Why Victor Khosla Sees a Major Opportunity in Europe

Global distressed-debt specialist Victor Khosla is putting about 60% of his firm’s assets in northern Europe. Why?

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Victor Khosla became a successful distressed-debt investor by taking advantage of opportunities all over the world. In the past four years, the Greenwich, Conn.–based fund manager has been spending one week a month in Europe, which tells you something about where he thinks the world’s best opportunities lie.

“Europe is experiencing its first true distressed-debt cycle in 25 years. It is only two quarters out of a recession, after having had another crisis in 2011, and the European commercial banks are finally selling their debt,” says the creator of the Strategic Value Restructuring fund.

Some large institutions offer their troubled loans directly to his hedge fund rather than going through brokers, an advantage gained through Khosla’s long experience and extensive contacts. He first started investing in Europe in 1995, as co-head of the distressed products group at Merrill Lynch, and led a team of 40 analysts and traders in New York, London, Tokyo, and Hong Kong.

He thinks the opportunity in European banking will last three or four more years, since European Central Bank President Mario Draghi will be conducting stress tests in 2014 on the top 100 or so banks, which could then be forced to unload more troubled assets. U.S. default rates, in contrast, already have come down sharply. “We’re in the seventh inning in the U.S., whereas in Europe, we are only in the third inning,” he says. The $1.6 billion Strategic Value Restructuring fund’s investments are mostly in northern European countries (60%), with the remainder in the U.S.

Its European investments include companies in the United Kingdom and Germany, rather than what the firm regards as riskier places, such as France, Italy, or the so-called peripherals. Strong rule of law and bankruptcy codes are prerequisites. “When you are working through a restructuring, they’re more commercial and receptive to right-sizing a business or closing a plant,” he says. But it’s more than just being in the right place at the right time, Khosla says, adding, “You have to be picky. Just because you can buy at 50 cents on the dollar doesn’t mean it’s a good deal.”

KHOSLA, 55, FOUNDED THE parent firm, Strategic Value Partners, in 2001 and serves as chief investment officer for all of its funds, which total about $3.8 billion in assets and include some private-equity vehicles. “I’m a classic first-generation immigrant. Where else would you come on scholarship and end up running a fund?” says the native of India.

Although it has posted a roughly 8.6% average annual return over the last 10 years (including a 16.2% gain in 2013), the Strategic Value fund has had tough stretches, such as in 2008, when it lost 20%, as both its long and short positions lost value in the financial crisis. “It didn’t feel so good; 2008 was an extraordinary tsunami. Every time you go through a crisis, you learn about your portfolio and risk management,” he notes. The returns are net of the Strategic Value fund’s 2% fee and 20% profit share.

In general, the fund prefers to invest in senior debt, wield some influence in a restructuring, then exit within two or three years. Typically, it buys the debt at roughly 60 cents to 70 cents on the dollar.

The Strategic Value fund’s most recent focus has been on sectors such as airlines, packaging, and housing, as well as specific bankruptcy-related deals. At year-end 2013, some of the fund’s biggest positions included American Airlines Group (ticker: AAL), Kloeckner Pentaplast and Pfleiderer of Germany, and McCarthy & Stone in the U.K.

Typically, the hedge fund has 50 positions, and its top 10 account for between 40% and 50% of assets. Last year, it made 10 significant additions to the portfolio.

American Airlines, the subject of a positive story in Barron’s last week (“A New American Team Goes for the Gold,” Feb. 17), has given the fund a great return. The debt of its former parent, AMR, traded at 20 cents to 30 cents on the dollar when it filed for bankruptcy. Strategic Value bought the debt at 70 cents on the dollar both before and after American merged with US Airways. The debt has since been converted to preferred securities and equity in the new company, representing a recovery of about $1.06-$1.20.

Although it took longer, Strategic Value also cashed in on Kloeckner Pentaplast, a German plastics manufacturer that had previously been owned by private-equity firm Blackstone Group. In June 2012, a group of creditors led by the hedge fund won control of Kloeckner after a nasty fight with Blackstone. “We spent a long time on it, and the debt deal was edgy. But here was a company that had done 120 million euros to €140 million [$165 million to $192 million] of cash flow over five years under Blackstone. In our first full year, we estimate it will break out to €175 million for 2014 alone. We are good in the emergency room. It was a classic deal for us,” says Khosla. Peter Rose, a spokesman for Blackstone, confirmed the transfer of ownership but at presstime couldn’t provide additional details.

 

 

The hedge fund converted Kloeckner’s junior debt into equity and retains 55% of the firm. “All the senior debt we refinanced, and was paid out at par. We’ve gotten our investment out already,” says Khosla. The company is for sale, although he declines to comment.

McCarthy & Stone, a British retirement-home developer, was taken over by lenders in 2009. The banks ended up selling the debt, and in 2012, the Strategic Value fund became one of the largest holders of debt and equity. Together with the two other lead creditors, it overhauled the board of directors and appointed a new executive chairman.

Aided by the big rebound in housing, Strategic Value sold its debt position, purchased for 60 cents to 70 cents on the dollar, for more than 100 cents on the dollar, while retaining its equity stake, Khosla says, adding, “The current business plan seeks to re-establish historically good profit margins, which we believe will allow McCarthy to recapture its premium valuation” to other British home builders.

The fund does have “short” positions, though it mostly uses options on indexes and credit-default swaps on companies it holds. Its biggest short is in power companies, largely in Germany, where government subsidies for wind and solar projects have hurt natural gas- and coal-fired systems.

But Strategic Value will remain focused on debt opportunities in Europe. “We are at an inflection point. Systemic risk is off the table in the medium term, and the economy is growing again,” says Khosla.