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Press article: Sunshine on the distressed debt market

Luxembourg Fund Review


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The current climate of economic and financial distress raises numerous liquidity and solvency concerns. With assets falling dramatically to a fraction of their face value, financial institutions are faced with the need to write down their assets due to mark-to-market accounting rules or simply from a prudency perspective resulting in recognition of large losses. However, as every cloud has a silver lining, windows of opportunity exist for investors: the niche market of distressed assets and, in particular, distressed debt.

Overview

Distressed assets are financial instruments which have suffered a substantial write down in value due to the financial and economic situation of the company which issued those assets. In many cases, the company faces serious difficulties, is in bankruptcy or is about to collapse.

Distressed assets consist of common and preferred shares, bank debts, trade claims, corporate bonds and derivatives.

Acquiring distressed assets allows investors to purchase assets at a discounted price with the underlying aim of making a profit upon repayment while ensuring recurring earnings, the investor’s philosophy being that the company’s situation is not in fact as distressed as the market believes and that an improvement in the issuer’s business will result in the debt being traded at par or fully reimbursed at maturity.

Broadly, investors’ strategies can be divided into two main camps. Firstly, investors could be “non control” driven, meaning that they will only influence the reorganization of the company and will then sell their distressed asset at a higher value or wait for repayment of the par value. Secondly, willing investors can be “control-orientated”, which means that they will become a major creditor of the company and even a major shareholder by converting their debt into equity.

The distressed debt market in particular, is a win-win situation where investors with available cash flow have an opportunity to buy loans from financial institutions at a trade price below par value with the expectation of recovering par value on an improvement in market conditions. For financial institutions, it is an opportunity to rid their balance sheets of impaired assets and to raise fresh cash to cover their liquidity short fall and improve their solvency margin.

The distressed debt market

Historically, distressed debt opportunities arise cyclically. A period of lenient lending policy followed by challenging global economic conditions and poor corporate credit worthiness will lead to an extensive supply of distressed debt opportunity.

The distressed debt market blossomed in the US in the 1980s and early 1990s when the savings and loan crisis was in full swing. Financial institutions faced a difficult patch by writing off loans granted to individuals. Created by the Federal Deposit Insurance Corp., the Resolution Trust Corp. was in charge of auctioning off those distressed debts. A new market had come to life.

The 1990s were characterized in the US by times of strong economic growth and low default rates resulting in a decline in the number of distressed transactions. These glorious years in the US coupled with the currency crisis in Asia were the catalyst for distressed debt investors to focus on the Asian market, thereby gradually globalizing the distressed debt market which originated in the US.

Fast forward to 2000 and 2001 and the telecommunications industry downturn, largely as a result of the American WorldCom Inc scandal., offered new opportunities for the distressed debt market as the companies affected were not in a position to repay funds they had borrowed to build their infrastructures and networks.

Distressed debt investors established their headquarters in London and the distressed debt market then spread to Europe taking advantage of the increase in defaults in payment.

Potential ultra-high rates of return generated by distressed debt investments seduced investors who succumbed to a new generation of funds specialized in those opportunities.

Finally, more recently traditional private equity houses and financial services firms such as Goldman Sachs, Blackstone, Carlyle and Apollo also turned to the distressed debt market.

Opportunities in the distressed debt market

During the years 2006 and 2007, Leverage Buy-Outs (LBO) activity entered its glory years. Banks lent huge amounts to private equity and hedge funds which, in turn, used that debt to highly leverage their investments in order to generate greater returns.

Today the LBO market is facing severe difficulties. Analysts consider that the crisis had its roots in the US credit market crisis9. Indeed, since the crisis began in 2007, lots of banks engaged in LBO transactions have been struggling to recover payment on receivables. As a consequence, money is more expensive and interest rates are increasing, de facto decreasing the appealing mechanism of leverage.

In 2008, about 53 LBO deals were cancelled. The best example is the failure of one of the biggest ever planned LBO’s of 48,5 billion dollars to take over Bell Canada Enterprises. The following charts illustrate the decline in LBO transactions and the trend by banks to divest themselves of LBO transactions.

Banks are now facing urgent liquidity needs and have to clean up their balance sheets, notably to comply with their indebtedness ratio requirements. Consequently, distressed debts could be discounted up to 40% of their face value thus creating attractive investment opportunities.

In addition, following the LBO demise, investors now want to deleverage their investments by selling their receivables at the estimated value of repayment which is lower than the par value. In this context a new cycle has started and an up-and-coming market is arising for distressed debt acquisitions. Specialists are inclined to think that the volume of payment default will inflate in 2009 and it is forecasted that one fifth of European speculative-grade companies could default in 2010, thus facilitating the purchase of distressed debts at rock bottom prices with potentially strong returns to investors. According to Moody’s, the default rate will reach 16,4% in the fourth quarter of 2009 exceeding the peak of 11,9% in 1991 and 10,4% in 2001.

The financial crisis did not settle things down; indeed companies are unable to refinance their debts as credit providers are more than cautious. Therefore, companies are now facing a deadlock, inability to repay and inability to borrow.

In this context, investors must strongly consider taking advantage of the snow ball effect of the liquidity crisis by contributing to the restructuring of companies in bad shape. Well informed investors with taking the view that a strong recovery is on the cards may well find the goose that laid the golden egg. Indeed, investors who become major creditors of a defaulting company and then convert their debt into equity can make significant profits from putting the company back on its feet.

In addition, the European legal framework regarding insolvency rules and procedures enhances the distressed debt market. Both at the European level and at individual country level, the trend is to encourage a company’s recovery rather than favor liquidation procedures. In this context, the investor’s risk is lowered.

Distressed opportunities are not geographically limited and are spread across various sectors.The emerging markets of Asia, Eastern Europe and Latin America have supplied numerous distressed assets while the main European distressed opportunities according to Debtwire20 are expected in the UK, especially in the financial sector, swiftly followed by the German automotive industry and the Spanish construction industry.The consumer retail sector and chemical and media businesses will also offer great opportunities as indicated in a 2009 Debtwire survey.

All stakeholders in the distressed debt process are satisfied; the lender to the company can exit a particular situation and get back liquidity while allowing investors to expect a greater return on their investment. At a time where people see the crisis with a glass half empty perspective, one can also take the view it is half full, with great opportunities for investors with liquidity in a market exponentially growing.

The pillars of solid investments in a distressed market

When entering the distressed debt market, one should keep in mind a number of matters to be monitored so as to optimize profits and the effective tax rate during the holding period and upon disposal.

Beneficial ownership requirements

Although the international fiscal meaning of beneficial ownership still needs to be specified and harmonized, the concept is a clear line of defence used by countries against treaty shopping. Source countries are becoming more and more reluctant to grant relief or exemption merely on account of the status of the intermediate recipient of the income.

Therefore, when structuring the acquisition of debts at a trade price below par value, one should ensure that the investor in the recipient country will be viewed as the beneficial owner of the income by the tax authorities of the borrower’s source country. Otherwise, withholding tax or tax cost (i.e. on interest and possibly gains) imposed by the source country may negatively impact the expected returns on the investment.

An example of a recent challenge to beneficial ownership can be found in the 2006 U.K. Court of Appeal decision in the «Indofood » case22 according to which the ‘International fiscal meaning’ of beneficial ownership prevails against the ‘narrow technical’ domestic law meaning and the recipient must enjoy the full privilege to directly benefit from the income. Against this background, on 26th February 2009, the Canadian Federal Court of Appeal gave its decision in the case of Prévost Car Inc. v. Her Majesty the Queen (2009 FCA 57). It upheld the decision of the Tax Court of Canada and dismissed the tax authorities’ appeal on the interpretation of the term “beneficial ownership”.

The absence of harmonization of the meaning of beneficial ownership obliges investors to adopt a sensible and pragmatic approach when considering distressed debt acquisitions.

Tax charge on interest and gains

Monitoring the tax cost on interest income and gains in the event of recovery at a higher value while complying with the arm’s length principle is another key aspect of the structuring. Similarly, Controlled Foreign Company “CFC” rules need to be considered. Indeed, these aspects can dramatically impact the expected return on investments.

A crucial point to be dealt with is the interest differential that may arise from the financing of a distressed debt acquisition.The cost of financing a distressed debt should be significantly lower than the yield arising on the distressed debt itself since the yield on the debt payable will accrue on the basis of the discounted price (i.e. the amount required to fund the acquisition) whereas the yield on the distressed debt will accrue on the basis of its face value.

In addition, in respect of distressed real estate backed debt opportunities, it is important to implement a structure which delivers the expected commercial outcome while minimizing tax leakages that could arise notably upon exercise of the guarantee such as transfer tax or taxation in the country where the real estate is located (especially in the absence of a double tax treaty).

Accounting and auditing implications

The key aspect, from an accounting perspective, is to identify the features of the debt acquired so as to determine whether the investment will be viewed as a distressed debt or a discounted debt.

The accounting implications for both asset types differ significantly (e.g. in relation to profit recognition, recoverability , etc.). In a nutshell, distressed debts refer mainly to an instrument incorporating a counterparty risk whereas discounted debts relate chiefly to liquidity issues. Defining whether we are dealing with distressed versus deep discounted debts should be analysed on a case by case basis depending on the overview and characteristics of the transaction and instrument.

From an audit point of view the main issue that may arise relates to valuation criteria with a distressed debt being more difficult to value due to the high risk of default by the entity that holds the debt.

Liquidity & credit risk

Investing in distressed debt necessitates, more than in any other financial field, the implementation of an accurate, comprehensive risk management process. A broad variety of risk drivers is known to rule the dynamics of a structured vehicle investing in distressed debt, ultimately affecting its financial condition and viability.

VAT impact

Depending on the manner and conditions of acquisition, buying distressed debts may result in performing financing activities.This may categorise the company as a VAT taxpayer and may thus have different VAT consequences (e.g. a VAT registration obligation or reporting obligations).

Depending on the situation, it may result in a higher VAT cost just as it may result in an opportunity to reduce the VAT cost. Every situation should be carefully analysed in order to ensure that all VAT obligations are met and that the VAT situation is optimised.

Cash flows and flexibility

Access to liquidity is a key element in the current market conditions: investors are eager for cash. Investment structures allowing efficient and regular cash management and/or repatriation must be considered when distressed debt is not paid in kind. Finally, when designing investment structures one should keep in mind that it must remain adaptable to change and divestment in a moving market.

Investing through Luxembourg allows for a choice of various types of appropriate and tax efficient vehicles, such as a specialized Investment fund under the law dated 13th February 2007, securitization vehicles under the law dated 22nd March 2004 or even SoParFis with very significant flexibility as well as, to a certain extent investment companies in risk capital (SICARs) under the law of 15 June 2004.

Structuring investments in distressed debts requires a thorough understanding of the current market and expert knowledge of the appropriate acquisition vehicles. For many years Luxembourg’s financial expertise situated within the heart of Europe has offered many distressed debt acquisition structures thanks to its legal and tax framework. Moreover, Luxembourg has developed and adapted structures to comply with investors’ expectations and with a market which is constantly moving.

Customised structures exist to ensure the optimal global tax charge for each specific situation while ensuring comfort for the investors that the way in which the investment is executed will not be challenged by tax authorities.

The choice of the appropriate structure will depend on a number of features such as the size and the location of the target portfolio, the need for a regulated vehicle or the number of investors. It is essential to implement structures which deliver the desired commercial outcome and at the same time tax efficient returns.

Luxembourg is more than ready to offer investors expertise in structures for distressed debt acquisitions which are tailored to their specific individual needs.

Last Updated: 

Contacts

Name:
Raymond Krawczykowski
Company:
Deloitte Luxembourg
Job Title:
Partner - Tax Leader
Phone:
+352 451 452 500
Email
rkrawczykowski@deloitte.lu

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