Underwriting big debt deals is a complex business, but can offer high returns, reports Lauren Parr
Financing European loan portfolio purchases is a compelling business, offering high margins, high fees and fast payback. It also allows lenders to be efficient in putting out large chunks of capital at one time, in return for a decent yield of plus or minus 600 basis points over three-month euribor.
A Goldman Sachs banker says: “Thanks to the fact that you have diversification in the portfolio – and if you have appropriate repayment mechanisms – you can get out of the risk relatively quickly from a credit perspective, which gives you comfort and you can make significant economic gains.”
The bank hopes to clinch the financing for Lloyds’ Project Harrogate debt portfolio sale, which would be its first deal since exploring the market in 2010, when it negotiated to finance RBS’s Project Isobel debt disposal, a deal RBS eventually funded itself.
“This asset class suits our business partly because it is fast repayment and high yielding, so we can recycle the money,” the Goldman Sachs banker adds.
However, this kind of business does not appeal across the board. While the margins are high, the typically short period of three years that a bank’s money is on loan can mean returns are not accretive.
“It’s a cost benefit analysis for many lenders: is it worth spending a lot of time on these type of deals, given that your loan may be out for 18 months or two years?” asks Peter Denton, head of European debt at Starwood Capital.
There have only been a handful of deals in this cycle (see table below), but demand for this type of financing is growing along with the number of loan portfolio sales.
In May, Real Estate Capital listed 17 European portfolio sales that had taken place since early last year. At least three more are now under offer, while about half a dozen are on the market.
Growing pool of lenders
Given banks’ well-publicised problems elsewhere, the lack of lenders in this market increases its attractions for a small number of investment banks, rather than commercial ones, although the pool of lenders is greater than it was at the start of the year.
Those investment banks that are already on board – the likes of Citigroup, Royal Bank of Canada, Goldman Sachs, Bank of America Merrill Lynch and HSBC – “have spent a lot of time and energy trying to understand how to make this work, because they feel that it is a very attractive new business line”, says Denton.
M&G Investments has also been active in this market and Starwood is financing one bid for Project Harrogate, having failed to be shortlisted as a buyer after doing a large amount of underwriting on the deal already.
“The challenge of this area of financing is that there are still very few lenders that want to hold the end risk,” Denton adds. “Those that do may have limitations on how much they can hold, while there are those that want to try to underwrite and sell later.”
A proportion of the £150m Citigroup lent Lone Star for its purchase of Lloyds’ Project Royal portfolio, as part of a £300m joint facility with Royal Bank of Canada, was syndicated to AIG, for example.
Fortress Investment Group and European newcomer Renshaw Bay are also studying the market, while Royal Bank of Canada is said to be looking to set up a business for loan-on-loan financing in London.
The latter arranged its share of the financing for both Lone Star’s Project Royal and the Excalibur acquisitions via its Dallas office, its centre of expertise in this area. Lone Star also has its headquarters in Dallas.
The value of an existing relationship with a lender was shown when Kennedy Wilson picked Deutsche Bank, rather than Goldman Sachs, as a partner for the purchase of Bank of Ireland’s UK loan portfolio late last year; the Deutsche Bank debt was sold on to M&G Investments. Kennedy Wilson’s decision to go with Deutsche Bank was based on its existing relationship with the bank in the US.
Not the best road to value
The German lender no longer provides third-party financing for other bidders. Don Belanger, a managing director in the bank’s real estate finance team, says this is because “we realised the risk/return profile wasn’t a good road to value, compared to being in the equity, where you may go a bit further in terms of loan-to-value levels, but your returns are in the mid teens.”
Loan-on-loan financing often requires detailed underwriting, with banks shaping loan documents to safeguard their positions, partly due to the nature of non-performing loans. Denton says: “These deals are relatively complex because you are under-writing loans that have issues, bad structures, are over leveraged, or involve difficult markets or assets. The underlying collateral and structures are imperfect.
“It’s a judgment call of what is likely and possible with regard to loan structure. You have to ask: ‘If necessary, can the sponsor enforce against it? If so, when? How long will it take? What is the process after enforcement? Is it an auction process? Can the sponsor convert its position to equity? Is a state administrator running the sale? Can the sponsor appoint a receiver itself?’”
A lender must also question how easy it will be to sell a poor-quality asset that is vacant, for example, or where spending to improve assets might come from. It must decide whether to sell the loan back to the existing borrower (known as a discounted purchase option), or if it takes ownership of the property, whether to try to improve its value, or sell it straight away.
“All strategies need to be considered for every individual loan,” says Denton. “That’s quite a lot of work and views to take.” Lenders’ main concerns are covenants and equity leakage, says a private equity buyer that recently secured loan-on-loan finance. “Ideally, the bank wants money back first with no real leakage to equity every time you resolve a loan.” This means the bank gets repaid ahead of the fund’s investors.
The Goldman banker says that for UK deals such as Project Royal, where most of the loans are matured or defaulted bilateral facilities and the focus is on the property value, “it’s easy to see the path to realisation of value by appointing a receiver, selling the asset and getting money back.
“In the UK, these portfolios tend to be concentrated on a number of assets that make up 70-80% of the portfolio, with huge granularity in the rump. As a lender you don’t want to depend on that rump; you want to make sure that once you’ve realised value from the key assets you can get out.”
Multi-country deals are a challenge
Deals featuring multi-jurisdiction loan portfolios are more complicated to arrange, largely due to the disparate legal systems, so covenants tend to be more plentiful.
Bank of America Merrill Lynch replaced Macquarie Bank as the financier behind Lone Star’s acquisition of a €200m French and German non-performing loan portfolio from Société Générale, because Macquarie changed the terms of the deal (but not necessarily the pricing). The underlying loans include syndicated positions, which could make potential enforcement harder.
While compiling loan agreements may call for heavy toil, the growing number of lenders vying to finance what is becoming a steady flow of loan portfolio sales suggests that the market is beginning to rev up.
The financing of Project Harrogate is currently the most coveted deal – terms for which must be committed by 1 August. But several others in the pipeline are in need of financing, including the German central bank’s €238.78m Portfolio Green CMBS portfolio, Allied Irish Bank’s £397m Project Pivot and its €675m Project Kildare.
Key covenants cover the lender for different outcomes
In debt portfolio deals where the emphasis is on property value, the key covenants concern leverage. Around 50% is the norm, while amortisation targets in line with a borrower’s business plan allow the borrower to return some cash to the deal’s equity investors if these targets are met.
“Say 80% or 90% goes to pay us,” says one banker, “then 10% or 20% goes to equity, and minimum release [sale] pricing, based on the allocated loan amount and a certain percentage, is calculated property by property.”
If the borrower doesn’t hit, or is only just hitting, the business plan’s target, the lender conducts a ‘cash sweep’ to pay down any outstanding debt with available free cashflow, and follows a plan for default, known as a default amortisation profile.
In the default process, the lender can demand to replace the servicer if, for example, it feels the servicer’s duty of care to the borrower means it is holding out for an increase in asset values and is not making enough progress to repay the debt.
For sub-performing loans where it is hard to realise value and a bank is effectively financing loans that provide an interest stream, the lender can also insert a covenant guaranteeing that it will still get repaid if the income on the loan changes, so that interest repayments are covered.