country focus
In search of higher yield, global investors are looking at distressed debt
Brazil
As the market matures and grows, asset managers are pursuing varied strategies and specializing in different categories of corporate andconsumer debt
By Rodrigo Amaral
As it tends to happen these days, a Brazilian businessman used his Facebook account to boast of an enjoyable holiday on his pleasure boat. A fatal mistake it was. The photo showed the name of the boat, and investigators took advantage of the clue to uncover that the boat was registered by an offshore company. Interrogations with staff members of the marina where the vessel was harboured made sure that the actual owner was the businessman, who was highly indebted at the time. Legal action was then pursued to impound the property to pay the debt.
The episode may sound like a sting by tax authorities or the federal police, but it was part of the daily routine at Jive Asset Management, one of the main players in Brazil’s fast-growing distressed debt market. Founded eight years ago with the Lehman Brother’s remaining assets in Brazil, Jive acquires a variety of consumer and corporate distressed debt.
The market for distressed debt isn’t new in Brazil. Years of easy credit followed by a severe economic recession from 2014 to 2016, left individuals, companies and local governments strapped for cash and unable to pay off their debt. Many defaulted.
At the end of June 2.37% of corporate bank loans were classified as 90 days or more overdue, compared to 1.83% before the recession, according to the central bank. Total non-performing loans, including consumer credit, was almost 3%. Meanwhile, Chapter 11 filings stood at 1,408 at the end of 2018, up almost 40% in five years. And the debt picture could deteriorate further as the Brazilian economy slows.
Traditionally, a relative handful of seasoned risk-takers participated in the distressed debt market Buying up bad loans is never a sure thing. It can take years for an investment in to pay off—if ever. But as interest rates around the world have fallen, so too has interest in distressed debt as investors chase higher yields and greater diversification.
“We are now beginning to look at opportunities to set up partnerships with international players who know the distressed debt market, but are not experts in Brazilâ€
Arlos Catraio, partner, BrD
Guilherme Ferreira, the managing partner and CEO at Jive, also points to the potential returns.
Asset managers report growing interest from family offices and high-net-worth individuals willing to fork over the minimum R$1 million required by the Brazilian law for this kind of investment. And it’s not just Brazilian investors who see opportunity. American pension funds, as well as North American and European distressed debt funds, real estate investors and wealth managers are also getting into the game, according to asset managers.
“Our R$1 billion Bullseye Fund, which only has American investors, is our biggest and most profitable fund,†says Rafael Fritsch, the CIO of Distressed Credit Funds at Canvas Capital. “We have also created other funds for American investors that are in the investment period.â€
The number of funds that invest in distressed debt climbed to 355 in 2018 from 300 in 2017, and assets under management went from R$34.6 billion to R$45 billion, according to Uqbar, a research firm. Jive’s Ferreira says his company was able to raise R$ 1.8 billion for its latest distressed debt fund in 2018. Three years earlier, it could only attract R$ 500 million.
Asset managers say interest continues to grow. Ferreira says Jive’s second distressed debt fund, which closed last year, is already 60% invested. And he talks about raising additional capital in 2020, rather than 2021 as the company had planned.
“This new growth phase started in 2017, accelerated in 2018 and continues to gain pace,†Ferreira says. “Companies that raised capital in 2015 and 2016 were able to allocate it all. In 2018, which was a year when most funds raised new money, it was possible to get four or five times as much capital as before.â€
Asset managers expect new opportunities to emerge as Brazilian companies and banks deal with the hangover of the borrowing binge that took place before the economy entered in recession. The continuing fallout from the Car Wash corruption investigation is also contributing to the pool of distressed debt. Several large companies such as Odebrecht and Oi have defaulted on their debt, as well as myriad small and medium firms that were part of their supply chains.
At the same time, Brazil’s five biggest banks, Itaú, Banco do Brasil, Bradesco, Santander and Caixa, which dominate the credit sector, are feeling more inclined to dump their portfolios of non-performing loans in order to benefit from tax accounting rules and improve their capital reserves.
“Nowadays, most financial institutions that have non-performing loans consider the possibility of selling them to third parties,†says Marcio Fujita, a partner at São Paulo-based asset manager BrD.
As the number of opportunities has multiplied, asset managers have begun to segment the market into different categories and develop strategies to handle different kinds of distressed debt. Big banks have created or purchased companies to spin off portfolios of consumer loans.
Other players focus on narrower niches. BrD, for instance, specializes in corporate debt between R$ 1 million and R$ 50 million, particularly from companies in the agribusiness industry. The firm also likes situations where foreign players are owned money from their Brazilian business partners. BrD has been in the market since 2010 and the volume of debt owned by the firm has increased by 50% a year, says partner Carlos Catraio.
“We are now beginning to look at opportunities to set up partnerships with international players who know the distressed debt market, but are not experts in Brazil,†Catraio says. As of today, BrD invests its own capital, with a small participation of domestic investors.
Canvas Capital manages distressed debt for US institutional investors. Fritsch says international investors are particularly suited to participate in these investments.
“It takes at least four years to recover the money in a distressed debt situation in Brazil. In Europe, it takes one or two years,†Fritsch says. “US institutional investors are used to these products and have the required patience to wait for them to pay off.â€
Legal claims are another category gaining popularity among investors. They have a high probability to be paid once a final determination is made by the courts, says Guilherme Scaf, a partner at São Paulo-based Quadra Capital, one of the newest comers in the market, with almost R$ 1 billion in assets under management. The firm focuses on legal actions against the federal and local governments, he says, with most of the firm’s investors based abroad
“Litigation finance funds have become common in the United States,†Scaf says. “The market for legal claims is very large in Brazil, amounting to several billion reais.â€
“Litigation finance funds have become common in the United States. The market for legal claims is very large in Brazil, amounting to several billion reaisâ€
Guilherme Scaf, partner, Quadra Capital
In another sign of specialization, Amaury Fonseca Jr, the founding partner at Vision Brazil, says his group is targeting money that was collected by the government’s Fundo de Compensação de Variações Salariais (FCVS) that was collected from the 1960s through the 1980s.
At the time, Brazil went through periods of high inflation and trade unions negotiated with companies and the government periodic wage increases to keep pace. Mortgage loan payments were also adjusted for inflation. But the increases often fell below inflation. The FCVS fund, which collected fees on mortgage loan payments, made up the difference. Eventually, the adjustments stopped, but the money collected was never returned to homeowners.
There are several ways investment funds cash out of distressed debt. Sometimes companies exchange the debt for equity, so that they can influence turnaround efforts by participating in the management of the debtor almost as a private equity company.
Swapping old debt for new is also often an option, as it is taking physical assets to repay as much as of the money owned as possible. Catraio recalls a case where BrD ended up with 15 cranes out of 20 purchased by a mid-sized logistic company that had borrowed heavily in the hopes that Brazil would go through an export and import boom. The cranes were later resold to other companies or disassembled to be traded as spare parts.
And it can also mean engaging into sleuth work to spot tricks played by debtors to protect their assets while defaulting on their loans. “We look for any shred of evident about assets owned by our debtors, including people related to the debtor, as they can be used to hide assets under their names,†Ferreira says.
