UK: NPLs – Car Boot Sale!

Time for a spring clean?

Institutions holding non-performing loans ("NPLs") have been and continue to be, under increasing pressure to divest these and "clean up" their balance sheets in order to free up capital, de-risk and preserve market reputation. Usually, a loan facility becomes non-performing when either payments of principal and interest are past due by 90 days or more, or where payments are less than 90 days overdue, it is expected that payments will not be made in full. Alternatively, other loans can also be regarded as non-performing if they are value impaired (e.g. if the borrower has breached key covenants in its facility or if repayment terms have been altered).

Where a borrower is in financial trouble, it may first look to a lender for restructuring options such as extending its facility, foregoing interest payments or deferring repayments. From a bank's point of view, holding on to NPLs causes a real issue since they increase a bank's management costs, with frequent analysis required to monitor the financial position of the borrower and its underlying assets. There are also broader repercussions to consider given that NPLs may tend to limit a bank's ability to lend. It also potentially drives up interest rate margins thereby creating uncertainty. Divesting NPL portfolios at a discount benefits banks who recoup some value, gain liquidity and distance themselves from the risk factors associated with holding onto distressed assets, such as a potential downgrades in its credit rating or a greater chance of bank insolvency.

Why take on a bad apple?

The reasons for investing into NPL portfolios are varied and divergent. Some may look to sell the loans on the secondary market for a quick profit, others, with management expertise who see potential for improvement in the portfolios and/or future economic factors may hold out for a recovery in its value. There are also some institutions who will buy enough distressed debt to have an influence in the borrower's restructuring options or insolvency so as to be well placed to acquire control of the company thereby benefiting from profits and value in the business itself.

Buying and selling the loan portfolio

The process of selling a loan portfolio is not always straightforward and is often an expensive exercise (but well worth it if the intention is to gain real risk transfer and capital release). The transaction starts with what may be a lengthy due diligence process on the loans and its underlying security (often replete with incomplete documentation, spread across multiple jurisdictions and involving multiple counsels).

There may also be various loan level issues to tackle which provide impediments to transfer. Potential issues include:

  1. a borrower's consent may be required to transfer;
  2. security packages may include collateral which is not supported by adequate registration evidence required to show that the seller has a right over the collateral and the subsequent right to transfer it; or
  3. a transfer may only be permissible to a "financial institution" – which can be problematic for sales to private equity firms, hedge funds, pension funds or SPVs.

Potential solutions to these issues include sellers holding the loans on trust with beneficial interest lying with the buyer, efficient and thorough due diligence which flags up issues as early as possible at the outset of the transaction (which can also be instrumental in influencing the price of the portfolio itself, at the bidding stage), amendments to loan documentation or perfecting registration of security to ensure the buyer holds a robust package of collateral.

The seller will almost certainly prefer a transfer by novation wherever possible, creating a direct standalone legal relationship between the new buyer and the borrowers. Transfer by way of assignment (where only the rights and not the obligations are transferred) may not have the effect of removing the loan from the seller's balance sheet. However, transfer by way of assignment can be useful where the seller's interest in underlying collateral cannot be novated. Moreover, an assignment can be achieved without notifying the borrower, although this will merely result in an equitable assignment.

What lies ahead for distressed debt?

Following the credit crisis, many institutions in the UK have undergone high profile divestment operations – instigated by the need to comply with stringent capital adequacy requirements. Currently, the ECB is implementing key stress tests amongst the top euro zone banks to ensure balance sheets are looking healthy – with a particular focus on non-performing loans. The distressed debt market is certainly growing and the UK appears to be a popular investment destination in this area together with Greece, Italy, Spain and Ireland. There appears to be a great deal of opportunity for many institutions to recoup distressed debt and estimates suggest that European banks have approximately EUR2.5 trillion of non-core assets available to sell.

So, it's certainly very true for the NPL market that one person's trash is another person's treasure!

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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