Addressing the problem of non-performing loans
February 2011 | TALKINGPOINT | BANKING & FINANCE
FW moderates a discussion on the issue of non-performing loans between Paul Severs at Berwin Leighton Paisner, Feng Gao at King & Wood PRC and Yulia S. Kyrpa at Vasil Kisil & Partners.
FW: Have you seen a continued rise in non-performing loans (NPLs) over the last 12-18 months? Where are the troubled hotspots?
Severs: In the commercial mortgage space the main issue is over-levered positions arising from loans made before the credit crunch and falls in capital values. Rather than borrowers defaulting on scheduled payments of interest and principal there are breaches of financial covenants and LTV breaches. So while there may be breaches of financial covenants, many loans tend to be performing in the terms of keeping payments current. This position has not changed over the last 12-18 months although the ability to refinance does become more pressing as maturity dates approach. In the residential mortgage space default levels have been stable due to low interest rates, however this could change very quickly if interest rates rise to address the current levels of inflation.
Gao: Based on our experience and the 2010 China NPL market Survey conducted by the China Orient AMC, although NPLs originating from the banks may be on the rise due to the likely real estate and credit crisis, the size of NPLs will be will be scaled down significantly thanks to the excess liquidity created by the central bank. During the past 18 months, China has adopted a relatively easy monetary policy and increased the credit availability in the capital market which has contributed greatly to the re-growth of China’s economy. In 2010, the NPL ratio of banks in China is slightly lowered. Nevertheless, a trend to tighten monetary policy has emerged in China in these three months as the interest rate hike cycle begins. It is estimated that the NPLs constituted by the new loans will increase around 2012. The future trouble hotspots could be anywhere across the first and second tier cities in China.
Kyrpa: There has been a continued growth in the Ukrainian distressed debts market over the last 18 months. Many borrowers affected by the economic downturn – most of all in the financial services, construction and retail sectors – can no longer rely on refinancing their debts to avoid defaults under loan agreements, especially if their debts are under-collateralised. Ukrainian banks under pressure of the National Bank of Ukraine (NBU), to manage their balance sheets and to meet the ratios set forth by the NBU, sold off a number of non-performing loans portfolios at a value significantly below par during the last year.
FW: What disposal and sale strategies are being employed to deal with NPLs? Are the options in today’s market improving or narrowing?
Gao: Different entities in the NPL market may employ different strategies when dealing with NPLs. For the banks, usually it categorises its loan and sells the NPLs to the big four AMCs in China or other qualified AMCs. The AMC itself sells the NPLs purchased from the banks in the market to the investors after sorting and packing. Those who are going to invest the NPL are concerned with acquiring undervalued opportunities arising from the real estate burst and the troubled loans associated with the financially capable guarantors and capitalise on the market upside. For other investors who are already in possession of an NPL, it is advisable that they should take traditional ways of disposition such as judicial or administrative action to recover the NPLs or transfer the NPLs to other local minor investors with the competent financial capacity. There are not too many changes in the disposal options except that foreign buyers are facing a much harsher approval process as well as nose-diving returns and the drying up of transactions in the secondary market.
Kyrpa: According to the laws of Ukraine three strategies of NPL disposal can be implemented, depending on the NPL’s value and the type of investor. First is the disposal of NPLs on the basis of a factoring agreement. In this case the investor must be established as a bank or a non-banking financial institution, registered by the State Commission for Regulation of Financial Services Market. Under the factoring agreement a discounted value is to be paid by the NPLs acquirer to the seller. The second strategy is to dispose of the NPL under an assignment agreement. In the case of NPL disposal under an assignment agreement, no special requirements as to the status of the NPLs acquirer are envisaged by the law. The deal, however, must be made at no less than par value of the NPLs. Buyouts of NPLs at par value can sometimes be made if the debt is over-collateralised or if the investor is willing to implement either a buy and hold approach, supposing buy-out of a distressed debt in order to gain a position of influence in a bankruptcy or restructuring process; or an opportunistic approach, for instance, when buying a distressed debt in order to get equity ownership afterwards as a result of debt-to-equity conversion. The third strategy is to transfer the debts to solvent borrowers. The transfer of overdue loans together with underlying security to solvent borrowers is to be carried out under the mutual consent of the lender and its borrower being in default. This strategy supposes transfer of the full amount of the debt to a new solvent borrower who will repay an overdue amount shortly after the transfer and then continue the debt’s repayment according to the schedule initially provided for by the loan agreement.
Severs: There is no ‘one size fits all’ approach. Different lenders pursue different strategies in relation to different types of loans. Key issues determining strategy include whether the loan can be restructured, the quality of the underlying collateral, projected recovery levels, size of exposure, location of collateral, whether lenders have accurately marked to market their positions and whether regulatory capital or funding is the key driver. Broadly we have seen lenders extending loan maturities to avoid defaults, enforcing where there are payment defaults, restructuring where deleveraging can be achieved through additional equity or free cash flow from the assets and straight auctions where the bids hit the written down value. The options are widening as market participants become more creative in finding solutions. For example, fund structures are increasingly being used as a means of selling down positions in a portfolio of loans. This is attractive because it provides investors with a diversified portfolio of loans with an alignment of interest to the asset manager.
FW: To what extent will banks and investors need to work together in the months ahead to find the best solutions for defaulting assets?
Severs: We are all in this together. Banks, investors and borrowers will need to work together and be creative in finding solutions to the problems they collectively face. Very often a fire sale is not the best way of realising value. This is best illustrated by an example. A bank has a loan secured on a property; the loan exceeds the property value but there is value to be created through active management and some CAPEX. The work out strategy is as follows: existing equity is removed from its legacy position but retained to actively manage the property and given an incentive fee to reward value created through management, a third party investor injects new money to fund CAPEX and takes a percentage of the equity, the bank converts part of its debt to equity and retains the balance reflecting current advance rates and pricing. There is a complete realignment of interest reflecting the revised economics. This works for everyone’s benefit – but all stakeholders need to be realistic about the relative value of their positions. For larger portfolios, collective investment schemes through various fund structures provide an attractive way for lenders to access capital from new sources and we have seen this through the establishment of funds such as Hadrian’s Wall Capital in the infrastructure debt space. The key is realistic pricing of loan portfolios and quality asset management.
Gao: In China, usually the banks will make no direct contact with the investors, but instead the banks sell the NPLs to the big four AMCs or other qualified AMCs. After the AMCs transfer the NPLs to the investors, the investors may need the banks’ help in digging out the asset lead and restoring the legal remedies, though the banks have exempted themselves from all the obligations through the NPL transfer agreement signed with the AMCs. However, in some cases there may be some different opinions between headquarters and the branches of the banks in dealing with NPLs. This can occur where the headquarters wishes to dispose of the NPLs for reductions in NPL ratios or a planned public listing while the branch does not want to sell the NPLs to AMCs and then to the investors. The local branches of the banks think the recovery amount will be much higher if the banks collect the loan themselves.
Kyrpa: In Ukraine there is not a uniform approach of banks and investor cooperation in the process of planning and structuring NPL sale and purchase transactions. As such, cooperation usually depends on the peculiarities of each transaction, its structure and timeframe acceptable to the parties thereto.
FW: What considerations should be made when preparing a portfolio of NPLs for sale?
Kyrpa: The following key legal issues and considerations are to be observed when planning and structuring an NPL’s sale transaction. First, the foreign currency control implications. Given that Ukrainian currency control regulations prohibit settlements between Ukrainian residents in any other currency than Ukrainian hryvnias (UAH), the sale of foreign currency NPLs will require an individual licence from the NBU for settlements between Ukrainian residents in foreign currency, and special contractual arrangements – to allow the foreign currency distressed debts to be paid in UAH. Second, banking secrecy issues must be considered. A properly drafted loan agreement usually contains the borrower’s permission to the lender to disclose banking secrecy information in case of assignment or transfer of loan. Should no such clauses be contained in the loan agreements, prior written consent from the bank’s clients would be required to observe banking secrecy rules prescribed by the laws of Ukraine. If this is the case the lender needs to make sure that such consent is obtained prior to actual transfer of the loan and the documents related thereto. The third consideration is accrual of interest. To continue accrual of interest under the acquisition of NPLs the investor has to enjoy the status of a bank or non-banking financial institution, otherwise the accrual of interest is to be terminated once the distressed debt portfolio is transferred to a company without this special status.
Gao: The primary consideration is the purchase price. The price cannot be too high otherwise it may scare the investors. Nor can the price be too low or it may be construed as the state-owned banks or AMCs selling the state-owned assets unreasonably cheap, which is not allowed in China. Besides, there are many tricky issues, like the legal, taxation, and remittance of investment proceeds. Before the sale of the NPLs, the banks and the AMCs should conduct due diligence on the target assets and fully understand the conditions and values of the same. Also they should consider the pattern of sale. This may include a direct disposal, a portfolio sale where the aim is to enhance efficiency and lower the cost of disposal, an auction, or a debt-for-equity swap that wipes out the debt obligation of a state-owned enterprise to its bank and substitutes it with equity ownership in the AMCs that took over the NPL from the bank. AMCs would then be entitled to dividends and subsequent share repurchases from the state-owned enterprises at agreed-upon prices for 10 years, should the latter become profitable. They should also decide whether to contact foreign investors or domestic buyers.
Severs: The key foundation to a successful trade is accurate and comprehensive portfolio data and a complete data room. This provides the basis for bidders to undertake appropriate due diligence through which they are able to accurately price the loans. Without this the price will not be maximised and there is a material risk of retention of liability through warranties or the sale process collapsing completely as bidders lose confidence in the integrity of the data. Also sellers need to understand the process buyers will go through in underwriting the deal. The buyers’ deal team will prepare an investment memorandum that sets out the detail of the portfolio and the pricing methodology applied – if they are not confident in the data provided they will not be able to progress the deal. Another key component is establishing a clear, transparent process and timetable. Buyers what to know what the process is and that there is a level playing field. The typical auction process would be the seller soliciting expressions of interest from potential bidders, selected potential bidders undertaking initial due diligence leading to indicative bids. From the indicative bids a short list of preferred bidders is selected who will be invited to undertake further due diligence and submit final bids. Usually final bids would be submitted together with the form of sale documents to be entered into. From a sellers’ perspective, the process should be managed so that bids can be compared – apples to apples and not apples to oranges.
FW: How should buyers of NPL assets approach the deal sourcing process? How can they select the most appropriate purchasing strategy?
Gao: Buyers are recommended to pitch their ideas to sellers – the headquarters of the big four AMCs – and convince senior management to put them in contact with operation managers in the AMC branches. Buyers need to strike a deal with the sellers based on the premise that the sellers will help them achieve their disposition target slightly higher than the seller’s acquisition cost. For foreign buyers, the following purchase channels may be considered. First is outright purchase with cash or with back-ending sharing. Assets available for purchases include debt, equity (converted from debt), and debt-expiated assets. Purchasing creditors’ rights is the most frequent type of transaction, followed by settled assets, and to a lesser extent, equity rights. Investors profit from the difference between the purchase price and their ultimate recovery price – typically through either negotiated settlements with the debtor or sales/transfers to a third party. Some investors manage to foreclose on assets backing the loans, although this is much more difficult due to legal and bureaucratic restrictions. The second option is the establishment of a joint venture (JV). At the beginning of foreign investor involvement in the disposal of NPLs, outright purchasing was not as popular an option as the establishment of a JV. The Chinese party would contribute an NPL portfolio to the JV company, and the foreign party would contribute cash. This method is not so popular these days.
Severs: Generally the universe of institutions that are potential buyers and sellers is well known. Buyers and sellers tend to have well established communication channels and these tend to result in ‘the usual suspects’ being included in the auction process. However, participating in auctions is a time consuming and expensive process with an uncertain outcome. Many buyers have spent time and money in an auction process only to find the seller is not a willing seller at the bid price. Buyers ideally want to identify the opportunities prior to the assets entering a formal auction process. Off market opportunities tend to be successful in more structured JV situations where the buyer is contributing more than just money – expertise in work out, recovery and value creation – and the buyer and seller enter into a JV arrangement. Also, buyers have different sweet spots and will play to their strengths rather than chasing every opportunity.
Kyrpa: Ukrainian lenders who are willing to dispose their NPL portfolios usually commence the disposal process on a tender basis – through public announcement of the main terms and conditions of the anticipated deal. Hence, investors become aware of such possibilities through mass media and/or information placed on lenders’ websites. Tenders are usually won by investors who suggested the highest price for the NPLs buyout and the most attractive settlement conditions, for instance paying the full amount of the purchase price upfront, with no deferred payment conditions. The strategy and methods of NPLs acquisition usually depend on what the investor is seeking. The following strategies can be used by investors to gain some value from distressed debts. First, a trading strategy that supposes buyout of distressed debts in order to sell them at a higher price within days or weeks. This strategy is to be implemented through entry into a factoring agreement by the lender, acting as debts seller, and the investor. Second, a buy and hold strategy which could be implemented if the goal is to gain a position of influence in a bankruptcy or restructuring process and to sell the investment at a higher value afterwards. For this strategy both a factoring and an assignment transaction structure could potentially be appropriate. Third, investors could adopt an opportunistic strategy that supposes buying a distressed debt to gain a position of influence in a restructuring process in order to get equity ownership with a debtor as a result of a debt-to-equity conversion afterwards. This strategy could be implemented though entry into either a factoring or an assignment agreement by the lender – the debts seller – and the investor. It should be noted, however, that an antitrust clearance may be required for acquiring equity ownership by the investor. The final strategy is to transfer the debt to solvent borrowers. The main advantages of this strategy for investors are access to borrowed funds on favourable conditions, and obtaining the title to collateral previously acquired by the original borrower at a value below its current market value.
FW: Has the valuation process for NPLs become even more challenging in this uncertain economic environment? What methods are being employed to calculate underlying value?
Kyrpa: The valuation process usually depends on the combination of the following factors. First, the number of days the loan has been overdue. Second, the actual financial standing of the borrower. Third, the value of collateral. Finally, the quality of legal documents, confirming the lender’s rights to require repayment of amount of the loan and the collateral, in place. The NPLs value depends on each specific transaction and could vary from 100 percent of their par value in some exceptional cases – for instance, if the loan is over-collateralised or there is an intention to acquire an equity with the debtor as a result of debt-to-equity conversion – to between 3 and 5 percent, in the case that the loan has been overdue more than one year and is not secured by any collateral at all.
Severs: The valuation of single large exposures will focus on the value of the underlying collateral or credit quality of the debtor. This remains unchanged. Clearly the uncertainty regarding the economy creates uncertainty on future values and this risk will be priced in any bid and through the discount rate applied to future cash flows. The variables that overlay the basic valuation include the time period to foreclose, costs of enforcement and taxes. Also, additional CAPEX or active management will be taken into account. In the context of granular assets such as residential mortgages, asset value and time periods to recovery are also key, although a portfolio approach will be adopted and the quality of the servicer is critical. The key driver to the ultimate bid price is the investor’s IRR hurdles. High IRR hurdles combined with little or no leverage has resulted in many bids not meeting the expectations of sellers.
Gao: To some extent the uncertainty of the economic environment will have an influence on the valuation of the NPLs. Mostly it may affect investors’ expectations of China’s economy. Besides, the instability of the economy will result in changes in China’s legal systems, especially in the attitudes of the legislators and the judges of the Supreme Court which will also affect investors’ confidence in the recovery of NPLs. Speaking as a lawyer, the value of the NPLs will be much higher if the NPLs are accompanied with any mortgage or other security assets. If no security assets or only guarantors, the values for the NPLs will be low. Regarding the calculation methods, according to the investors that we have cooperated with in dealing with the NPLs, the pricing methods stay as usual – discounted cash flow by factoring in the legal issues and the obligators’ staff relocation and compensation and the risk premium, and so on.
FW: What general advice would you give to NPL purchasers on negotiating and structuring the deal?
Kyrpa: To mitigate the risks related to an NPLs buyout by potential investors, a number of recommendations can be made. First, due diligence of distressed assets and legal documents related thereto is advisable prior to NPLs acquisition in order to identify possible shortcomings that could potentially lead to the impossibility of enforcement or declaring the transaction documents void by the court. Second, investors or their legal advisers should negotiate and impose certain liability on the seller for misrepresentation in order to make the seller liable for any untrue statement regarding distressed debts which induced the buyer to purchase them. And third, in the case of an NPL’s sale through either a factoring or an assignment agreement, the underlying security will be automatically transferred to the purchaser by operation of law. However, to enhance security, certain contractual arrangements in respect of pledge and mortgage agreements need to be made. Besides, re-registration of encumbrances over the collateral in the state encumbrances’ registers is required by the purchaser shortly after the debts acquisition.
Severs: NPL purchasers must understand the motives and expectations of the seller. They must ask if is there a different angle to the trade that can make their bid more attractive to the seller. Different countries have different insolvency regimes and these can impact significantly on recovery time periods and hence IRRs, so purchasers must check out the insolvency regimes carefully. If teaming up with an asset manager, NPL purchasers must ensure appropriate incentives that align their interests to equity are created. They must also decide early in the process if seller reps and warranties are important and the value of these relative to the sellers balance sheet. Finally, they should structure the acquisition vehicle to minimise tax leakage but most importantly they must not let the tax tail wag the deal dog.
Gao: In China, investors should conduct a full analysis and survey of the PRC’s politics, economy and legal systems before entering the market. In addition, buyers are advised to consult the relevant governmental agencies and local law firms to get a ballpark estimate on the assets.
FW: What are some of the primary accounting and tax implications attached to the disposal or purchase of NPLs?
Gao: Based upon years of experiences dealing with NPLs, a foreign buyer of NPLs is required either to form a JV with Chinese counterparts or to set up a wholly owned foreign enterprise holding the NPL portfolio, which would fall under the general regulation and supervision of the local State Administration of Foreign Exchange, the tax bureau, the Administration of Industry and Commerce, and so on.
Kyrpa: In Ukraine, separate tax planning of NPL sale & purchase transactions is required for both the seller and the purchaser. If NPLs are sold at a discount, the amount of the discount may be reflected by the seller as its losses in tax accounting and, therefore, could be used for reduction of taxable income derived from other transactions.
Severs: Vendors will only want to exit their position if tax relief can be claimed for the ‘distressed’ element of the asset to be sold. Purchasers will want to ensure that debt can be moved into a new holding structure free of stamp/registration taxes. In vendor financing structures, planning may be required to ensure that any debt sold at a distressed price to a friendly creditor does not give rise to a tax charge for the borrower/issuer by reference to the written down accounting value of the borrower/issuer’s liability. Acquisition structures will need to minimise withholding taxes on interest payments. Most RMBS/CMBS should be gross paying securities. Corporate loans will generally be subject to domestic withholding taxes and may require their holder to be resident in a jurisdiction with a broad double tax treaty network. A further key consideration for the purchasers is whether their jurisdiction will tax the ‘pull to par’ or ‘discount’ component of the underlying debt over time. Careful planning should ensure that the ‘principal’ accrual should not bear tax at the asset holding vehicle level.
Paul Severs is a partner at Berwin Leighton Paisner. He advises both on the buy side and sell side of NPL trades and advised on more than £20bn of non-performing loan trades including residential and commercial mortgages, consumer debt and corporate loans. He advises funds and financial institutions on restructuring debt, debt/equity swaps, credit bids and work out and recovery strategies. Most recently, Mr Severs has advised RBS on the sale of part of its non-core loan assets. He can be contacted on +44 (0)20 3400 4626 or by email: firstname.lastname@example.org.
Feng Gao is a senior partner at King & Wood PRC. During his 17 years of practice, He has gained extensive experience in handling international commercial litigation and arbitration. He has represented many international/domestic banks and financial institutions concerning the matters of loans, security interests, project finance, letters of credit, and commercial papers. Mr. Gao regularly represents International/domestic financial institutions and asset management companies in due diligence reviews and the disposal of NPLs. He can be contacted on + 86 1380 8804 410 or by email: email@example.com.
Yulia S. Kyrpa is a senior associate at Vasil Kisil & Partners. She has more than eight years of banking and debt restructuring experience across a variety of industries, including banking and financial services, real estate and construction, agriculture, retail, etc. Her banking and debts restructuring expertise was recommended by Ukrainian Law Firms (A Handbook for Foreign Clients) Edition (2008-2010), as well as by Legal500 (2010). She can be contacted on: +38 044 581 77 77 or by email: firstname.lastname@example.org.
© Financier Worldwide
Berwin Leighton Paisner
King & Wood PRC
Yulia S. Kyrpa
Vasil Kisil & Partners