With great legal and political change comes opportunity for the well- prepared investor. A current case in point is the rapidly evolving bank regulatory framework in Europe, which is serving as a catalyst for large-scale asset dispositions by banks throughout the E.U. In anticipation of asset-quality reviews by European and national regulators, banks are unloading portfolios of loans onto the global loan market. These loan-portfolio offerings present an opportunity for buyers to quickly deploy signiﬁcant capital—and potentially reap outsized returns.
This white paper considers key aspects of the loan portfolio sale process that prospective buyers must be aware of to properly evaluate, and take advantage of, the possibilities before them.
The ﬁnancial crisis focused attention on many risks in the global ﬁnancial system, including the capital adequacy of banks. The Basel Committee on Banking Regulation has agreed upon a third installment to the Basel Accords, an international, voluntary regulatory standard for uniform capital adequacy, stress testing and market liquidity risk. Basel III aims to strengthen bank capital requirements by increasing liquidity, decreasing leverage, and reducing balance sheet exposure to risky assets. Meanwhile, banking regulators in many jurisdictions are continuing disciplined stress testing to ensure that banks are adequately capitalized in a range of adverse economic scenarios. As a result of the testing, capital shortfalls have been identiﬁed and weaker banks have been forced to raise capital, deleverage (by selling assets) or both.
In Europe, the European Central Bank, working with national regulators, is using the asset quality review process to harmonize (across jurisdictions) the categorization of non-performing and impaired credits and develop uniform standards for provisioning against the risk of impaired credit default. The ECB’s asset quality review will re-value illiquid and non-performing loans on banks’ balance sheets and establish uniform methodologies for valuing collateral. Following deﬁnitional harmonization across national jurisdictions through the asset quality review process, the ECB will conduct additional stress testing, beginning this summer.
Banks will likely respond to the asset quality reviews and stress tests by aggressively deleveraging balance sheets through loan portfolio sales or by creating “bad banks” to quickly and systematically exit non-core positions. Indeed, banks now appear to
be deleveraging ahead of capital adequacy initiatives by pre-emptively selling single-name corporate credits and portfolios of non-core assets to lessen the impact of the invigorated asset quality review process.
While portfolio loan sales create a special opportunity for buyers on the other side of these transactions, they also present special challenges. The portfolio sale process is competitive and often conducted within signiﬁcant time and information constraints. A buyer will generally receive imperfect information and will rarely have the luxury of reviewing all of the (imperfect) information received. To optimize success, buyers should approach portfolio loan sales with (i) a plan for assessing the portfolio, including a pre-established framework for conducting due diligence on its constituent loans, (ii) a competitive a strategy for bidding on the portfolio, (iii) an appreciation of the power to efﬁciently allocate risk between seller and buyer in portfolio sale documentation, and (iv) an awareness of its post-settlement responsibilities, including servicing the loans.
PLANNING FOR A PORTFOLIO PURCHASE
Participants in the global secondary loan market routinely buy large volumes of loans by trading on a loan
-by-loan basis. Compliance, credit, operations and legal support for trading desks engaged in individual loan purchases and sales have existed for decades and function within a well-established loan trading framework. Standardized trading documentation has been developed and promulgated by trade organizations (including The Loan Syndication and Trading Association in the United States and Loan Market Association in Europe) and has spurred liquidity and simpliﬁed the loan trade settlement process, while codifying risk allocation and key trading conventions.1
Such a standardized process does not exist for loan portfolio sales, which are qualitatively different from seriatim loan purchases. Among other reasons why this is so, several factors unique to portfolio sales make the due diligence process a more complex and varied endeavor than it is in the case of single-loan dispositions.
Obtaining Credit Information
To conduct due diligence in connection with a portfolio purchase, a buyer must obtain information relating to (i) the selling bank, (ii) the borrowers, and (iii) the loans themselves. In many jurisdictions, little information about borrowers and their loans is publically available. This is especially true in the European leveraged loan market, where companies (even large companies with listed shares) rarely ﬁle loan agreements publicly. Most of the time, the best credit information will be contained in credit ﬁles maintained by the selling bank and provided to prospective buyers in connection with the portfolio sale process.
As a condition for disclosing due diligence information about a loan portfolio, selling banks require potential buyers to agree to conﬁdentiality undertakings. Parties to a portfolio sale process generally use bespoke conﬁdentiality agreements rather than modifying standard terms of forms promulgated by trade organizations. Any conﬁdentiality agreement should be tailored to ﬁt the intended portfolio sale transaction. Important issues to consider include (i) the availability of information about the selling bank, (ii) the duration of the conﬁdentiality undertaking, and (iii) permitted use of the conﬁdential information. Information regarding the selling bank is particularly important in portfolio sales, given that, in contrast to multiple individual loan sales, the counterparty risk is concentrated exclusively in one entity, the selling bank.
- Key documentation conventions include allocating accrued but unpaid interest between buyer and seller, rules about compensation for delayed settlement, and establishing a liquidated damage framework for failed or troubled trades through uniform buy-in/sell-out rules.
Organizing Due Diligence Tasks
Once the conﬁdentiality agreement is negotiated, a potential portfolio buyer will need to conduct commercial and legal due diligence of the loan
- Likelihood of Repayment
Buyers must analyse a borrower’s ﬁnancial condition, most importantly the borrower’s ability to generate cash ﬂow necessary to service the loan and other debt obligations, and to access the capital or credit markets
Price Discovery and Loan
While the above considerations apply equally to the single-credit context, price discovery may be complicated in portfolio loan sales by a number of factors, including:
Multiple jurisdictions: Portfolios with underlying loans that touch on multiple jurisdictions can be challenging to value, particularly when the relevant law in those jurisdictions is not well settled. The need to understand and account for variations in the secu- rities, insolvency, and tax rules in multiple jurisdictions makes the valuation process more challeng- ing and less certain.
The sales process: The proce- dures and number of parties in- volved in a particular loan portfo- lio sale can have a considerable impact on the price—whether depressing it due to a tight timeframe in which the bank chooses to conduct its sale, or raising it through competition among buyers in a portfolio auc- tion. Such conditions can distort the value of a portfolio below or above a level justiﬁed by its con- stituent loans.
Liquidity: The assets being sold in a portfolio disposition often include a high percentage of illiquid loans (e.g., bilateral loans originated to middle market or “small and medium enterprise” borrowers). Usually a buyer is required to bid on and, if success- ful, purchase all of the loans in the portfolio. A portfolio skewed toward illiquid loans will be hard- er to price and the loans will be more difﬁcult to transfer, adding to transaction costs.
the line between “commercial” and “legal” due diligence is blurred, but both inquiries focus on two primary questions: (i) how should the portfolio be valued, and (ii) how best can the full economic value of the portfolio be transferred to the buyer?
Determining the Value of the Portfolio
The value of a leveraged loan portfolio is derived from (i) the projected cash ﬂows of principal and interest payments on the loans and buyer’s view of the underlying borrowers’ risk of payment default, and (ii) the underlying credit support, including guarantees and collateral. Credit support for a loan is particularly important in the event of a default by the borrower, and it should be tested in the diligence phase based on an assumption that a default will occur.
to reﬁnance or extend obligations coming due in the near term. Buyers should conﬁrm any purported contractual subordination of competing borrower obligations and test the borrower’s capital structure to determine the rights of the bank against other creditors. A senior loan at a parent company may very well be structurally subordinated to another debt obligation at the subsidiary level.
- Credit Support
In any due diligence process, all purported credit support should be veriﬁed to the greatest extent possible and should not be taken for granted. Veriﬁcation should involve both a commercial valuation of the underlying collateral and a legal analysis conﬁrming access to the collateral and the terms of the governing guarantee, security and intercreditor agreements. Perfection of security interests, particularly in the context of a bilateral loan without an independent administrative or collateral agent, should be conﬁrmed. At the very least, buyers should review granting clauses of security agreements to verify (i) the scope of the collateral, and (ii) the payment obligations of the borrower supported by the collateral.
The due diligence process must identify any party that is entitled to priority over the bank’s right to the identiﬁed collateral or the bank’s right to repayment. Buyers should also investigate the possibility that other parties are entitled to share collateral on a pari passu basis – whether as a member of the lending syndicate or a counterparty to a hedging transaction permitted under the loan agreement.
- Insolvency Risk
The credit support analysis cannot stop after reviewing the loan agreement and the security documents. If a borrower becomes insolvent, the rights set forth in the
legal documents will be tested against the laws of the relevant jurisdiction(s) governing debtor and creditor relationships. Many banks that sell portfolios of loans have active cross-border lending businesses, increasing the likelihood that the portfolio sale includes loans to
borrowers in different
- Tax and Other Issues
Other issues may also surprise the prospective buyer of a loan portfolio and complicate the valuation analysis. These include, for example, rules governing the withholding of taxes on the interest payments on the loans where the borrower is in a different jurisdiction
Diligence Algorithms and the 80/20 Rule
Ideally, every borrower, loan and credit support arrangement should be fully investigated. Often, however, the number of loans in a portfolio is too large and the bidding timeframe is too tight for a thorough analysis. It is imperative that buyers have a well
-conceived diligence algorithm designed to distinguish between “important” loans that must be thoroughly reviewed and “less important” loans that can be subject to more cursory attention.
If it is true that 80% of a portfo- lio’s return may come from 20% of the loans, how should the due diligence process capture the right candidates for a more thor- ough review? Certainly it is un- wise to have an “alphabetical” methodology organized by bor- rower name. It can be equally unwise to trust an algorithm that focuses solely on loans with large outstanding principal balances. Pricing a large loan from an es- tablished, creditworthy borrower may be less risky and require less due diligence than pricing a mid- size loan from a relatively un- known borrower secured by col- lateral in several emerging market jurisdictions.
jurisdictions. Even if all borrowers are conveniently located in the same jurisdiction, weighing insolvency risk may involve co- borrowers, guarantors, collateral or other credit support providers in different jurisdictions. Insolvency proceedings in multiple jurisdictions may produce substantially different recoveries against credit support providers once thought to be providing equivalent support.
Many jurisdictions have complex and often untested rules and remedies in insolvency proceedings, which may not produce outcomes analogous to the Chapter 11 bankruptcy process in the United
than the buyer, entitlement of the lenders to agree to a forbearance or waiver of any default, and future funding obligations and obligations to share any payment with other lenders or creditors pro rata. These are all issues that can potentially have a signiﬁcant impact on a buyer’s expected return on the investment and should be investigated thoroughly in the portfolio-pricing context.
Ensuring all Economic Value Is Transferred to Buyer Once a buyer has determined the value of the loan portfolio (and by implication the price at which it will bid for the portfolio), the buyer turns its focus to understanding the framework for transfer of the entire bundle of seller’s rights comprising that value. The ﬁrst and most obvious component of that bundle is transferring the right to payment of the loan itself. The second is transferring seller’s security interest in the underlying collateral supporting each loan in the portfolio.
- Transferring the Loan
The ideal transfer structure from a buyer’s perspective is usually an assignment or novation—the buyer steps into the shoes of the seller under each loan agreement. But sometimes an assignment is not feasible. In many jurisdictions outside of the United States, bank licensing laws prohibit non-banks from originating or, in some
States. Some jurisdictions are amenable to out-of-court restructuring solutions while others lean toward direct intervention, a mix that makes predicting the restructuring process difﬁcult. An advance understanding of the insolvency process in the relevant jurisdictions is essential to accurately valuing a loan portfolio.
cases, purchasing a loan. Even where no regulatory
restrictions apply, the relevant credit agreement may limit the type of institutions that can hold the loan as a lender. If a buyer is not an eligible lender, or otherwise ﬁnds it impossible or impractical to transfer the loan by assignment or novation, it may consider alternative ownership structures, including purchasing certain loans by participation.
Participations can come in different ﬂavors: (i) “true sale” participations—the participant owns a “beneﬁcial interest” in the loan and the grantor owns “bare legal title,” or (ii) derivative-like participations—the grantor retains ownership (legal and beneﬁcial) in the loan but promises to pay the participant an amount equal to payments actually received under the loan agreement. In either case, the buyer (as participant) is exposed to the continuing credit risk of the seller (as grantor), which adds a dimension of credit risk to the portfolio purchase.2
In rare cases, transfer by both assignment and a participation will be prohibited. If that is true, it may be possible to use a traditional derivative arrangement (such as a total return swap) to transfer the value of the loan to buyer. A derivative structure may allow buyer to beneﬁt from protections embedded in derivatives master agreements (such as an International Swaps and Derivatives Association master agreement), including the termination and netting provisions and favourable treatment in the event of a swap counterparty insolvency in certain jurisdictions.
However, using a derivative structure to transfer value will also require compliance with newly adopted regulatory regimes in many jurisdictions around the world. Most importantly, a derivative arrangement may prevent a seller from removing loan assets from its balance sheet and therefore may be unacceptable to the seller and also entail speciﬁc tax, accounting and other issues that a buyer should consider.
- Transferring the Collateral
The second “transfer of value” issue relates to obtaining the beneﬁt of seller’s security interest in the underlying collateral supporting each loan in the portfolio. If the loan portfolio consists of syndicated loans, a collateral agent will hold the security for the beneﬁt of all lenders and there will be no need to transfer beneﬁt of the
security interest to the buyer. If there are bilateral loans or other loan facilities in the portfolio that do not utilize a collateral agent, the security interest may need to be transferred and perfected in the name of the buyer to comply with local notice and ﬁling regimes governing the perfection of security interest. Stamp duty may also apply to such collateral transfers.
In Europe it is sometimes disadvantageous to assign or novate the security interest. Some European jurisdictions view novation as the discharging of the transferred rights and obligations and replacing them with new ones that are identical to the “old” discharged rights and obligations—potentially invalidating the security or resulting in the loss of priority over creditors that ﬁled after the original security ﬁling.
THE BIDDING PROCESS
Bidders for loan portfolios follow bidding procedures developed by the selling bank, and the procedures have resisted standardization. They vary signiﬁcantly depending on the seller, the portfolio and current market conditions. A portfolio seller will generally pre- clear a bidder’s creditworthiness and obtain any internally required counterparty approvals prior to permitting due diligence on the portfolio to begin. The diligence phase can last thirty days, but some portfolios are sold on a more compressed timeframe. Sellers often provide for more than one round of bidding. The set of high bidders in a preliminary round are invited to continue to diligence the portfolio and to submit binding bids in a second, ﬁnal, round of bids.
Some sellers permit bidding on individual loans or a subset of the portfolio, while other sellers require an all- in bid for the entire portfolio. Adopting an eBay-like approach, some sellers offer a “buy it now” option for buyers who are willing to buy a loan at a price set by the bank to remove the loan from the auction process.
- There may be reasons for a buyer to prefer a participation structure. The most notable example is that it may be able to avoid withholding tax that is otherwise levied if it were to hold the loan as a lender.
NEGOTIATING THE PORTFOLIO SALE
To the greatest extent possible, a successful bidder for a portfolio of loans will want to negotiate the terms of the governing portfolio purchase agreement. Selling banks will often include (seller-friendly) transfer documentation templates in the bidding process, and successful buyers must judiciously comment on the documentation – too heavy a mark-up may allocate risk in a manner
unacceptable to the
unfunded commitment and accrued interest. The conﬁrmation also will contain a contractual agreement that the parties promptly enter into a deﬁnitive purchase and sale agreement. While an LSTA or LMA standard trade conﬁrmation could be modiﬁed to support a portfolio sale and evidence the parties’ agreement to trade, it is more likely that the seller will use a bespoke conﬁrmation tailored to the speciﬁc loan portfolio. A buyer would want to avoid, or negotiate, “long stop
Which Law Governs the Portfolio Sale?
The laws of several jurisdictions must be considered when deter- mining the governing law of a portfolio sale. Different laws can govern seller, buyer, borrowers, the collateral and the loan agree- ments themselves. Parties may need to contend with vexing conﬂict of laws issues where mul- tiple jurisdictions are involved. Seller and buyer can often negoti- ate and select the governing law as part of the deﬁnitive purchase and sale agreement.
However, to the extent buyer needs to enforce its rights as a lender against the borrower it may be advisable to ensure that the transfer of the loan (and the seller’s rights under the credit agreement) satisﬁes the require- ments of the governing law of the credit agreement as well as the law of the borrower’s jurisdiction. When the borrower and the col- lateral are located in different jurisdictions, transfer of the secu- rity interest may need to satisfy the requirements of both the law of the borrower’s jurisdiction and the law of the jurisdiction where the collateral is located.
selling bank and cause the bank to consider other bids, including bids that are less attractive on a purely economic basis. A well- organized diligence process will often identify issues about the underlying assets that require substantive comments to seller’s form transfer documentation, and these asset-related comments often stand the best chance of being successfully negotiated within a seller-generated documentation framework.
Documenting the Sale A trade conﬁrmation may be used to start the documentation process,
dates” after which the trade will terminate if not completed. Portfolios containing non-syndicated loans in emerging markets are notoriously difﬁcult to transfer in a timely manner. Even if the portfolio involves a straightforward transfer process of syndicated loans, the sheer volume of loans involved in a portfolio transaction may overwhelm the operational capacity of a buyer, and settlement delays may be inevitable.
Deﬁnitive Purchase Agreement
The deﬁnitive purchase agreement will allocate the risks inherent in owning the portfolio of loans. The agreement will contain representations and warranties from seller about the loans, and in some cases, seller’s historical conduct with respect to the loans. If buyer expects to sell some of the portfolio, buyer should know that the secondary market will expect a customary set of representations and warranties on resale, and endeavour to negotiate those representations and warranties from the seller in connection with the portfolio purchase. Sometimes, however, a portfolio loan seller will vehemently resist making any representations aside from its ownership, because it prefers to avoid making a post- settlement reserve for a breach of its representations.
A deﬁnitive agreement should address pre-settlement
but the parties can also agree to enter into a deﬁnitive purchase and sale agreement promptly.
If used, a trade conﬁrmation will set out the material terms of the trade, including, among other things, the description of the loans, price, outstanding principal,
issues both in terms of covenants (including negative
covenant) to be complied with before, and conditions precedent to, settlement. The agreement should also address post-sale issues relating to, among other things, the exercise of voting rights and the extent to which seller is obligated to assist buyer in enforcing rights under the loans, including the right to foreclose on collateral. These voting and “further cooperation”
provisions are particularly important to a buyer when the portfolio consists of bilateral or club loans where the lack of an administrative or collateral agent may require the buyer to “fend for itself” to protect its rights under the relevant loan agreement.
Efﬁcient Settlement Structures
Transfers of each loan in a portfolio of loans are unlikely to be accomplished simultaneously and a seller may prefer to utilize a “temporary participation” structure, under which the seller sells some or all of the loans by participation on a temporary basis in exchange for payment of the purchase price, and thereafter the parties cooperate to “elevate” the participation in each loan into an assignment or novation. A buyer, on the other hand, should negotiate for payment only upon assignment being perfected to avoid taking the seller’s credit risk and also to gain some leverage to ensure the seller’s cooperation in the assignment process.
Following the settlement of the portfolio loan purchase, a buyer will need to ensure that the intended transfers are properly completed from a technical perspective. Portfolio purchases that are settled via a “temporary participation” must be elevated into an assignment for each loan in the portfolio. Local law may require the re- registration of the security interest in order to preserve the interest of the buyer and its priority. Sometimes re- registration of a security interest in buyer’s name is not a requirement but is nonetheless highly recommended. While technical, these actions are critically important to the realization of a buyer’s investment expectations in the loans.
The buyer’s work is not ﬁnished when it becomes the lender of record for the loans in the portfolio. Among other things, the buyer will need the operational capacity to monitor and collect funds from the borrower, fund a draw request, reﬂect an interest reset and otherwise competently service the loans. A prudent buyer will proactively monitor the credit of the borrowers, consider amendment or waiver requests and
periodically make decisions to buy or sell individual loans into the secondary market.
Global loan markets are currently experiencing cyclical disposals of loan portfolios by banks in certain jurisdictions, often motivated by balance sheet, capital, credit risk or other drivers. In order to take advantage of the growing number of loan portfolio sales, buyers must understand the legal, regulatory, insolvency and tax regimes of relevant jurisdictions as they apply to secondary loan purchases and develop a proactive methodology to review key provisions in the credit and security agreements. Where the time for due diligence is compressed, a buyer will need to identify signiﬁcant loans and rationally deploy limited due diligence resources. An efﬁcient purchase agreement should incorporate economic conventions and contractual provisions readily available in the increasingly global secondary loan market. Buyers that are guided by these fundamentals will ﬁnd that loan portfolio sales present opportunities for efﬁcient and proﬁtable investments.