressed debt managers from Germany's leading banks. Almost half the respondents (48%) have been working in the area of distressed debt for over five years.

Falling transaction volumes

According to bank estimates, the transaction level for corporate debt will fall from EUR 21 billion in 2006 to EUR 7.5 billion in 2007 and EUR 10 billion in 2008. The transaction volume for mortgage/real estate loans will also drop from EUR 39 billion to EUR 21.4 billion within the same time period. According to the study, portfolio transactions will decrease by almost ten percentage points, from 39 to 29.1%. In contrast, individual and basket transactions are expected to increase (from 47.7 to 55.1 % and 13.3 to 15.8%, respectively.)
While the majority of the banks surveyed (85%) expect a total volume of corporate distressed debt of less than EUR 100 billion, they believe that real estate credit volumes will be higher: 71.4% of respondents expect a volume of up to EUR 100 billion, while 28.6% believe that it could be even higher.

Reasons to liquidate distressed debt

Three-quarters (79%) of banks involved in the distressed debt business are exclusively active as credit sellers. There are no pure buyers among the banks. However, 21% of banks act as traders. Michael Blatz, Head of the Restructuring and Corporate Finance Competence Center at Roland Berger Strategy Consultants and author of the study, thinks that this is because "many banks want to streamline their credit portfolios, while at the same time earning money from the credit trade."

Banks sell off distressed debt to streamline their credit portfolios (74.1%), or because they can achieve an attractive sales price (20.4%). They are less motivated by a need to improve their own equity levels (14.8%) or credit worthiness (11.1%).

Obstacles to credit sales

The study showed that differing price expectations (88.9%), and legal considerations (72.2%), for example the lack of a bank license, have thus far been the biggest obstacles to distressed debt trading. For this reason, 58% of respondents would like to conduct distressed debt trading through an organized credit exchange. An exchange would make the market more transparent, which would in turn make it easier to trade loans. However, banks still do not know how such trading could be organized in detail.

At the moment, corporate debt makes up the bulk of banks' distressed debt portfolios (53.2%), followed by mortgage/real estate loans (34.1%) and consumer loans (12.7%). The study also found that mid-sized businesses are more affected by distressed debt than large corporations. At the banks interviewed, companies with sales of under EUR 10 million per year account for 24.7% of distressed debt, while companies with annual sales between EUR 10 and 100 million and between EUR 100 and EUR 500 billion account for 30%. Only 15.9% of distressed debt affects corporations with more than EUR 500 million in sales.

Banks use internal early warning systems

In order to recognize distressed debt at an early stage and assess related risks, 61.3% of banks use an internal early warning system. To classify loans as bad debt, banks also rely on objective information such as payment default (22.6%) and Basel II default criteria (19.4%). For 16.1% of respondents, the borrower's economic situation serves as an indicator.

The study showed that at two-thirds of banks interviewed, the workout department (specializing in restructuring and special purpose loan management) is in charge of credit sales. 90% of banks have no set sales criteria, but handle potential borrowers on a case-by-case basis.

The buyer's reputation is decisive to the transaction

41.2% of respondents said that the most important factor in selling distressed debt is the buyer's reputation. In addition, banks consider it important to avoid damaging their own reputation with a sale, and that the buyer is experienced with such processes (29.4%). "Special purpose banks in particular want to minimize the risk to their reputation. They seek buyers with strong turnaround competencies to avoid negative effects on their own business," says Nils Kuhlwein von Rathenow, Partner at Roland Berger Strategy Consultants' Restructuring & Corporate Finance Competence Center and co-author of the study. Only 15% of banks consider the sales price as the only decisive criterion.

Almost all interviewed banks sell senior debt, or did so in the past. 63.2% of banks focus on guarantees, while 52.6% sell subordinated loans/mezzanine capital.