Friday Workout - bad news still good news; Core Blimey done for?
- Chris Haffenden
August can be a tough month for traders. Liquidity is poor, juniors are stuck at their desks and with their bosses out of the office they are not motivated (or authorised) to buck the trend. Market reaction to August news is as a result often magnified. The current goldilocks narrative plus a human tendency to look for turning points, saw lower than expected US CPI and PPI data — mostly due to declining gasoline prices — pour more fuel onto the fire of the late summer rally.
I’ve lost track. Is bad economic news still good news for the market, or is good economic news now seen as bullish?
After the CPI print on Wednesday, the iTraxx Crossover, in consolidation mode after decent gains in late July took it as a bullish sign and dived below 500 bps for the first time since early June, closing at 479 bps on Thursday. It was the cue for further gains for some of the higher beta beaten-up EHY names which are now up five-to-seven points from their lows. High Yield funds which were short duration and underweight are now struggling to get back to market weightings. It will be interesting to see if fund flows are enticed by the price moves and finally turn positive.
In late June, we had pointed out the value in senior-secured paper, most notably for sterling deals such as ASDA, whose SSNs have since retraced much of their spread widening from late May to early July. I would caution that spreads to SUNs despite widening on the price recovery for many deals still looks too compressed and I would stick to buying higher up in cap structures.
Second quarter earnings held up surprisingly well despite margin erosion as unit volumes remained strong (not sure how this fits with the market’s imminent recession tempering Central Bank actions narrative) with few negative earnings surprises. For companies such as Boparan, their chickens had already come to roost, as price rises finally fed through in Q2 to re-coop earnings.
In loans, confidence is returning to the point where investors and bankers are now talking a
bout bringing a slew of LBO deals to market in September. With a number of CLOs printing of late, there is increased talk that even CLO demand may be returning.
We still have loan warehouses from January stuffed full of significantly underwater single B paper at margins of 400-425 bps, and with the latest CLO prints having AAA tranches north of 200bps, this could temper any significant margin compression. As 9fin’s Owen Sanderson writes in Excess Spread “Loans are still cheap compared to January’s levels, but they’re no longer bargain basement, and CLO liabilities are lagging.”
Another factor is the appetite of private credit funds to take down paper, as my colleagues Lara Gibson and Laura Thompson wrote this week, their criteria is widening. The period where they were competitive versus Leveraged Loans is drawing to a close — is their backstop bid gone?
In summary, I would be cautious here.
After all, syndicate bankers often tend to kill the golden goose (btw does anyone know how that business is trading, the bonds popped in the last couple of weeks) by stuffing too much paper into a recovering but still fragile market. Value can selectively be had, but it is disappearing fast.
Core Blimey and done for?
But not all sectors are out of the woods, some are facing structural change and are more perceptible to increases in interest rates and other macro factors. The most notable is real estate, and nowhere is this more apparent than in Germany, which saw the strongest commercial real estate growth in Europe during the past decade.
As CBRE notes, investment activity has dropped sharply, “pressured by exogenous risks and the subdued economic outlook. As a result, investors are acting more cautiously overall, in addition the decision-making process for investors and banks is taking longer due to more intensive review and approval procedures resulting from the new situation and the generally greater risks.”
CBRE adds that the German Commercial Real Estate market is trying to strike a new balance, with the greatest impediment the discrepancy between buyer and seller expectations.
Arguably, the reversal in sentiment couldn’t have come at a worse time for Adler, Aggregate and Corestate — previously interconnected — and now forced sellers, desperately seeking to offload their development assets to raise cash to meet looming maturities.
Last October, as we started to investigate German Real Estate in earnest, we said that the more we look into Adler, the history, its operations, and transactions it becomes clear that the connections between various German RE companies, and their major shareholders are key to its understanding:
“A whiteboard at 9fin towers resembles a scene from a Scandi Noir detective series, with a web of connections and transactions between Adler, Aggregate, Vonovia, Vivion, often with Corestate providing the financing, with most deals being cash-lite via share/receivables transactions.”
It’s almost a year ago, that Aggregate managed to privately place €100m of SUNs at 6.875%. In April 2021, Adler got a deal away at 2.25%. The days where German Real Estate companies could issue high yield bonds with 2% coupons to fund risky development projects are long gone.
And if you still thought the game wasn’t completely up, and you could extract value given their bonds trading at very distressed levels, Corestate’s Q2 22 release makes for sobering reading.
More on this later but let’s first set the scene and allow ourselves at 9fin to bask in self validation.
In February, we expressed scepticism that the German/UK real estate asset manager, debt and equity provider and investor would be able to deleverage in time and refinance its November 22 and April 23 maturities.
“Unlike its peers, whose corporate bonds are directly funding purchases of real estate assets or funding development, Corestate is effectively borrowing against its management fees.”
Sounds strange, what did we mean by this? Their lending business is not easy to understand — which is perhaps why they managed to keep the odd funding scheme going for so long.
This is how it works:
Subsidiary Helvetic Financial Services (HFS) provides mezzanine debt funds, which are used to provide development loans via Corestate to real estate companies at 15-20% margins with an average life of 1.5 years. These bridge loans are repaid after the final building permit is obtained with the developer refinancing via other debt providers after this de-risking event.
If those returns weren’t decent enough (they amazingly claimed no defaults during the life of the funds) HFS also earned a selection of fees on top — underwriting fees, asset management fees, coupon participation fees, handling fees (for generating financing term sheets) and fixed trustee fees (for holding land charges for the benefit of bond purchasers).
But HFS’s Stratos Funds business has churn rates of over 20% per year, so new fund investors must be constantly sought to keep the mezzanine financing engine running, meaning that defaults must stay low and returns high. They also required a healthy level of deal flow.
“While the German RE market remains red hot (from a valuation and transactions basis) any reduction in activity and asset prices could affect its performance and management fees, the main drivers of EBITDA,” we cautioned in our analysis in February which clients can read here.
With Aggregate’s owner Gunther Walcher owning a significant stake in Corestate, and Aggregate owning 29.9% of Adler, there was suspicion that a significant amount of Corestate’s lending was to these two. But the company never disclosed its exposure — saying that it would not talk about individual clients. What we do know is that the other two businesses were growing fast, leaving no shortage of opportunities to fund development loans for friends and family.
After Aggregate and Adler went into run-off mode earlier this year, and Walcher exited his Corestate investment, its lending business has since completely dried up.
However, that wasn’t the only reason for Corestate’s woes and loss of business. Its reputation took a big hit in March after its FY 21 results were delayed by auditor EY, initially concerned about lack of information at Corestate Bank, the former Aggregate Financial Services.
A month later, the accountant forced it to take a big goodwill write-down at HFS. Corestate then withdrew its FY 22 financial outlook. Higher interest rates affected terminal values and had driven up the weighted average cost of capital, management explained.
When asked about the prospects for further impairments at HFS, they said “the market is difficult, leveraged finance is difficult, but with some banks stepping away [from lending], there is some potential for private debt funds.”
It was subsequently reported that Corestate had gated its HFS mezzanine funds to avoid further redemptions, and the full impact of troubles at HFS is glaringly apparent from the Q2 release.
During the quarter it took another large impairment at Stratos Funds after switching from Gross Development Values to Residual Values. This translated into negative revenue for the quarter with Assets Under Management (AUM) sinking sharply, with Q1 revenues also revised down.
To quote management on the Q2 22 call:
“[It is] the perfect storm, which is out there, it's an uphill struggle to convince clients to stick with us firstly. And it's much more difficult to convince new money coming in our AUM currently.”
If that wasn’t bad enough, at least another €1.5bn of AUM is expected to leave after the cancellation of three asset management contracts in Q3 22.
It is not too sensationalist to say that the company is battling to stay alive.
As 9fin’s distressed credit analyst Denitsa Stoyanova says:
“Management at Corestate have admitted the need to rebuild customer trust. Arguably tarnished by past associations with Adler and Aggregate, its bonds are quoted in the 20s with a perceived inability to refinance. Management face challenges in reinventing the company, or what’s left of it, as its business model of using mezzanine funds to provide bridge loans to developers appears broken.”
Management now admit that a new strategy cannot and will not come about until they successfully address their debt, saying they are exploring restructuring solutions for the two bonds and looking for fresh liquidity. But we at 9fin see little chance of realising significant cash value from disposals in H2:
“In conclusion based on all of the above, we feel that sufficient and timely new liquidity can only come from external sources. However, it will be a tall order at this stage to convince bondholders to lend into a business with substantial doubts on future earnings potential and a funding model which may be irreparably broken. Fresh equity from current shareholders appears unlikely given the miniscule market capitalisation and dilution fears from a likely debt-for-equity swap.”
The company will be run for cash while it seeks to convince bondholders that it still has a place in the German RE lending landscape and can still fund itself competitively.
Core(state) blimey, it could be done for.
House of cards?
They key question is how many other casualties will emerge from the downturn in the German RE market. Aggregate will undoubtedly be next as its liquidity challenges we think are too great. Adler in de facto run-off, the question is how much value can they extract from their upcoming sales?
Adler Group’s sale this week of two Frankfurt development projects, the Ostend Quartier and Westend Ensemble at a 13.6% discount to gross development value was spun positively by the troubled RE group. Despite a challenging market environment “it underscores Adler Group’s ability of delivering on its pledge of further improving its liquidity position in 2022 and beyond.”
Given that these assets were in the Consus subsidiary where there is most suspicion of the greatest overvaluation, we can understand the slight bond rally. After repayment of project debt, around €100m of cash is incoming, but it still must deliver on the sale of its BCP subsidiary (bids due September) to meet significant maturities due in the next 12-months.
In coming weeks, we will see how badly affected other German HY real estate peers are by the slowdown. On our watchlist are Peach Properties, SIGNA Development and potentially Vivion.
Watching the Defectives
I keep mentioning 9fin’s watchlist, but what is it?
How do we choose which names to spend attention on, and what reports do we provide? Compared to other providers, why is our approach different?
These were questions asked by a law firm trialist, and after developing a FAQ and explainer this week, it’s time to share our programme for those regularly Working Out on a Friday.
Our distressed/restructuring team provides a varied mix of content. This includes deep dives, bespoke reports, earnings previews and reviews, and bitesize updates on fast moving situations.
How do we select which companies to track?
Similar to our advisor and distressed funds clients we use our extensive screeners to develop a long list. This is the first stage in seeking out potential mandates and investment opportunities.
Spread to worst is our main measure to identify stress/distress (it avoids issues with convexity). We then use other metrics such as leverage, upcoming maturities, liquidity runway and interest cover to refine our searches, reduce the number of names, and to establish which deals might struggle to refinance, those which might experience liquidity issues, etc.
It is not just the use of absolute figures, their trends and speed of development are as if not more important. Our real time data allows you to spot the biggest movers and then dig further into the financials, deal docs, news, and assess the legal considerations.
In addition to quantitative factors, we also use qualitative information — such as early warning signs of potential candidates from our reporters’ sources, especially for loan names.
Triggers are another factor, is there anything likely to happen in the next 6-12 months?
From all the above, we devise a watchlist of 20-25 names, from an initial list of 250 bonds/loans.
Our fast growing team of dedicated distressed/restructuring reporters and distressed analysts meet once a week to discuss coverage and whether to add/remove names from the watchlist.
In the next few weeks, we will be revealing more of the names on our current list, and some exciting developments regarding our platform and our distressed/restructuring content.
If you want to know more or want us to run through some of our content — contact firstname.lastname@example.org
What we are reading this week
I’m in business and product development mode, meaning that there is still a raft of Q2 financials and news still to look through. Apologies in advance for the lack of an in-brief section this week.
In a busy earnings season, HY analysts can often struggle to cope with their 40-50 names.
So, news that Schroders is looking to hire a special situations credit analyst for a six-month fixed term contract piqued our interest — for just one situation — with extensive German restructuring experience. Could it be for Corestate or Aggregate?
As a restructuring processes nerd, I have plenty to catch-up upon as jurisdictional changes from the EU minimum standards directive kicks-in. Matheson has a good explainer on the Preventive Restructuring Directive as it takes effect in Ireland; whereas Hogan Lovells detail the new safeguard (its very different from its French namesake) obligations in Italy.
As the Tullow Oil/Capricorn merger faces an uphill struggle to get done on current terms, Brevarthan Research outlines the operational difficulties it faces in Ghana. This is a special situation we will take a closer look at in the coming weeks, given the binary outcome for their expensive 10.25% USD notes.
Not everyone thinks that inflation will subside quickly as recession hits, and after reaching terminal rates in Q1 23, interest rates will be aggressively cut in the second half to boost growth. Bridgewater believes that the odds favour a stagflationary environment that could last for years.
Whatever your views on tech valuations and VC investment, there has been a substantial amount of value creation and destruction in the past 2-3 years, no more so than at Softbank’s Vision Fund. This chart of cumulative gains and loss on Investments is incredible (and scary).
It was probably no surprise that there were no unicorns jumping out of valleys in their latest presentation, instead we have this:
And finally, Rob Smith at the FT must be salivating at the prospect — the holy trinity of his favourite subjects — Credit Suisse is suing Softbank over its clients’ losses in Greensill, with applications being made to the English High Court. But are there any Yachts?