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. Last Updated: 07/27/2016

Junkyard Bonds




Victor Huaco is not planning to join the crowd of people seeking a one way ticket out of Moscow. As locals and expats alike bail out of Russia's submerging economy, the Peruvian-born investment banker is putting to work the skills he honed in Latin America a decade ago in hopes that he can make his fortune by helping investors recover at least a portion of the huge sums invested.


An investment banker who once managed more than $300 million in overseas capital in Russia, Huaco says one lesson Latin America's crisis in the 1980s taught him is that many apparently "lost" investments are ultimately recoverable. He should know - when Mexico defaulted on its external debt in 1981, Huaco worked for U.S. bank Citicorp, managing its South American portfolio and later helping the bank collect on the debts it was owed by corporates in Brazil, Mexico and Venezuela. Astute recovery strategy helped Citicorp to not just recover its investment but to make a return on some of it - recouping as much as 120 cents to the dollar on some of the debts, according to Huaco.


But asset recovery is a murky business - the ultimate in back-room wheeling and dealing. Effectively, it's a zero sum game. If the debtors had enough money to satisfy all their debts, then they would probably either service their debts or negotiate openly with all their creditors. So those creditors who turn to asset recovery firms are stuck in a razor's edge race with other creditors to snap up whatever might be available of value.


Not surprisingly, most people in the business are reluctant to talk about the deals they have concluded or the companies on whose behalf they are acting, for fear of having a horde of creditors descend on the debtor company that has agreed to a settlement. "If you resolve a portion and the debtor has other debts outstanding it is probably not a good idea to publicize," said one recovery adviser, adding that this is why such transactions must be carried out before bankruptcy is initiated and a creditor hierarchy established.


Picking up on what he sees as the many parallels between the Russian and Latin American crises, Huaco last October set up a company called Russia/NIS Capital Recovery, or RCR, to broker deals between indebted Russian corporates and regions, and foreign creditors, anxious to get back even a fraction of their original investment. His co-founder, Sergei Vasiliyev, also has plenty of insight into the debt mountains that have crushed many a Russian business empire. Vasiliyev had been a deputy chairman at MFK Bank, an investment bank with strong ties to the Interros empire of Vladimir Potanin - now one of Russia's more spectacularly insolvent and indebted financial and industrial groups. MFK was the leading player on the market for agrobonds, the lowest of the low in all of Russian debt instruments.


A New Era Dawns?


Huaco is not the only one to latch on to the idea. As well as several other smaller concerns, the Big Five international accountancy firms are touting their international corporate recovery experience to distressed creditors. Brokerages that have seen investment flows dry up are also refocussing their energies on asset recovery.


"Asset recovery has become a focus point with us," says Michael Workman, vice president for fixed income at MFK Renaissance, a brokerage that has sent some of its traders to Asia to study asset recovery processes there.


With recovery advisers come vulture funds, companies that specialize in preying on distressed debt. All of which according to experts is setting the stage for a large-scale transfer of assets in Russia.


The debt default and ruble devaluation last August left many investors sitting on mountains of heavily discounted debt and wiped out at a stroke Russia's precarious banking empires. It was a depressing climax to a tumultuous five years that had seen over $100 billion channelled into Russia, much of it as debt and very little of it as direct investment.


"The investment era has ended and the recovery era is beginning," Huaco says. "I believe Russia will follow the same path as Latin America, where investors began to recover the value of their investments through directly negotiated deals via sales, swaps and workouts."


Huaco and Vasiliyev say that RCR is already working to recover debt worth close to $1 billion. So far the pair claims to have achieved returns ranging from 30 to 100 cents to the dollar. They cite their success in restructuring a $40 million loan for Russian diamond monopoly Alrosa, also known as Almazy Rossii Sakha, as their crowning achievement to date.


Meanwhile MFK Renaissance - once the largest brokerage in Moscow - has set up a group called MFK Renaissance Capital Recovery that also claims to have already effected several large recovery deals.


Digging Through Waste for Gold


Companies like RCR are quick to stress that they differ from the "security firms" specializing in debt collection "with extreme prejudice" that mushroomed after the financial crisis hit last August. Where security firms have a reputation for approaching negotiations with an air of menace, asset recovery companies take a softer, more patient approach. They seek to match creditors with people willing to buy out their debt, or help broker deals between creditors and debtors to restructure obligations or swap them for something else.


Recovery agents first identify people who hold debt, then seek a recovery mandate from the creditors. With that in place they can either try to find investors interested in acquiring distressed debt, or try to negotiate a payment rescheduling with the borrower. Payment is made on a success basis allowing the agent to retain a portion of recovered assets.


The quickest recovery method clearly is to sell the debt off at a discount to anyone who will buy it and a thriving under-the-counter market for cheap distressed debt has sprung up in Russia. But in many cases those buying the debt are the issuers themselves and some market players said that recovery agencies are often acting on behalf of issuers keen to buy back their debts at current low prices.


In recent weeks several Russian corporates and regions have paid their Eurobond coupons - after first announcing that they would likely be unable to service their debt. Analysts have said the issuers - which include MGTS, the Moscow City Telephone Network, Irkutskenergo and the Nizhny Novgorod region - could have been sending negative signals to the market to push prices down to allow them to retire the debt though a buyback. While this is not illegal, it is considered unethical and could affect the issuer's chances of raising money in future.


One corporate that did default on its Eurobond - Uneximbank, once Russia's fourth largest private bank - has said it is negotiating with a creditors' committee to issue alternative debt instruments with longer maturities. This, according to recovery agents, is likely to be the most widely used method among Russian corporates who are willing to pay their creditors.


The third option is to swap the debt either for equity stakes in the companies involved or for real estate or other assets.


"Ideally the creditor would like to get his money now, if that is not possible he would like to get it later and if that is not possible, he would be willing to take equity," said Geoffrey Townsend, partner for corporate restructuring at KPMG. "He would even be prepared to write off something so that he would be able to recover at least a part [of the debt]."


"You can either sell the assets at a heavy discount, or swap into another debt instrument which over time will give you a little more return than getting cash today or you can swap into an equity stake in a company which over five or seven years will allow you to recover a larger portion of your investment," Huaco said.


Debt for Sale


The prospect of higher returns sometime in the future is not likely to tempt many investors to hang around in Russia and most transactions represent sellouts by creditors who feel that a little something now is better than probably empty promise for higher returns at a later date.


This is especially true in the current conditions of chronic political and economic uncertainty. When it is hard to be sure what kind of Russia will exist after the middle of next year, taking a few cents on the dollar now could turn out to be a better decision than taking up offers of say 20 cents on the dollar from 2005 onward.


"Ultimately, everyone including obligers and creditors are holding out to see what the outcome of the elections will be," said Robert Devane, an independent investments adviser in Moscow. "This will be the single most important determinant as to how these creditor situations will be worked out."


The State Duma elections at the end of this year will show what kind of regime Russia is heading into, he added.


"The perception of country-specific risk has changed dramatically," said Alexander Tyomkin, manager of financial advisory services at PricewaterhouseCoopers. "Under the situation which has evolved since last August, foreign investors would be reluctant to enter into ownership of any Russian assets. ... The consideration that the assets are Russian is likely to outweigh financial considerations."


Dennis Smyslov, an economist with Global Fund Management - an investor that has sued the Russian government over treasury bill recovery - agreed. "At present, another redistribution of assets is going on in Russia," he said. "No one knows what will happen to the equity stakes that foreigners take in companies."


A case in point is oil company Yukos, where foreign banks received a 30 percent stake pledged against the company's defaulted syndicated loan for $256 million. Now, however, the foreigners' stakes may be diluted several times if Yukos can make stick a planned share issue to be placed with select offshore investors.


This could be where distressed debt investors come in. While the original holders were not professional holders of assets like real estate and did not plan to take on investments that would pay for themselves only after 10 years, the buyers of the debt are prepared to do so. "There are two different kinds of mindsets - a bond trader in London who does not want to bother about a building outside Moscow, must be matched with a person who has a longer term approach," MFK's Workman said.


But this method is still rare here and one London-based analyst with a bank that has outstanding debts in Russia, said he had hardly heard of any instances of a foreign company actually receiving property against debt. This option is moreover exercised only when the borrower's receivables and perspectives both preclude the possibility of a debt restructuring, he said adding: "People would love to own shares in Gazprom or even companies like Tatneft but no one is offering those."


Others, keen to recover their funds as soon as possible through methods that offer a reasonable level of reliability, have settled for taking commodities like timber and oil from the Russian side.


"This is the most common way of generating a recovery," MFK's Workman said.


Most debt is selling at deep discounts, with rates varying from company to company said Vasiliyev at RCR.


Investors holding certain kinds of securities are more likely to sell out rather than negotiate, with agrobonds a prime example. These bonds are changing hands at between 10 and 20 cents to the dollar, market players said. Vasiliyev admits that few foreigners are prepared to hang around to see what happens to the paper and are only too happy to dump it even at a discount.


So far, his company has worked with about $50 million worth of agrobonds issued by the Moscow region and the Chelyabinsk, Nizhny Novgorod and Saratov regional administrations. It is also negotiating a deal with the republic of Tatarstan.


Foreigners are believed to have held more than 50 percent of the agrobonds, paper that Russian regions issued to securitize their debts to the Finance Ministry against loans given to prop up farms. The bonds were worth some $830 million at then prevailing exchange rates. Even before the crisis broke, 90 percent of the regions had defaulted on the agrobonds, relegating them to junk bond status.


It is easy to question the prudence, or even the sanity of Western agrobond investors - analysts say the riskiness of the instruments was evident from the start.


Interestingly, MFK, where Vasiliyev was head of fixed income until recently, was the Finance Ministry's agent for the agrobond issue and has been accused of over-enthusiastically flogging the high risk paper to investors. But Vasiliyev does not see anything strange in going from selling the bonds to restructuring them.


"We do have a lot of contacts with the regions while others will have a hard time figuring out what to do," he said.


RCR is elusive on the issue of what it intends to do with the paper, and Vasiliyev says the bonds could either be resold, held to maturity or used in order to negotiate with the regions to swap the bonds against concrete assets.


Analysts believe this last option is more realistic than it sounds, especially if recovery agents enjoy close ties with regional administrations. The chance of swapping the paper is even greater if the governors have political ambitions, while others will likely to do some kind of restructuring effort when the time nears to go to the market again.


Scenting Blood


While buying out debt, recovery agents often work in tandem with so-called vulture funds, which pool the cash of risk-happy investors convinced that a big financial crash has created a big pile of cheap but essentially valuable assets to be snapped up. These investors, analysts say, are turning their attention from senior debt like sovereign Eurobonds - where spreads have tightened in recent weeks - further afield to even cheaper securities.


RCR for instance says it is in discussions with Western distressed debt investors interested in creating a pool of capital to invest in recovery transactions in Russia.


However, others said that distressed debt investors would do even better if they were to team up with a Russian partner.


A local company would likely find it easier than the foreign creditor to negotiate with the Russian debtor, said PricewaterhouseCoopers' Tyomkin. Second, the more the debt buyer is owed by the Russian side, the more clout he brings to the negotiating table.


"You have a greater participation in the company's restructuring and if it comes to liquidation, you have more chances of getting a piece of the company's assets," Tyomkin said.


Delayed Gratification


It may seem hard to believe right now, but many of the larger Russian companies will make an effort to pay off their debts in the very long term. These companies want to retain, or restore, their good name on international financial markets, but current straitened circumstances prevent them from paying creditors in the short to medium-term, analysts say. In such cases, rescheduling maturities is the best option. Ultimately, investors could end up getting better terms than under the original issue.


Under the Alrosa restructuring, for instance, the corporate issuer received an extended repayment schedule while creditors exchanged their ruble and dollar paper for a longer-term dollar instrument. Not only did this end their currency risk exposure, the new instrument is administered under English law and collateralized by the company's diamond export contracts.


But such methods only look attractive when the debtor has concrete assets, cash flows or exports to offer as collateral.


"What is done in these cases is to shift the risk from a standard default risk to the risk that the bondholders will somehow have to realize the assets or receivables if the issuer fails to deliver," said Arnab Das, a strategist at J.P. Morgan in London.


This method if successfully applied, would enhance the creditworthiness of the corporate and at the same time reduce the effective exposure of the bondholder, Das added.


Devilish Details


No one expected debt recovery to be a cakewalk but most of the people who have set up in the business are finding it harder than expected. The size of the task is daunting to say the absolute minimum. The amounts involved are several times more than the $16 billion or so that was at stake in South America, and the legal and technical complexities that are part of doing business in Russia make recovery transactions here an especially difficult task. The absolute lack of liquidity is forcing many investors to accept payments in kind even for their 10 cents to the dollar.


"Initially, people were aggressive in discussing restructuring proposals and there were high expectations but now most of them are very frustrated," Workman said. "Primarily, any successful transactions that have happened are based on relationships with Russian counterparties."


The best example are probably the agrobonds, which are being tackled by both MFK and by Sergei Vasiliyev at RCR.


Even with best efforts, just a fraction of the original investment is likely to be recouped and RCR's Vasiliyev puts the overall recoverable figure at about 20 percent for all sectors taken together. Workman named an absolute top rate of 35 percent.


The biggest thorn in creditors' flesh is Russia's banking system, which owes almost $4 billion in syndicated loans alone and most analysts believe these debts will have to be written off.


Banks which expect to survive, such as Alfa, Avtobank and Gazprombank are holding talks to reschedule maturities of their loans. Others are not answering their faxes or phones.


This is a no win situation for creditors, said an analyst with the Rating Financial Information Center. It is useless to try to seize banks' property because most property such as buildings or art is registered in the name of a company unaffiliated to the debtor bank, he said.


"Equity stakes in these banks are worthless because the banking sector's future here is practically nil," the analyst said. "Second, they will basically be getting access to empty shells as most of the assets have already been siphoned off."


Max Gutbrod, a securities attorney with Baker & McKenzie who worked in Brazil during the South American crisis, says the basic problem is that Russia is unprepared for the kind of recovery transactions that have happened in America or Asia.


"Latin American economies have functioned in more or less stable manner for almost 200 years while in Russia, the age is less than 10 years," Gutbrod said.


One of the biggest problems is likely to be the good faith of the Russian side, Gutbrod said citing asset stripping by banks.


"If someone has spent time and money on the debt restructuring process and the bank disappears in the meantime, the end result is nil," he said.


Others caution that many of the deals being brokered are of doubtful legality as they involve transferring assets from companies on the verge of insolvency. "In many cases it just boils down to asset stripping," Townsend of KPMG said. "In other countries they could end up going to jail."


Townsend explains that in case a company has managed to swap its debt for assets but is later pushed into bankruptcy the external administrator goes back a period of time to see what was done in preceding months and can institute proceedings if he manages to unwind any crooked deals. There is not however a track record for this in Russia as yet.


"On the whole these are positive processes but there have obviously been cases when one group of creditors has put itself on the list and muscled others out," said one economist. "If the process is not fully transparent or fair it could just end with the most powerful guy getting hold of the things."