You can find the article here: Prosperise Capital Eyes Structured Credit and Italian NPLs
Prosperise Capital currently runs circa USD 800 million in four strategies: liquid long/short corporate and structured credit; special situations credit; Italian non-performing loans (NPLs), and Italian real estate development. “Our DNA has always been in structured trades and special situations,” says CEO and CIO, Gennaro Pucci, who set up the firm with other partners of PVE Capital. Most of the PVE staff have remained at Prosperise’s London office, which has also made some senior hires.
On the liquid side, Prosperise, which has assumed PVE Capital’s investment mandates, focuses on structured credit, CDS and indices, rather than cash bonds. They can trade throughout the capital structure, including first loss equity, mezzanine and senior tranche of CLOs, CDOs, and other associated derivatives. In July 2020, selected structured credit was offering both yield pickup and lower default risk.
In illiquid credit, value is now returning to Italian NPLs, which are managed from a new Milan office. Positive structural changes since 2017 had increased pricing to levels that Pucci judged were too high to compensate for the complexities and uncertainties of the strategy. Long term value has now re-emerged due to the coronavirus crisis. While the pandemic is naturally likely to delay the recovery process this year, on a five year view the asset class has now repriced to levels that make it worthwhile revisiting for those targeting a mid to high teens gross IRR.
At the macro level, Pucci has for some time been prepared for economic stagnation. His view for some years has been that Europe would succumb to “Japanisation”. Arguably now the coronavirus crisis could bring the same outcome to other parts of the globe. He is however cautiously optimistic on Europe, viewing European policy initiatives as supportive – and arguing that “the European recovery fund could be a real ‘game changer’, shifting attention from the US to Europe”. The macro view is the first stage of Prosperise’s investment thesis, which then moves on to fundamentals and technicals.
Liquid credit and UCITS launch
Pucci, who traded structured credit for Commerzbank, and the world’s oldest bank, Monte dei Paschi de Siena, before becoming head of trading at Credaris and later setting up PVE Capital in 2009, likes structured credit because the credit risk is fundamentally good, based on the underlying assets and subordination providing a cushion. But structured credit is a technically driven market full of pitfalls for the unwary. Some funds have lost 30, 40, or even 50% over March and April 2020. The asset class does not always offer a good short term risk/reward profile so Pucci is patient in opportunistically waiting for good entry points. These tend to come after crises, including the GFC and the European sovereign debt crisis, and more recently the coronavirus crisis. “In late 2019, we had started reducing risk and building up cash reserves because yields on corporate CDOs were very low. Entering 2020, the early outbreak of Covid-19 in China and Italy made us cautious. But by March 2020, it was possible to find paper that had sold off down from 90% to 70% of face value, offering a yield of 8.5% for ‘BBB’ rated risk with 17% subordination. This opportunity did not last long: after the Federal Reserve announced it was buying ‘AAA’ rated paper, that underpinned the whole sector giving investors the confidence that they would be able to refinance. Within a few months, the yields had compressed down to 3.75% by June in a very swift recovery,” says Pucci.
Therefore, structured credit valuations in September 2020 are not likely to provide the triple digit returns that Pucci’s teams generated after the GFC – at Credaris – and after the European sovereign debt crisis – at PVE Capital, in a special situations account.
Nonetheless, structured credit remains relatively attractive. “It still offers a significant yield pickup relative to corporate debt of the same credit rating, and should also face lower default risk due to the structural subordination. Yield pickups could be as high as 300 or 400 basis points – for paper that has close to 20% subordination,” says Pucci.
His overall credit view is evenly balanced. Downgrades are creating a growing universe of formerly investment grade “fallen angels” and defaults are clearly expected to rise in this environment, but central banks are also providing considerable support for credit markets. Pucci is generally prepared to take on more junior risk for investment grade European credit, but will be biased towards senior tranches for high yield credit. The CDX and Itaxx investment grade and high yield credit indices, in the US and Europe, are an important part of the investment universe, as are credit default swaps (CDS) on the indices or on single names.
Some credit managers invest in their own CLOs. Prosperise does not manage CLOs, but Pucci selects them carefully: “we prefer CLOs with ‘tier one’ managers, who should be able to add value through active management of the names in the CLO”. Since Prosperise will sometimes have differences of opinion with CLO managers, Prosperise itself can also selectively hedge its CLO exposures with indices, single name CDS or options. “We can pick up enough spread to use half of the yield for protection through short or option positions,” says Pucci. However, he is not inclined to do relative value trading within or between different CLOs, because the bid/offer spreads of 2-3 points are too wide.
The strategy will rotate around trade types according to the opportunity set for credit and volatility markets. “In a more benign credit environment, the initial yield on a CLO can be enhanced by the roll down that arises from an upward sloping credit yield curve. In mid-2020, the curve is flat or inverted so roll down is not so relevant. And if implied volatility comes down, a convexity strategy using tranches and options could also start to look interesting,” explains Pucci.
A UCITS is being set up because many investors prefer the structure. Prosperise has obtained Luxembourg CSSF approval for a UCITS version of the Pearl Vega strategy, which should launch in September 2020. The Long/Short Credit Enhanced UCITS targets returns of 7-10% with volatility of 4-5%, from a varied blend of carry, market neutral and convexity strategies in European and US credit.
The UCITS would not be able to carry out some more exotic trades, including non-publicly traded securities, level 3 assets, short cash bonds, and bespoke CDO/CSO tranches, that can be pursued by the Pearl Vega strategy, but Pucci is not currently finding much opportunity in those areas. PVE Capital also previously managed a UCITS fund, the PVE Credit Value Fund, which won The Hedge Fund Journal’s 2015 and 2016 UCITS Hedge performance award for Best Performing Credit Fund.
In Italian NPLs, Prosperise has so far launched three closed end funds for US and European investors, including pension funds, endowments, family offices and foundations. The loans are held in special purpose vehicles under Bank of Italy Law 130 SPV. The three vehicles have a gross book value around EUR 600 million. Prosperise has set up a local office in Milan, with a team made up of general manager Guido Rossi, a CFO/COO and two lawyers. Rossi was head of Deutsche Bank’s investment banking arm in Italy, and its credit recovery business. He has been involved in creating SPVs to acquire NPLs since 2007, which arose from Deutsche Bank itself granting mortgages.
The Italian team acquire and value distressed assets, handle legal matters, control recoveries, and sometimes identify investors and tenants. Prosperise has recently re-entered the distressed loans market, having last acquired Italian NPLs back in 2015-2016; in 2015 it was one of the largest buyers of secured NPLs in the market. In 2017-2019, prices increased due to positive structural developments. “A big moment came when the government stepped in to guarantee senior tranches of securitisations. It then became possible to do a securitization 70% guaranteed by the government, and some banks stopped selling the loans to hedge funds,” says Pucci. The Guarantee on Securitisation of Bank Non-Performing Loans (GACS) insurance scheme, which started in February 2016, guarantees principal and interest on senior notes in NPL securitisations. “Potential IRR forecasts came down to around 4%, which is not the right price when you can buy a more liquid, single ‘B’ CLO yielding 8% and avoid the difficulty of judicial proceedings,” says Pucci.
The coronavirus crisis is now leading to more supply in the market. “The fact that some banks may now be forced sellers is improving pricing,” says Pucci. This is reducing loan pricing to levels consistent with Prosperise’s return targets. “Our pricing is based on discounting at a 17% IRR, over seven years. This is conservative when the average foreclosure had taken 5 years. A gross IRR of 17% before fees could translate into a net IRR for investors of 12% after management fees, commissions, and servicers’ fees,” says Rossi.
Prosperise is active in the “Bad Loans” rather than the “Unlikely to Pay” category, which would require restructuring and is more sought after by private equity firms. Loans emanating from bankruptcies could have both secured and unsecured liens, but Prosperise always buys loans that are secured on property. It also selects single loans backed by specific collateral, and mainly acquires in the primary market, to avoid the “adverse selection” risk in the secondary market. “You do not know how the pool was set up, so you may get low quality. You have to be very careful in calculating the price, assets and cashflows to noteholders. Servicers may have already sold the best loans, so you could be left with the tail end of loans. We might have historically paid 5-10% of gross book value for secondary loans but 30-40% for primary purchases. Now post-Covid, even prices in the primary market can go down substantially,” says Rossi.
This may seem low, but outside Milan, Prosperise are underwriting to much lower expected sales prices and cashflows. In some cases, estimated sale prices have been cut by 40-50%. But there could also be hidden gems. One anomaly that Prosperise can exploit is that appraisal prices based on averages for a town do not consider unique features of a property.
Loan servicer selection
Selecting a good servicer is an important part of the strategy. “The servicing market has been consolidating in Italy since 2010, in order to use economies of scale to reduce prices. However, margins have dropped and some servicers are under-staffed, which has reduced the quality of servicing. Servicers are required to correctly calculate 20 years of mortgage interest in accordance with usury laws, and some of them have made errors in doing so. They have also made more simple errors, omitting to pay court fees before deadlines, which resulted in foreclosure proceedings being cancelled,” explains Rossi.
“Many servicers have so many loans that they cannot devote enough attention to each one. Therefore, some private equity funds decided to set up their own, captive servicing companies, to service their own loans, and then extended the offering to third party funds. Prosperise has relationships with several servicers as well as set its own,” says Rossi.
Very few of the loans Prosperise has acquired are monetized through the borrowers making a discounted repayment, and even fewer are resolved through a voluntary sale of property. Prosperise nearly always has to go through a judicial resolution process to repossess property. Here, Pucci, “expects to make lower recoveries in 2020, because tribunals have been closed for part of the year and upon reopening they need to work through a long backlog of cases. Once this is done, it is possible that a new 2019 law on credit recovery for mortgages could speed up foreclosures, which have taken an average of seven years”.
After foreclosure, the process forks off into two routes. Some 80% of properties are sold through public auctions, which in Italy reduce selling prices by up to 25% after each unsuccessful auction. But creating a real estate company to acquire properties can remove the need to sell at auction – and allow for value creation strategies.
Active legal management
Active involvement is needed to expedite recoveries – both for the auction and the real estate management avenues. For instance, thorough legal work may reveal that a borrower is trying to acquire their property at a discounted price, under another identity. Or searches may reveal that guarantors have other properties that could be used to enforce personal guarantees, effectively transforming an unsecured loan into a secured one.
Renovation and repurposing
More complex workout strategies make use of local know-how, which is one area where Prosperise has an edge over purely financial investors. “Most loan servicers do not have the time or skill to negotiate a joint venture with a local property developer,” says Rossi.
Prosperise and its partners might refurbish and renovate buildings that have in some cases been abandoned for a decade or more. Prosperise can also repurpose properties. “For instance, a hotel could be turned into a residential development with parking, a restaurant, and some community amenities to secure planning permission. It may be more profitable to keep running a business, such as a healthcare centre, as a going concern rather than liquidating it. In one case the value of a clinic was doubled by keeping it in its original use with a license to treat the elderly. This has also salvaged a line of credit. A 120 room hotel near Rome was repurposed as student housing, which could increase its value from hundreds of thousands to millions,” says Rossi.
Longer term, securitization could also be an exit route for some of Prosperise’s loans.