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Europe's Distressed Debt Purchasers Face Mounting Risks Amid Tough Economic Conditions

European DDPs' performance proved resilient last year, despite a deteriorating macroeconomic environment and significantly tougher financing conditions. Asset quality remained broadly stable, while growing collections supported cash earnings. At the same time, financial leverage fell below pre-pandemic levels for most rated entities, estimated remaining collections (ERCs) reached a historical peak, and available liquidity remained adequate.

All this implies that most DDPs have entered 2023 in a decent starting position, providing them with some headroom to navigate what S&P Global Ratings expects to be a challenging operating environment. We reflect this in our stable outlooks on most of the DDPs we rate in Europe. That said, risks are growing for the sector, with a weaker economic environment weighing on collections, and difficult conditions in the capital markets making refinancing a challenging and costly endeavor. In this environment, negative rating actions are more likely than positive ones, and can be triggered by failure to refinance debt well in advance of an upcoming maturity, or by a weaker collection performance than we expect and deteriorating leverage metrics.

A Resilient Performance In 2022 Should Help DDPs Weather Tough Conditions In 2023

Following their resilience to growing headwinds last year, Europe's DDPs greeted 2023 with generally lower leverage, comfortable liquidity buffers, and broadly stable asset quality. Almost all players increased their new portfolio investments, utilizing significant dry powder in the form of cash on the balance sheet and undrawn revolving credit facilities (RCFs), which collectively amounted to close to £3.07 billion at the beginning of 2022. Active portfolio purchases brought the combined ERCs of our rated entities to a new record high of £16.9 billion as of Sept. 30, 2022, up 9.1% from a year earlier (see chart 1). That said, the portfolio growth was uneven, with strong purchases by Intrum AB (growth in ERCs of more than £680 million or 11.4% for the first nine months of 2022) and Garfunkelux Holdco 2 S.A. (Lowell; growth of close to £150 million or 4.1%), versus a decline in ERCs of close to 13.2% for iQera Group SAS in the same period.

Chart 1


Collection performance was resilient across most European countries thanks to the robust labor market, savings accumulated during the COVID-19 pandemic, and government support programs for corporates and households--factors that so far have supported the payment discipline of vulnerable borrowers. Nevertheless, in the second half of 2022, some players started to note the first signs of deteriorating collections and settlement values, and had to reforecast their collection performance and recognize impairments for some portfolios, although negative revaluations have been low and rare so far.

All rated players managed to reduce their leverage in 2022, thanks to the healthy collection performance, supporting growth in cash-adjusted EBITDA. We estimate that rated DDPs' average debt to cash-adjusted EBITDA fell to 4.1x at year-end 2022, which is below the pre-pandemic level of 4.4x and the 4.6x we observed at the beginning of 2022. Liquidity buffers, including available cash and the undrawn RCFs, have receded 13% from historical highs, reflecting portfolio acquisitions, but remained at a healthy level of close to £2.8 billion on Sept. 30, 2022 (see chart 2). That said, available liquidity remains unequally distributed across the sector, with Intrum and Lowell accounting for close to 60%, while other entities, such as AnaCap Financial Europe S.A. and Axactor ASA, have more stretched positions in relation to their upcoming debt maturities.

Chart 2


In the second half of 2022, amid a more challenging macroeconomic situation and potential pressure on liquidity from upcoming bond maturities in 2023 and 2024, we revised our outlook on B2Holding ASA to stable from positive, reflecting the lower probability of an upgrade over the following 12 months. We also revised our outlook on iQera to negative from stable because we think that increasing competition in France and iQera's modest size and lack of geographical diversification make it more vulnerable in a weaker macroeconomic environment than similarly rated peers.

Table 1

Distressed Debt Purchasers: Ratings And Key Metrics
Fiscal 2022 Expected (mil. £)

AnaCap Financial Europe S.A.

Sherwood Parentco Ltd. (Arrow Global)

Axactor ASA

B2Holding ASA

Garfunkelux HOLDCO 2 S.A.

Intrum AB (publ)

iQera Group SAS

Ratings B/Stable/-- B+/Stable/-- B/Stable/-- B+/Stable/-- B+/Stable/B BB/Stable/B B+/Negative/--
Revenue 133.4 327.7 303.8 475.6 1,014.2 1,818.1 254.9
Cash-adjusted EBITDA 99.3 291.8 200.1 323.7 596.0 859.1 108.7
FFO 79.8 219.3 135.9 257.6 453.4 445.9 76.0
Debt 359.0 1,405.5 780.5 799.8 2,441.0 4,250.8 557.3
Adjusted ratios
EBITDA interest coverage (x) 5.3 4.0 3.9 5.9 4.5 2.0 3.5
Debt/EBITDA (x) 3.6 4.8 3.4 2.5 4.1 4.9 5.1
FFO/debt (%) 22.2 15.6 21.9 32.2 18.6 10.5 13.6
FFO--Funds from operations.

Weaker Economic Conditions Will Weigh On DDPs' Collection Performance And Asset Quality In 2023

We expect that broad economic weakness in Europe in 2023, including a recession in some countries, such as the U.K., will weigh on European DDPs' collection growth and asset quality (see "Credit Conditions Europe Q1 2023: Time To Face The Music," published Dec. 1, 2022). That said, we think that the hit to collections will be less significant than what we observed during the pandemic in 2020, when many rated entities had to postpone a material volume of collections and settlements due to court closures and state-imposed payment moratoria.

In our view, the pressure in 2023 will vary by asset class and region. A resilient labor market in many European countries, ongoing nominal wage growth, and new government support programs to address the cost-of-living crisis could make it easier for vulnerable borrowers to keep paying on schedule. The performance of portfolios secured by real estate assets might suffer from price pressure and weaker liquidity, but this will ultimately depend on multiple factors, including location, asset type, and servicing strategy. Last, portfolios with defaulted small-to-midsize (SME) loans may demonstrate weaker performance and a longer recovery time, considering the hit to private consumption in many countries and soaring costs for businesses, although the often-collateralized nature of such loans could provide some relief.

In general, DDPs' asset quality and collection performance will largely depend on the length and depth of the recession, as well as on state-initiated support measures to offset the repercussions for businesses and vulnerable individuals. The performance of a particular entity will depend on the nature of its assets and geographical mix, as well as on the volume and underwriting quality of its portfolio purchases over the past 12-24 months (see chart 3). Larger and better-diversified players will likely demonstrate better resilience, with just slower growth in collections, while more geographically concentrated entities with less diverse portfolios face a higher risk of a decline in collections in 2023.

Chart 3


As most players in the industry could face higher customer default rates and a need to postpone collections, we expect revaluation losses to increase, translating into lower profitability. Even though such revaluation losses will not have an immediate impact on operating cash flows, they could indicate lower expected cash collections in the coming quarters.

Rising Asset Quality Risks In Europe May Bring Positive Medium-Term Business Prospects

Although we don't expect a material deterioration in European banks' asset quality and a tsunami of new nonperforming loans (NPLs) to the market, we do forecast an uptick in the supply of problem assets in 2023-2024 (see "Credit Trends: Global Banks: Our Credit Loss Forecasts: Manageable Rise In Credit Losses As Our Base Case," published Dec. 13, 2022).

The pandemic's effect on European financial institutions' asset quality was relatively modest, not least because of the unprecedented fiscal support that governments deployed across the region. According to the European Banking Authority (EBA), the volume of NPLs in EU banks fell to €370 billion, or 1.8% of total loans as of June 2022, versus 2.3% in June 2021. Although banks in the EU continued to divest some of their problem assets, especially in Greece and Italy, supply was still lower than before the pandemic. This, together with higher demand from DDPs as they sought to utilize their spare liquidity, has led to high portfolio-acquisition prices, depressing profitability in some market segments, such as highly competitive unsecured consumer loans in the U.K.

We expect this trend to gradually reverse in 2023. Even though the NPLs on banks' balance sheets reached multiyear lows by mid-year 2022, Stage 2 loans, which indicate elevated credit risk, increased by 14% to €1.45 trillion, or 9.5% of total loans, the highest level since the introduction of International Financial Reporting Standard 9, according to the EBA. The increase in Stage 2 loans was mainly due to banks migrating about €460 billion of loans from Stage 1 to Stage 2 due to worsening economic projections. Loans to commercial real estate and SME loans--two asset classes of potential interest for DDPs--have the highest share of Stage 2 loans compared with other sectors--16.6% and 15.7%, respectively. Consumer loans, meanwhile, have the highest NPL ratio (5.3% of total loans) across all sectors. As the macroeconomic situation could continue to deteriorate in the first half of 2023, we expect that some of these Stage 2 loans will become NPLs throughout the year (see chart 4). At the same time, regulatory capital requirements and supervisory pressure (the NPL backstop) will incentivize European banks to offload problem assets, potentially leading to higher supply late this year and moving into 2024.

Chart 4


On the other side of the equation, we see more difficult access to and materially higher costs of capital. Coupled with general macroeconomic uncertainty, these factors will make European DDPs highly selective about new purchases (see chart 5). We anticipate that most rated players will be mindful about their capital deployment this year to maintain leverage discipline, while focusing more on the collection and servicing of their existing back books, as well as cost control.

Chart 5


Although it is hard to predict, the result of this supply-demand discrepancy could mean a normalization of pricing in the debt portfolio markets, improving DDPs' profitability prospects. This would open opportunities for players with easier access to capital, excess liquidity, and solid strategic partnerships. We think that co-investment through joint ventures, with the use of a portion of the co-investors' balance sheets, could become even more widespread as a way of sharing risks and supporting capital deployment if supply increases materially.

A greater volume of problem assets could also bring more servicing mandates and volumes for DDPs, as we have seen in the past. At the same time, the third-party servicing business will become particularly attractive, considering its capital-light nature, in an environment where capital is becoming scarcer and more expensive. Growing servicing revenues will support the profitability of entities with high shares of such revenues, particularly Intrum and Arrow Global Group PLC, and may offset a stronger decline in collection income (see chart 6).

Chart 6


Financial Leverage Should Remain Under Control Despite Being High

A weaker collection performance and rising costs spurred by high inflation could put pressure on DDPs' profitability and hamper earnings growth in 2023, making it harder for them to deleverage in what is traditionally a highly leveraged sector. Although DDPs will continue to focus on tight cost control, which has been an essential component of their strategy over the past two years, they will face higher collection costs, and, in particular, higher personnel costs. This reflects not only inflationary pressure and continuing growth in nominal wages, but also the need for greater effort to sustain collection performance in the current environment.

Nevertheless, in our base case, we expect that cash-adjusted EBITDA will continue to grow for most DDP players we rate, supported by significant portfolio purchases in previous years and higher servicing income. Meanwhile, the lower capital deployment we expect in 2023 could keep debt levels stable, supporting deleveraging for many entities. In particular, we expect that the sector's average unweighted debt to cash-adjusted EBITDA will decline slightly below the current rate of 4.1x and approach the 3.7x-3.9x range (see chart 7).

While our view of the adjusted financial leverage ratio--where we adjust EBITDA for cash collections--is important, and in many ways a headline metric for sector performance, in our opinion it is not the sole determinant of financial risk for DDPs. For example, unadjusted leverage--where we exclude the benefit of portfolio amortization from EBITDA--remains particularly weak, despite some signs of improvement, with an unweighted average exceeding 10x for many DDPs.

Chart 7


All players inevitably face higher interest expenses arising from debt issuance in the rising interest rate environment and a higher reference rate on floating-rate instruments like RCFs and securitization facilities. Nevertheless, interest coverage ratios will remain broadly stable this year, or might even slightly improve for entities with no immediate refinancing needs and lower debt such as Arrow Global and Lowell.

Although we don't expect most rated entities to face a dramatic reduction in their interest coverage ratios in 2023, sustainably high interest rates will raise questions about the sustainability of some players' business models in the medium term. Moreover, low cash-unadjusted EBITDA interest coverage ratios ranging between 1x and 3x and averaging 1.7x paint a more precarious picture. Should an entity spend all of its portfolio amortization on acquiring new portfolios, they will have only a small portion of operating cash flow remaining for debt servicing.

The sector's capitalization, measured by its debt-to-tangible equity position, is an additional consideration in our view of an entity's financial risk. Only B2Holding and Axactor have positive tangible equity, while other players will continue to show deeply negative tangible equity over 2023-2024, due to significant goodwill and intangibles.

DDPs' Refinancing Needs Ramp Up In 2024, But The Debt Markets Will Remain Tough For Speculative-Grade Borrowers

Since spring 2022, it has become very difficult for speculative-grade issuers, including European DDPs, to raise new public debt. Rising interest rates and widening credit spreads have led to a dramatic decline in bond prices, with yields to maturity floating in the range of 8%-15% versus 4%-7% a year ago (see chart 8). Nevertheless, in the second half of 2022, some players managed to tap the primary market, which had been virtually closed since the end of February 2022. For example, at the beginning of December 2022, the market leader, Intrum, raised €450 million by issuing bonds with a coupon rate of 9.25%. Earlier that year, B2Holding issued a €150 million senior unsecured bond with a coupon of the three-month Euribor rate plus 6.9%, which now translates into about 9.1%. At the same time, access to the securitization market seemed easier, with Lowell raising €100 million in asset-backed securities in April 2022 at the SONIA rate plus 3.25%, and in the autumn, another €170 million at the SONIA rate plus 3.9% to fund its acquisition of Hoist Finance.

Chart 8


We expect credit conditions to remain difficult, especially in the first half of 2023, amid the worsening economic environment and tighter monetary policy. In these conditions, we think that entities' funding profiles themselves become a source of competitive advantage or disadvantage, with benefits to those with longer debt maturity profiles and a preponderance of fixed-rate debt, as this enables more competitive pricing.

DDPs' refinancing needs are relatively low this year, with total debt to be repaid by the end of 2023 of around £1.0 billion, or about 8.0% of the total debt of our rated entities. Axactor has the largest repayment due this year, as it needs to refinance up to €545 million of its RCF (of which it had drawn €438 million as of Sept. 30, 2022). Intrum has to repay Swedish krona (SEK) 2.9 billion (around £235 million) of its public bonds, and B2Holding has to repay close to €114 million, most likely by drawing on its RCF. We believe that it is generally easier to refinance RCFs with private banks rather than tap the public debt market, considering the super senior status of the RCFs and banks' greater flexibility to negotiate terms. In our base case, we expect that all rated entities will be able to refinance their RCFs this year.

However, DDPs' refinancing needs in 2024 are almost twice as high as this year, including public debt maturities at AnaCap, Axactor, iQera, Intrum, and B2Holding (see chart 9). An inability to refinance their public debt at least 12 months before maturity, or to present a credible way of debt repayment, will negatively affect our view of the entities' liquidity and debt maturity profiles, possibly leading us to take negative rating actions.

Chart 9


The Quest For New Business Niches And Models Will Continue

We expect that some DDPs will continue to explore new business models and nontraditional asset classes such as commercial real estate. This trend has become particularly apparent at Arrow Global and AnaCap as they try to find new niches amid depressed pricing and intensifying competition in some market segments.

For example, last year, Arrow Global made progress in developing its investment management business. By attracting capital to its closed-end credit funds and co-investing its own capital with limited partners, Arrow Global is diversifying its revenue sources, reducing the capital intensity of its business, and continuing to invest at scale despite the turbulent environment. Meanwhile, AnaCap has materially increased its investments in acquiring commercial real estate assets from distressed sellers at high discounts to the market value; these investments now represent more than 50% of its ERC. Although the investments support AnaCap's business volumes and tend to have higher returns than NPL portfolios, they are also prone to higher revaluation losses and liquidity risk, making AnaCap's future collections more volatile and increasing its business risk.

Ratings Face Growing Risks, Despite Their Resilience Last Year

Despite a resilient performance and improving leverage ratios in 2022, our ratings on all European DDPs have remained unchanged over the past 12 months. The improvements we observed were not material enough to raise the ratings in this highly leveraged industry, and are largely offset by the growing risks for the sector stemming from weakening collection performance and profitability and adverse financing conditions in the capital markets. Although in our base case we expect only a limited deterioration in collections and no major hit to the financial leverage ratios, a deeper and longer recession, leading to a protracted decline in collections, could bring leverage closer to the levels we observed at the beginning of 2021 and nullify the recent improvements.

Due to the clear risks for the economy and the sector, we do not envisage positive industry-wide rating actions at this stage. Negative rating actions are more likely, and can be triggered by weaker performance than we expect, deteriorating leverage metrics, or failure to refinance debt well in advance of an upcoming maturity. Considering the potential for liquidity constraints as soon as 2024, we think that most rated entities are likely to remain well placed in the 'B' rating category, with Intrum being the sole DDP with a 'BB' rating.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Dmitry Nazarov, CFA, London +44 776 963 27 17;
Philippe Raposo, Paris + 33 14 420 7377;
Secondary Contacts:Andrey Nikolaev, CFA, Paris + 33 14 420 7329;
Heiko Verhaag, CFA, FRM, Frankfurt + 49 693 399 9215;
Olivia K Grant, Stockholm + 46 84 40 5904;
Thierry Chauvel, Paris +33 (0)1 44207318;
Research Contributors:Hugo Casteran, Paris 33140752576;
Laura Jimenez, London +44 2071760839;

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