Regulatory pressure and the high cost of capital are driving a radical change of asset ownership in Europe. But most banks could take years to sell their non-core assets.

When UniCredit’s share price was laid low by its rights issue in January 2012, there was a growing expectation that asset sales would have to account for most of the €115bn capital shortfall that the European Banking Authority (EBA) asked banks to fill by the end of June 2012.  

However, in February 2012, the EBA published a report showing that in the plans submitted by banks, only 7% of the required recapitalisation would come through asset disposals. A further 3% would be from deleveraging, of which 2% was in any case mandated under restructuring plans approved by the European Commission for banks that had received state aid.

It remains to be seen whether banks can successfully execute the other components of recapitalisation. But the EBA’s analysis seems to coincide with the experience of market participants.

No deluge

“When the EBA first announced its requirements, financial advisors were warning law firms about the deluge of merger and acquisition [M&A] activity and asset sales that was about to happen. But we are not seeing every bank on the street trying to sell their portfolios, and it now seems unlikely to happen by July given that there is typically a lead time of several months on such deals,” says Charles Roberts, a partner in the finance team of law firm Paul Hastings in London.

The European Central Bank's (ECB's) long-term refinancing operation (LTRO) commenced in December 2011 is widely credited with helping to avoid the deluge. While it has not removed the capital pressures imposed by the EBA, or Basel III further down the line, it has given a three-year financing window for shrinking balance sheets.

That reduces the risk of a broad firesale, which looked a real possibility in the final quarter of 2011 as bank funding all but dried up. However, banks still need to use the breathing space to carry out a strategic rethink.

“With a handful of exceptions, most banks are not earning their cost of capital and this is forcing a fundamental overhaul of their business model. European banks are facing a choice between immediate deleveraging and the consequential impact on core capital by selling now, or continuing to fund these assets with a negative carry,” says Siddharth Prasad, head of European, Middle East and Africa (EMEA) financial institutions group (FIG) finance at Nomura.

And governments now look like long-term players in bank strategy. In some cases such as Ireland, the UK’s RBS and Lloyds, Germany’s Commerzbank and landesbanken and the Spanish cajas, this is through direct government assistance. But even where governments are not major investors, they are still often pressuring banks to focus on home markets.

Where to sell

There is much debate about whether and how banks should exit from the most troubled economies at the periphery of the eurozone. Those banks most exposed are also most capital-constrained, so they cannot afford to sell periphery assets unless they are already marked to market – which is rare. Ben Davey, head of EMEA FIG investment banking at Barclays Capital in London, says the LTRO may have pushed out the timeline on sales of distressed assets generally.

“Most banks are likely to re-evaluate strategies for distressed assets, because the ECB’s stable line of funding allows them to work these assets out over a sensible timeframe. They need to take a hands-on approach to the individual credits, to work out which loans will never pay, and which can pay but need partial restructuring,” he says.

Stronger banks might be in a position to move first on asset sales. They would have good reason to do so, says Nils Melngailis, a co-head of the EMEA financial services team at turnaround advisory firm Alvarez & Marsal who has advised on financial sector restructuring in Ireland and now Greece.

“For larger international banks that are exposed to very high-profile economies, they might be ready to get out of these investments even at a loss, simply to cap their losses and to announce that they are no longer exposed to a highly distressed market,” he says.

In central and eastern Europe (CEE), subsidiary sales are already a reality. Many CEE banking sectors had foreign ownership shares well over 50% – sometimes more than 90% – but these subsidiaries are often small compared with the size of the parent.

Real estate dominates debt trading at the moment; mainly commercial real estate, but also some residential and multi-family developments in Spain and Ireland

Kingsley Greenland

Banks that received government assistance, such as KBC, Commerzbank, Volksbank and Hypo Group Alpe Adria, have all agreed to sell CEE subsidiaries in order to meet EU state aid rules. Healthy banks active in the region, such as Erste Group Bank and Raiffeisen Zentralbank, have emphasised their intention to keep their geographic footprint. But they have flagged that there will be some business disposals (up to €600m in the case of Raiffeisen) to meet their EBA capital requirements.

Meet the new boss

Selling larger subsidiaries or networks is no easy task. Austria’s Volksbank sold its CEE network, Volksbank International (VBI), to Russia’s Sberbank in 2011. But the deal apparently repriced downward several times before closing, and Sberbank rejected VBI’s Romanian operation due to asset quality fears.

Horst Ebhardt, M&A partner at Austrian law firm Wolf Theiss, says any easing of the eurozone crisis may encourage strategic buyers from Russia, the US and China to put money to work. The CEE region is still underpenetrated, with bank assets that average 40% of gross domestic product. Mr Melngailis also believes that the current retrenchment by western European banks offers a unique opportunity over the next 18 months or so for private equity buyers to move to CEE.

“They can go in now, build up a banking platform over the next two to three years and sell it back to a strategic player in the next upturn. It is a market that you cannot ignore, it is on western Europe’s doorstep, and in many cases bank balance sheets are arguably more transparent than those in western Europe,” he says.

Some funds have already taken the plunge. UK-based AnaCap Financial Partners became the first private equity firm to buy out a UK deposit-taking bank in 2009, which it transformed into specialist small and medium-sized enterprise (SME) lender Aldemore. In 2011, it bought the Czech subsidiary of Italy’s Banco Popolare and renamed it Equa Bank, with a focus on direct channel retail banking.

TBIF, the financial services arm of Dutch-Israeli-listed investment vehicle Kardan, bought the Bulgarian subsidiary of Slovenia’s loss-making Nova Ljubljanska Banka in 2011. TBIF chief executive Ariel Hasson says the stagnation of existing bank balance sheets during the downturn helps to lower the execution risk for a new entrant.

“You need time to extract synergies from operations and change the business focus of a new acquisition. Right now, we can work on the infrastructure of the bank knowing that we are not missing out on market share in a boom,” he says.

Refinance option

But the eurozone is not the only complication. Mr Hasson says many cross-border banking groups have retained goodwill value against their CEE subsidiaries, and may be unwilling to take significant write-downs on this to sell up.

“Parent bank financing exposure is often larger than their total equity exposure in the subsidiary, and they expect the buyer to refinance the parent bank in any transaction,” he adds.

The ECB LTRO will offer a way for non-banks to refinance new acquisitions inside the eurozone, but that still excludes countries that have not joined the euro. And liquidity problems can cut both ways.

“Some subsidiaries had liquidity gaps, but in other cases surplus local liquidity was centrally managed to the parent bank, which has created central bank concerns about potential systemic risk. We are comfortable taking macro and entrepreneurial risks, but we need liquidity and legacy asset risks to be resolved before making an acquisition,” says Fabrizio Cesario, partner in charge of M&A at AnaCap.

As Mr Cesario points out, regulators are closely watching these transactions. Mr Hasson says the path to TBIF’s acquisition in Bulgaria was smoothed by a supervisory relationship cemented by the firm’s existing leasing and consumer loans businesses there. Erik Berglof, chief economist at the European Bank for Reconstruction and Development, has acted as something of an interlocutor between private and official sectors in the region.

“There is no particular optimal ownership structure in these banking systems. What matters is how banks are run, regulated and supervised. On that basis, private equity ownership is not a bad transitional arrangement, but it may not be such a good model for the long-term,” says Mr Berglof.

That view seems to be echoed by local CEE regulators. Nikola Babic, a Belgrade-based lawyer with Austrian firm Schoenherr, says the Serbian authorities have tended to raise difficulties for investments of more than 5% of a bank’s capital by private equity firms.

“The National Bank of Serbia requires a minimum of three years' existence and co-operation with a home supervisor to grant permission to invest in a Serbian bank. This does not work with a private equity fund that has a five-year horizon in which to invest its money,” he says.

Assets without capital

Further west, regulators may be more familiar with private equity. But the moving target on regulatory capital requirements poses a challenge for a fund-based investor with finite amounts to put into a transaction, and high rate of return expectations.

“Since banks have high operational leverage, our buyouts typically have less than 1% financial leverage, the rest is fully equity funded. And we are an operationally engaged investor, so we have more than 20 core staff in our private equity division, which is larger than a traditional private equity model,” says Mr Cesario.

The track record of major private equity acquisitions of European banks is not reassuring. JC Flowers was forced to place the ownership trust that held its stake in Germany’s HSH Nordbank – acquired in 2006 – into bankruptcy in 2010 and seek state aid for a recapitalisation of the bank. Lone Star bought distressed German bank IKB in 2008, but announced in October 2010 that it was seeking a new buyer, with a question mark over funding once state liquidity guarantees run out in 2012.

Stephen Campbell, global head of FIG advisory at investment bank Lazard, says even non-European strategic buyers are now more interested in capital-light businesses such as asset management or financial technology subsidiaries. There is far less balance sheet and regulatory complexity to price into such deals.

Dutch bank ING sold its European and Asian real estate investment manager, ING REIM, to specialist real estate firm CBRE Global Investors in February 2011. Deutsche Bank has begun a sale process for its non-German asset management businesses, including alternative and real estate asset manager Rreef. These deals make sense for sellers as well as buyers, says Mr Davey.

“The multiples that these businesses are attracting are still relatively sensible. If they do the deal properly, the bank can retain a valuable product distribution agreement, so that they maintain a forward flow of revenues without owning the asset,” he says.

Running from real estate

However, selling uncapitalised business units is no substitute for shrinking the capital-intensive parts of the bank balance sheet. Certain portfolios are particularly difficult for banks because of asset quality, the duration of financing required, or new regulatory treatment. Commercial real estate (CRE) falls into both of the first two categories.

“Real estate dominates debt trading at the moment; mainly commercial real estate, but also some residential and multi-family developments in Spain and Ireland,” says Kingsley Greenland, the chief executive of the largest independent sell-side debt trading platform, DebtX, which has a contract with Ireland’s National Asset Management Agency (NAMA).

In central and eastern Europe, market participants say Erste and Raiffeisen are both seeking buyers for CRE loan portfolios, although neither has publicly announced any sales. Erste chief executive Andreas Treichl acknowledges that CEE commercial real estate “is struggling to find an appropriate price level. The feeling in the financial community is that we have enough of this exposure on our books, we have no appetite for further financing.”

Nassar Hussain, the managing partner of Europe’s most active CRE restructuring advisors, Brookland Partners, says delinquencies on balance sheet lending to CRE across Europe are about double those on commercial mortgage-backed securities. But the CRE bank debt market has very little transparency. Banks in continental Europe have historically not marked CRE debt to market except where there is a cash-flow default. In other cases, they may suffer a capital loss in the event of a sale.

Even so, Société Générale sold a CRE portfolio to Australia’s Macquarie in late 2011. And accounting has been more rigorous in the UK, allowing a more active process of divestment. Lloyds sold its Project Royal CRE portfolio to distressed debt fund Lone Star in 2011. Although private equity firm Cerberus apparently offered a better price, it also needed partial financing which could have delayed the sale.

By contrast, RBS has chosen to sell only 25% of its Project Isobel CRE portfolio to Blackstone’s real estate management arm. A bank financing syndicate fell through, but the China Investment Corporation provided part of the equity. Mr Hussain says this gives RBS the opportunity to replicate the deal with other parts of its portfolio, selling to a sovereign wealth investor that has lower return requirements than a typical leveraged buyer.

Shadow banks emerging

With so many banks dropping out of the market, non-bank investors will be crucial for refinancing commercial real estate. US funds are the leading players, with Kennedy Wilson opening a European arm in mid-2011 and buying a UK portfolio from Bank of Ireland. CBRE Global Investors is contemplating offering a European debt fund – it already invests in CRE debt in the US.

“Insurers are looking at funding real estate debt, which fits well with Solvency II regulations. Senior loans originated by the banks are becoming popular with investors because they have a good risk/return profile. That partly solves the European banks’ problem, and meets investor demand for an indirect route into real estate,” says Pieter Hendrikse, head of EMEA for CBRE Global Investors.

But he urges new debt investors to avoid the mistakes made by some of the banks during the boom years, which accumulated large CRE loan portfolios without building the expertise to manage their relationship with developers and equity providers. Banks will need to consider more than just sale price.

“The modus operandi of distressed real estate funds is typically to sell-on to third parties, or to complete a discounted pay-off with the borrower, or to enforce and try to get control of the assets. They have higher return requirements than the banks and some of them can be aggressive servicers of loans which can upset borrowers. Banks should think carefully about which loans they sell in any portfolio and the nature of the buyer,” says Brookland’s Mr Hussain.

There are similar questions facing would-be buyers of other debt portfolios. AnaCap has created two debt-buying funds, which head of credit opportunities Justin Sulger says were a natural build-out from their private equity acquisitions in the financial services sector. He says banks have tended to start with sales of assets that have higher capital requirements against them, such as unsecured consumer and SME loan portfolios, particularly in European markets outside their home country.

“Reputational issues are very important, especially if the bank is selling a portfolio of performing assets originated from good paying customers. We have the experience of building banks and regulatory relationships around Europe,” says Mr Sulger.

Relationship breakdown

But AnaCap may be something of an exception. Even with non-European trade buyers, such as Japan’s Sumitomo, which acquired an aviation leasing business from RBS and a project finance portfolio from Bank of Ireland, relationship banking may not be on the agenda.

One investment banker sees little sign that non-European buyers are looking for a European client base. They are instead looking for an asset that has cash flows which are easy to model, and where they can make use of their funding advantages over the European banks.

"In particular, the recent vulnerability of dollar funding for European banks means cross-currency portfolios such as project finance are far easier for US or Asian banks to digest," says Lazard's Mr Campbell.

Perhaps the best prospects for business continuity lie with the tiny group of European strategic buyers, mostly from the UK – banks that are new, or second-tier players that came through the crisis well. Virgin Money is expected to bulk up further after acquiring Northern Rock, Nationwide has been buying UK mortgage portfolios, and the Co-operative Bank bought Lloyds’ Project Verde non-core branch network.

Mr Melngailis notes that the near-universal nature of deleveraging at least creates one advantage for sellers. They have less to fear about losing quality staff or clients unintentionally from non-core divisions before sale, because there are so few competitors looking to expand.


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