Sometimes a bank just has to sell assets. For many banks confronting capital shortfalls, this is one of those times. Last week, we wrote generally about the "Investing in Distressed Bank Assets Conference" in London. Great conference. Marquee headline: EU Banks Will Sell Risky Assets. Time for a deeper dive into issues confronted by the sellers.
So, if you want to sell a big pile of assets (steaming or otherwise), what do you do? You can certainly hire one of the well-known brokers (er, I mean loan sale advisors) in the market and tell them to have their way with you. They will do some level of loan file organization; produce some type of tape; produce a book (pretty pictures); and set up a war room. They will run a public auction process. They will jawbone the bidders. Do they do a really good job? Read on. Is this the only option? No.
The auction sale is designed to produce a market clearing price. Note, however, that as disintermediation continues, buyer fatigue is beginning to set in in the auction space. The cost to make a competent bid on a sizeable pool of loans with an unlimited number of eager bidders is enormous. Will that process continue to pull in the best and most well-heeled bidders? Don’t know. It is clearly best to structure the auction as a multi-step process so first look bids can be made with limited diligence expenses and the non-real culled. A good bid process will work hard to qualify the truly serious and create a bidding environment where the real bidders don’t feel like they are bidding with a herd. Thus, only the truly serious have to execute a truly deep dive. Is the right number 3? 10? Certainly not 20 plus!
In addition, a public auction is, well, public. What does it say about the seller? What information is available to any bidder who can hit send on the confi? Rooting around in a selling bank’s financial drawers has become a sort of financial porn – almost irresistible. Dirty laundry comes out and the rumor mill is fired up about the seller, its health, its prospects, plans and management. At the very least, that may be less than entirely enjoyable. And market chatter can move markets and influence regulators and political constituencies.
Moreover, an auction is a one-size-fits-all execution. Sure, the broker can set up an infinitely complex array of alternative bids (Pool A, single loans, all loans in Milwaukee CBD, etc.), but it’s still a straight sale of loans. That may not always be the ideal execution.
The seller should always consider a private, negotiated deal. In a negotiated deal, there is much more structural flexibility as buyer and seller work together to sort out what works best. This can have huge value to the seller if it feels it has selected the right counterparty. And the sausage making is private. On the other hand, did you get the best, market clearing price? It is hard to prove the counterfactual to the market, senior management and the Board.
An alternative to either of these sale processes is securitization. We have recently seen seasoned portfolios securitized; indeed, we are on the cusp of industrializing the securitization of sub- and non-performing loans. Can a bank find a high-yield buyer to take the risk piece and sell some IG bonds? Absolutely! This could maximize control over the process, control confidentiality and disclosure, and perhaps produce the highest return.
In any case, if you want to sell loans, you start by rounding up (warming up and qualifying) the usual suspects. In the States, there has been a very strong bid from well-capitalized banks for performing par product, while the hedgies and private equity are a strong bid for distressed and sub-performing. Notably, the high-yield players may also be a bid for par product. Pools can be flipped through securitization, with the high-yield player keeping the bottom while the top is sold to the IG gang, providing long-term leverage for the transaction.
Pick a sales process, warm up the crowd, but don’t forget to put some lipstick on the pig.
Diligencing a pool of seasoned loans can be painful, really painful (and about as bad for the seller preparing a book as for the buyer). Seasoned loans were not originated for sale. They were not serviced for sale. They are relationship loans. Getting a data tape that is not incomplete or corrupt is enormously hard. Sorting out non-customary servicing records is hard. Finding the loan documents is hard. One missing note, an inconvenience; all missing notes, existential problem. The harder it is to diligence the pool, the bigger the uncertainty discount in pricing.
Valuation is made much more difficult because of heterodox collateral and heterodox loan documentation. A loan secured by a commercial building is good. A loan secured by a commercial building, a fleet of delivery vans and an undivided interest in a race horse is less than ideal. In documentation, we customarily see multiple basis provisions, pay dates, grace periods, swap and hedge structures, recourse features, maturity and amortization, etc. What a headache.
Best in class in the bad news category are restrictions on the lender’s right to assign the loan. Maybe for future funding loans or the like, these restrictions could make sense. Otherwise, they do not. Drafting point going forward: don’t go there. But go there, many have done, and the headaches from these restrictions reverberate through the note sale market. We find these most often in the loan documents of the European banks. There are several flavors of these restrictions, and none are good. We have seen restrictions that limit assignability to other banks, or to other banks and financial institutions (often an undefined term), or to financial institutions with a certain credit rating. We’ve also, and this is the most painful of all, seen transfer restrictions that simply require the borrower’s consent. It’s a borrower payday when that loan has to move.
If the lender has sufficient lead time, document flaws and structural flaws can be fixed, borrower consent can be obtained (although be prepared to pay a price) and other problems resolved. But, even if problems cannot be fixed, if the seller can get its arms around document and structural problems before it exposes the pool to the marketplace, it will pay dividends. Regrettably, we have yet to see a pool cleaned up good before it got to the party.
Abandon all hope, you who enter the land of swaps and hedges. OK, that’s an exaggeration, but swaps and hedges deserve a separate circle in Hell when trying to sell loans. Many European bank loans (and, of course, many loans in general) have embedded swaps, collars or other derivatives. In many cases, the value of the loan is, in significant measure, dependent upon the value of the derivative. Unfortunately, derivatives typically have their own transfer restrictions and these are regularly overlooked when the loan is made. We have seen derivatives that can only be transferred with the consent of the borrower, while many others contain a litany of transferee restrictions. Cutting to the chase, the most common restriction is that the derivative must be held by a bank, and often a bank with a stipulated ratings level. If the potential buyer universe includes non-banks, this creates problems. And while there are lots of workarounds, including Total Return Swaps (TRS), 100% participations and back to back structures, they are hard, carry negative externalities and, certainly, are best sorted out before the dance begins. Fix it before exposing the pool to the marketplace. Did I say consider? I think it is insane not to fix up what can be fixed up before exposing a pool to the market. Any residential broker who can fog a mirror will tell you that a fresh coat of paint, new kitchen appliances, a mowed lawn and a new carpet gets the sale done. Same here.
And here’s a thought for overachievers. This is the bonus round stuff. Consider prepackaging leverage; a cover bid from a lender prepared to lever the portfolio might be an interesting added feature to maximize the value of the bids.
In any event, enough about the sellers. Next week – some thoughts about buying: diligence, reps and other concerns.
By: Rick Jones
