The Middle East Distressed Debt Opportunity

International Financial Reporting Standard IFRS 9  was born out of the 2008 financial crisis, announced in 2014 it became mandatory as of January 1st 2018. With it comes a step-change in how companies report credit exposures which we believe will ultimately result in:

1. Increased secondary market loan activity
2. Greater transparency for investors

IFRS 9 is not restricted to financial institutions either. Firms are affected if they hold any of the following financial assets:

1. Debt instruments
2. Lease receivables
3. Trade receivables
4. Contracts assets (defined in IFRS 15)
5. Related party loans (a Middle East favorite)
6. Construction work in progress
7. Derivatives.

At the center of IFRS 9 is the Expected Credit Loss (ECL) model. It includes a requirement for forward-looking estimates on how credit exposures may evolve. The disclosure of these estimates will reflect the efficacy of management decision-making. The key point for banks in particular is that they must disclose anticipated losses over the life of an asset (loan), which even includes undrawn assets such as revolving credit facilities.

We believe IFRS 9 will have a significant impact on the Middle East for reasons that Deloitte highlights below.

Credit default is also viewed differently in the region—for instance, it is a known business practice not to charge interest on late payment, and equally common for debtors to delay payments for months. Related party loans are sometimes given at low or no interest charge, irrespective of the borrower’s financial credibility. IFRS 9 will require an impairment provisioning on such assets after taking into consideration the associated risks and the probability of default, including the time value of money related to delays. This requirement directly impacts the profit and loss statement and is likely to influence business decision-making in the future.

A recent article by the International Financing Review (IFR) reflects our expectations that changes in capital requirements for legacy assets on Middle East bank balance sheets will result in selling pressure.

… this will mean there will be some forced selling of assets. We anticipate that the Middle East will be a source of loans up for sale in the secondary market, particularly in the distressed space, where greater capital provision against expected credit losses could bring about the liquidation of portfolios which have been sitting on the books for years. – IFR.com

A PWC survey estimated that loan provisions at banks globally would rise between 25-50% from previous levels as a result of the accounting changes.

The IFR article goes further.

Middle Eastern banks have experienced deteriorating loan portfolios on the back of weak oil prices and the consequent feed-through to overall economic growth. At the same time, there is considerable concentration risk in loan books to single names and a limited number of sectors, mainly in property and construction. – IFR.com

Sector concentration is unlikely to improve. The Middle East continues to abstain from meaningful SME lending, whilst at the micro level retail and trading businesses face growing competition from global players, accelerated by technology-enabled price discovery and e-commerce. Furthermore, Government borrowing is set to increase, heightening the risk of crowding out the private sector. Selling loans may be the only palatable option for many banks in the Middle East.

At SC Lowy we have seen a lot more activity in distressed loans from the region, comprising legacy single name paper – although there is constant chatter about portfolio sales – ranging from Kuwaiti investment firms, Saudi Arabian bankruptcy claims on the big conglomerates, and Bahraini banks with exposure to Saudi risk. We have been very active this year in exposures trading from 5-95 cents. However, distressed trades at sub-25 cents have been a material part of that, as the IFRS 9 policy bites and banks look for liquidity. – IFR.com

It’s interesting to see foreign firms dominate the Middle East secondary loan market. This due to an under-developed local asset management industry, particularly groups with credit expertise. The recent failure of the Abraaj Group, although not big credit investors themselves, will likely hinder the ability of other credit investors to raise significant fresh capital.

The other dynamic in the market is that there are no ME-based funds dedicated to a strategy of distressed credit. We have more traction with local buyers in the performing or post-restructuring credits, but typically investors are international funds which have the bandwidth to invest outside their core markets and in the region. This creates increased sensitivity to the ‘technicals’ of the market and impact of changing yields elsewhere, for example the widening of global EM credit yields recently has changed the pricing dynamics locally as funds switch due to relative value.

Conclusion

In many ways little has changed since the last downturn of 2008/2009. Capital markets have developed somewhat in terms of public equity trading and index inclusion, but the credit plumbing has fallen behind.

Bank lending continues to be fraught with inefficiencies and unsavory risks. Lenders’ loan books are too concentrated. Related party lending poses continued governance problems. Local asset managers lack innovation (look how many Saudi IPO and REIT funds were launched in rapid succession) and significant scale (Total assets under management vs GDP remain paltry and the top handful of managers control over 90% of the total).

SMEs, the lifeblood of most successful economies, continue to be neglected. The other elephant in the room are the governments. They’ve gone from being huge depositors in the local banking system, to now being substantial borrowers, mopping up swathes of local liquidity.

Although IFRS 9 won’t address many of the above points, the additional transparency and “accountability” that it brings will introduce a more real-time assessment of credit quality and shine a light on how management perceive their own business. This will hopefully enable investors to make better decisions in choosing destinations for their capital. Time will tell.