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Hedge funds and US banks spy gold in distressed Schuldscheine

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With the Schuldschein having grown into one of Europe’s foremost private debt markets, Asian and European banks have swarmed to it on the hunt for implied investment grade companies to lend to. But at the corners of the market, new characters are edging into the picture. According to several market sources, hedge funds and US investment banks have started to work their way into a still rare element of the centuries-old German market — distressed debt. Silas Brown investigates.

A major Schuldschein investor at an Asian bank said he had received overtures from Citigroup, Goldman Sachs, JP Morgan and Morgan Stanley in the past few years. They had offered bids on Schuldscheine issued by borrowers in credit difficulties, including Gerry Weber, the German fashion retailer, and Steinhoff International, the South African-owned furniture and retail group.

“We are a buy and hold investor and these US banks approach us and say, ‘Hey, we have sold Schuldscheine before. If a deal goes bad we are here to help, if you are ready to trade’,” the investor said.

He had not taken up any of their offers. He thought the US banks would then sell the debt on to asset managers and hedge funds. An official at another Asian lender said he had held discussions in the same vein with a US bank.

Another person familiar with the development said: “JP Morgan buys Schuldscheine in trouble or beyond that, insolvent. It buys directly from the investors and provides liquidity in stressy situations. It was involved in both Steinhoff and Gerry Weber.”

JP Morgan is the most active dealer, according to the first investor, followed by Citigroup. Several sources said JP Morgan had acted as a broker, investor and trader in Schuldscheine in the secondary market. It generally approaches Schuldschein investors directly on a bilateral basis.

In the case of Gerry Weber, which filed for insolvency in January 2019, having issued a total of €215m of Schuldscheine in 2013 and 2015, JP Morgan teamed up with asset managers Robus Capital Management and Whitebox Advisors. The trio paid €49m to repay some of the debt owing to other lenders, and in return acquired 100% of Gerry Weber’s share capital through a debt-for-equity swap. Other lenders received recoveries ranging from 32% to more than 50%.

A source familiar with the situation said: “Goldman Sachs trades Schuldscheine in various situations. This won’t be driven by looking to make markets in Schuldscheine as an asset class, but by the individual situation.”

Goldman Sachs, JP Morgan and Morgan Stanley declined to comment. Citi did not respond to requests to comment.

‘Not ideal’

An investor said that in the few cases when hedge funds enter Schuldschein deals, “they buy in at 30%, 40%, 50%, 60% and if it goes into restructuring they really dictate the process — it’s not ideal.”

A senior lawyer who covers the market said he was wary about whether hedge funds were appropriate parties to transfer Schuldscheine to. “[Investors] have to review their positions very carefully,” he said. “Some are interpreting who they can transfer to very liberally.”

In his judgement, the legitimate investors in the Schuldschein market were banks, insurance companies and pension funds domiciled in the EU.

According to a senior Schuldschein arranger at a Landesbank, as long as the issuer has fulfilled its duties, an investor is not allowed to sell a Schuldschein to an opportunistic investor. But once a covenant is breached, an investor is allowed to transfer the debt more freely.

Some market participants are worried that the legal mechanism of Schuldscheine means hedge funds could acquire distressed paper and then control workout situations, and even potentially influence them in mischievous ways.

“In scenarios where the borrower goes into serious credit default, you will definitely see almost fire sales,” said another German lawyer. “That’s exactly the main criticism that we see, because the Schuldschein is set up for strong credits. 

“You can trigger acceleration rights, there are no majority [investor voting] rights, you can push for a debt for equity swap or accelerate. Strategic investors can take a cheap position and then hope to get equity in turn at a later stage — nothing is preventing them.”

He even argued that hedge funds could try to drive a company into difficulties in order to benefit a competitor in which they had also invested.

In Steinhoff’s case, large funds such as Blackstone, Centerbridge and SVP held its distressed debt, though it is not clear whether this included any of its €730m of Schuldscheine.

“You can create havoc as a Schuldschein investor with cross-default thresholds and individual acceleration rights,” the first lawyer added.

Investor dilemma

More traditional lenders in Schuldscheine hold the debt until the loan expires. Few are prepared to buy paper in the secondary market, so when a borrower falls into difficulty it is hard for investors to sell out of their positions.

As buy and hold buyers, Schuldschein investors often know little about how paper can be transferred.

A fund manager who has bought several Schuldscheine in the secondary market said: “The first question I’m asked when I first approach a Schuldschein investor is ‘Oh, I can sell those?’”

But with interest rates at record lows, a few defaults in a Schuldschein portfolio can wipe out all an investor’s annual return. In the case of UK support services firm Carillion, which issued a £112m Schuldschein in 2017, months before defaulting, several Taiwanese banks were unable to sell their exposure and were, a banker said, “wiped out”.

So there is arguably a gap in the Schuldschein market for players that will buy and trade distressed paper.

An investor at a German savings bank, who had been approached by a series of brokers wanting to buy both distressed and healthy Schuldscheine, said: “In cases of distress, Schuldschein investors are really not the group best equipped to manage this. So in that respect, the opportunity to sell is important.”

Another distressed situation has arisen recently, as Leoni, a German company that makes electric cables, has had difficulty refinancing its debt. According to several market sources, traditional investors in a €170m Leoni Schuldschein have approached Landesbanks, seeking to sell their paper. Two sources familiar with the situation said hedge funds had been interested in buying it.

Leoni has since received bank financing and will now be able to service its Schuldschein without defaulting.

The second Asian lender said of situations like this: “You really need opportunistic investors to come in. The arranging banks that sold the Schuldschein are not going to buy it back and add more exposure [of the distressed credit] on to their books, and they would not have the contacts with hedge funds and distressed debt funds to take it on their books to trade — never, never.”

Schuldscheine are mostly arranged by German Landesbanks, even as the market has grown and internationalised to see €25bn a year in volume in recent years. Some global banks — the sort that number the world’s hedge funds among their clients — have entered the market, as have international issuers and investors, but it remains far from having the sort of demographic of, say, the public investment grade credit market.

Clouds gathering

It is not hard to find analysts who predict credit problems will intensify in the Schuldschein market. So far, defaults have been isolated, and often company-specific.

Folli Follie, the Greek jewellery and accessories maker, and Steinhoff had produced inaccurate and overstated accounts.

But some fear the market will soon be hit by downturns that affect whole industries.

A fund manager who has bought Schuldschein paper in secondary offerings said: “We have already seen a lot of cases on the cusp and I’m pretty sure that sellers at JP Morgan and Goldman Sachs, etc are smart cookies and they have spotted an opportunity too.”

Schuldschein bankers have earned the right to claim their market as the go-to place for European companies wanting to diversify away from public bonds and syndicated loans. Though the instrument dates back hundreds of years, it only became popular with companies in the last quarter century. 

Schuldscheine are defined as promissory notes — bilateral loans, in effect — under German law. This legal status means the market has sidestepped the snags of MiFID II and other regulations on securities. Investors also do not have to mark their books to market. The product enjoys lighter documentation as a consequence, which attracts many borrowers through quicker execution and lower legal fees.

However, the instrument shares some attributes of a bond. It can be marketed to as many as 500 investors, for example. Some arrangers run Schuldschein transactions from their loan desks, some from their bond desks. Borrowers can be muddled, too. ZF Friedrichshafen sold a €2.1bn Schuldschein last year, the largest issue of the year, which it classified as a “bonded loan”.

Senior bankers in the market are keen that regulators should not reclassify the product as a bond, as they think that would heavily complicate it and detract from the instrument’s appeal. Bankers at BayernLB, Helaba, LBBW and NordLB have told GlobalCapital that their banks do not market Schuldscheine to US investors on principle, as they want to guard the market from the gaze of the Securities and Exchange Commission, lest it decide to treat Schuldscheine as bonds instead of loans.

But the fact that US banks are now approaching Schuldschein investors directly means the more traditional, often German, arrangers that cast themselves as gatekeepers to the market, are only vaguely aware of these developments, as some senior bankers have confirmed.

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