Hedge Funds Await Euro Bank Crisis Opportunities

This article went to press prior to the European Union’s October 27, 2011, announcement of a plan to manage Europe’s debt crisis.

The debt crisis in Europe presents a plethora of trading opportunities for hedge funds —distressed assets, short positions, bankruptcy debt or fixed income — but the landscape is not for the fainthearted.

Funds must weigh the risks of a possible double-dip recession on both sides of the Atlantic and of the emerging reality that even the most historically solid economies of France and Germany are not immune to the ripples from the more vulnerable Greece, Spain, Portugal, Ireland and Italy,

To add fuel to the fire, action in mid-August by the European Securities and Markets Authority to temporarily ban short sales on financial stocks in France, Belgium, Italy and Spain has hedge funds further concerned that sporadic regulation may affect their investments in the region.

According to Paul Rowady, a Senior Analyst at research firm TABB Group, some hedge funds that are highly leveraged are being distracted from exploring money-making opportunities and are instead engaged in damage control. “But for those funds able to focus on making money, there are a number of ways to achieve it in this environment,” he says.

To choose the right set of investments, some guidelines should be kept in mind, according to Duncan Sankey, Senior Portfolio Director and Head of Research at London-based Cheyne Capital. “It is a matter of looking for [corporations] that have the ability to fund themselves through a sovereign default until financing conditions are improved. Such companies should have adequate access to alternative liquidity, such as cash, existing bank lines of credit, or readily salable assets,” he says.

Additionally, companies with nondomestic revenue streams (particularly from high-growth emerging markets) may be better investments in today’s market because the more nondomestic revenue sources a company has, the less vulnerable it will be to the economic fallout of austerity measures in its domestic economy.

“In the unlikely event that its home country leaves the euro, [the company] will still have euro liabilities, while domestic revenues will re-denominate into a much depreciated domestic currency. So having nondomestic revenues from which to service the euro liabilities is, therefore, key,” says Sankey.

Financials firing line

The uncertainty around Europe’s banking sector, with the possibility of banks defaulting, as they did in Iceland, will be watched keenly by hedge funds, especially as short-sale bans have now come into play. The ban went into effect in a number of countries, including France, with rumors of a downgrade and concerns over capitalization and exposure of its banks.

Whether or not hedge funds will be allowed to take or benefit from existing short positions of European financial stocks remains to be seen. Nevertheless, in the meantime, the distressed assets on the balance sheets of the banks are providing a gold mine of opportunities.

“Europe’s banks are going to have to sell some assets, or the cost of funding will go up,” says Ron D’Vari, CEO and co-founder at New York-based NewOak Capital. “They have some project finance infrastructure that is in a debt form, but it will become less and less efficient to keep on their books, so they will eventually have to de-lever.”

Louisa Watt, a Partner at London-based law firm Richards Kibbe & Orbe LLP, agrees. “In Europe, there is a lot of pressure for banks to start selling off their assets. So hedge fund investors are looking at what distressed portfolios may come out of them,” says Watt, who assists clients of bankrupt Icelandic banks in filing claims, many of which have subsequently been sold on the secondary market.

Particular focus should be cast upon small Spanish banks. They are under a great deal of pressure to sell their debt portfolios, which have significant holdings in construction and real estate. “These Spanish assets are selling off at extremely distressed prices,” says Watt.

Fixed Income

Volatility in fixed income markets is providing hedge funds with opportunities on a relative basis. Funds are taking advantage of unprecedented fixed income spreads by buying the bonds of one country and selling those of another based on the expectation that they should be trading closer together.

“This is translating into relative value opportunities, distressed opportunities and capital structure arbitrage opportunities, as well as a lot of activity in commodities from energy to precious metals,” says Rowady of the TABB Group.

To make the most from a volatility play, some managers recommend timing the trade to coincide with European Commission examinations of countries to see whether they have adhered to austerity measures in place. Often, some austerity measures are not fulfilled, leading to increased volatility and, therefore, more opportunities for fixed income traders, says Rowady.

In addition, hedge funds will have the opportunity to take advantage of negative basis trades, as European corporate bonds are pulled into junk status as a result of some countries experiencing sovereign ceiling downgrades.

Because most fixed-income index investments require constituent bonds to be issued by a country of investment-grade status, any bond downgradings will create opportunities. “To the extent that expectation that sovereign debt occurs and causes bonds to underperform credit default swaps, it is possible to extract value from this by putting on negative basis trades,” says Sankey of Cheyne Capital.