Lenders adjust terms to match longer-term work-out strategies, writes Lauren Parr
Borrowers looking for finance to buy non-performing loan (NPL) portfolios have seen banks’ terms and structures change as the market has evolved over the past four years.
“The first deals that came to the market were simpler to digest in terms of portfolio composition and business plan,” says Russell Gould, lead transactor in the commercial real estate finance team at Citi, one of the first banks to provide loan-on-loan financing.Rapidly changing property values, the nature of portfolios and buyers’ business plans all have to be accommodated by the financing taken out by NPL borrowers.
“These portfolios were hand-picked by sellers to appeal to a limited pool of interested sponsors. The portfolios tended to comprise bilateral whole loans with some lumpy credits that provided significant value coverage for the financing, generally backed by stabilised cash-flowing assets. Business plans were relatively straightforward, with limited emphasis on value-added strategies.”
Citi’s earliest deal in this cycle was jointly financing Lone Star’s acquisition of Lloyds’ Project Royal with Royal Bank of Canada.
Gould describes the process as akin to a “quasi brokerage exercise”, with sponsors focused on monetising assets quickly, whether through foreclosure or consensual deals with borrowers. This led to a fairly straightforward underwriting exercise from a lender’s perspective.
Then, and until last year, the bulk of NPL deals came out of the UK and Ireland. But with the low hanging fruit now taken, trading is moving towards Nordic, Southern, Central and Eastern European markets.
“The loan-on-loan market has evolved significantly,” Gould adds. “Sponsors are bidding on larger, more complex portfolios. We are seeing granular portfolios, some comprising mixed collateral pools (residential, commercial and SME lending). The real estate can include land or transitional assets and on the loan side, it’s not uncommon to see syndicated or junior positions combined with bilateral whole loans.”
Federico Montero, head of loan sales in EMEA Corporate Finance at Cushman & Wakefield, says: “As lenders and asset management agencies in the UK and Ireland reach the final stages of deleveraging strategies, larger, more granular portfolios secured by a range of CRE and residential assets are being marketed, rather than the more lumpy portfolios of the past few years.
“As well as these strategies being more viable for the vendor following a general improvement in secondary real estate markets, investors can use their acquired servicing platforms to maximise the value of these more granular portfolios.”
Business plans have also changed. Instead of attempting to monetise assets quickly, investors are now looking at which value-
added strategies can generate the most value, with longer turn-around times.
As a result, the restrictions lenders place on the amount of equity a borrower can take out (known as equity leakage), potentially for capital expenditure if an asset is foreclosed on, have been relaxed.
In the earlier deals, loans were almost fully cash sweeping – with excess cash flows used to pay off debt, rather than being taken out by an investor – because banks’ concern was to get repaid as quickly as possible.
Today, leakage is often still limited early on in a loan’s term, but as the business plan and amortisation targets are met, there is a greater tendency to share the excess cash.
Other features have moved in borrowers’ favour. With most investment banks back in the market (see table), loan-to-cost levels have risen from 60% to 75%, giving a better return for investors and allowing them to bid higher for portfolios, although leverage is 40-50% in Southern or Central Europe.
Meanwhile, both fees – taken out up front – and margins have fallen, according to one NPL borrower. Margins have fallen from the 500-600 basis points charged for the first loan-on-loan deals to 300-350bps.
With leverage rising, lenders still look for some early amortisation, whether in a cash sweep or through high release pricing – the percentage of the sale price pro rata that the lender is owed after an asset has been sold. A lender will set a higher release price for better-quality assets, so that a borrower has more incentive to sell those better assets, allowing the other assets to get paid down.
Early deleverging expected
Early deleveraging is broadly expected as big positions, large assets or large connections often get resolved first, although the amortisation of a facility should ultimately follow a business plan.
Sources estimate that typically, 10% of borrowers come forward with discounted pay off offers when NPL deals close.
Bankers say it wouldn’t be unusual to see 20-25% of a loan repaid in the first two quarters after a portfolio financing, followed by amortisation targets to deleverage the loan. On a three-year loan, for example, a third would typically be repaid by the end of year one; another third by the end of year two; and all repaid by the end of year three.
Yield maintenance clauses, which demand a minimum amount of interest from a loan, are often a discussion point between lenders and borrowers. “We may try to make sure we’re entitled to pay down debt without being penalised if we know we’re going to be resolving stuff early,” says one borrower.
Another way borrowers maximise their investments is to put their equity into NPL financings by way of a subordinated loan, through a holding company, for tax reasons. “Economically, this is still equity, just structured as subordinated debt, as paying interest on that is a deductible expense,” says David O’Connor, a lawyer at Mayer Brown.
One banker lending on NPLs stresses that: “Debt finance for loan-on-loan packages is always extremely tricky and there is no one-
size-fits-all approach.” The move towards granular portfolios in new jurisdictions and value-added strategies brings with it new challenges, which debt structuring must continue to flexibly adapt to. n
NPL buyers lead lenders into less charted territory
Over the past 12 months the non-performing loan market has opened up. Previously dominated by trades backed by UK and Irish collateral, there is now a spread of deals including portfolios containing Spanish and Central and Eastern European assets.
For example, in January, Blackstone bought the Aneto book of 39 non-performing loans backed by Spanish housing developments and land with a par value of €237m, from Sareb.
This brings challenges for lenders, not least owing to less creditor-friendly enforcement regimes than in the UK. Italy is notoriously slow, while in Germany enforcement takes about 18 months, but is predictable.
While the returns on offer in more tertiary markets such as Eastern Europe can be appealing “these are often small real estate markets and legal regimes are too brain damaged”, says one investment banker.
He adds that while nothing is off banks’ radar, there is less of a financing requirement for portfolios in places like this, as discounts are often greater due to the volatile and opaque nature of markets. “A lot of portfolios are bid for with equity; financing is a bonus.”
Besides the fact that loans may need to be advanced in different currencies, “understanding the expertise a sponsor has to exercise on a more complicated business plan, in terms of crossing different geographies and asset classes, is more of a challenge for banks”, says another investment banker.
Fast payback comes at a cost for loan-on-loan lenders
Early generation non-performing loan financings have been repaid far more quickly than banks first envisaged, one investment banker admits. Five-year loans have sometimes been paid off in 12-18 months, he says.
Examples of fully repaid loans include Citigroup’s and Royal Bank of Canada’s £300m senior financing of Lone Star’s Project Royal purchase from Lloyds in 2011. This is partly because sponsors have been good at executing business plans quickly and property values have moved in their favour, and also owing to loans’ restrictive equity leakage.
Some banks have questioned the business model as a result, although today’s more value-added strategies naturally mean loans and assets are held for longer.
“Banks want borrowers to repay from a credit perspective, but want to make money
as well,” says one NPL adviser. “This is putting money into a highly difficult, work-intensive asset class. So if a sponsor asked a bank to finance a small NPL portfolio, it wouldn’t bother to do it, as it is a lot of work.”
He adds: “It’s a tough business for banks because in a conventional deal it can take action through enforcement to get cash back; in an NPL deal, it’s not that easy, as an investor might have already done that.”
In one sense, this type of financing is a form of unsecured credit.
So far this cycle there have been no loan-
on-loan securitisations. Loan-on-loan financing is treated as lending on a financial asset (and therefore a securitisation) and resecuritisation would face punitive capital treatment.