The onset of the financial crisis, and the subsequent double dip recession triggered a collapse in credit quality as excessive leverage and weak profitability among Italian corporates and SMEs caused bank loans to sour. The situation in Italy was exacerbated by the unique structure of its system. More than half of the sector consists of mutual or cooperative banks that have strong ties to the local communities in which they operate. This strong connection with clients, coupled with poor underwriting, led to a sharp ramp up in lending prior to the financial crisis. The subsequent losses in these portfolios were compounded by excessive red-tape and a weak and inefficient judicial system that made it difficult to collect loans or seize the collateral underpinning those portfolios.
The NPL crisis peaked last year, as fears began to mount that the rising losses could trigger a spate of bank failures including Monte Dei Paschi (MPS) and maybe even the banking giant, UniCredit. With confidence in the sector crumbling, liquidity pressures spiked as depositors fled the weakest banks for fear they could also lose money if their bank failed. As a number of banks edged towards failure, share prices plummeted to deeply distressed levels.
Finding the right contrarian opportunity
We sensed there was a contrarian investment opportunity amidst this crisis, but struggled to put a floor on the downside of the banks. Investors were focused mainly on MPS and UniCredit – both had massive NPL portfolios and needed to raise capital. Both teams were under enormous pressure to convince investors that they could turn around the fortunes of their banks. In the end MPS shareholders were wiped out while UniCredit shares recovered. While MPS potentially had more upside at the time (given its very distressed valuation), UniCredit ultimately had the more credible business plan with more levers to pull and assets to sell.
We steered clear of investing directly in the banks, but we did find two very interesting opportunities to play the recovery without taking on the same risks: Eurocastle and Anima.
Eurocastle: tapping the €300bn NPL opportunity
In our view, the Italian NPL crisis was an ideal hunting ground for debt purchasers and loan servicers. The market was full of distressed sellers of NPLs and the €300bn mountain of NPLs would have to be serviced and cleared one way or another.
We saw two clear opportunities in this area for Eurocastle. Firstly, its investment in doBank was materially undervalued in our opinion. Around 40% of Eurocastle’s NAV consisted of its investment in doBank. doBank is the leading NPL servicer in the market with c€80bn of NPLs being managed on behalf of some key clients including UniCredit, Intesa and Fortress. The over €300bn stock of NPLs in the market still needs to be addressed, and we believe the independent servicers will play a key part. In July 2017, doBank was IPO’d valuing Eurocastle’s stake at €350m and the doBank shares have since appreciated another 20 per cent. We continue to see the long-term potential in doBank, and therefore participated directly in the IPO.
The second opportunity for Eurocastle is investing directly in Italian NPLs and distressed real estate. Eurocastle’s manager, Fortress, has been successfully investing in the Italian NPL market for several years. This has enabled it to build a strong platform for pricing, acquiring and managing NPLs including the plan, named FINO, to re-organise UniCredit’s NPLs. By investing in Eurocastle, we obtained exposure to a recovery in the Italian banking system but without the risks associated with investing directly in a bank.
Anima: a play on MPS but without the risk
Anima is the leading independent asset manager in Italy. Its distribution is primarily through its network of partner banks, including MPS and Banco Popolare Milano (BPM). Anima’s shares had been sold off on fears that the AUM sourced through the MPS and BPM networks were at risk. After careful analysis, we concluded that the share price was broadly pricing in the very worst-case scenario. We struggled to see this scenario panning out, even in the event MPS failed and needed restructuring. As we were able to put a floor on the downside, we felt more comfortable investing in Anima with the upside gearing coming from a stabilisation in the situations of MPS and BPM.
In the space of nine months, sentiment towards Anima has moved from fearing a worst-case scenario of losing its major distributors to trying to price in the upside opportunities from Anima fully penetrating the giant distribution networks of Poste Italiane, BAMI and a restructured MPS. Following the acquisition of Aletti, Anima will now have unparalleled distribution in Italy, with access to more than 4500 branches focused in some of richest parts of the country.
Pras Jeyanandhan is senior investment analyst at SYZ Asset Management