Opportunities to invest in European non-performing loans will increase notably in 2012, say Charles Roberts and Conor Downey
Since the beginning of the credit crunch, European banks have seen the value of their balance sheet loan investments decline steadily. Most banks held tight to these assets in the hope their values would improve. In any case, even if the values did not increase, they hoped they would be able to achieve higher realisations on these loans over time rather than the prices the market was willing to pay for them. As a result, there have been few loan portfolio sales by banks in Europe since the collapse of the credit markets.
Unfortunately, the credit markets have not yet returned in any substantial manner. Therefore, in turn, the values of these loan investments have continued to decline, as did the revenues from these assets for most European banks.
The continuing disruption of the European banking industry has led the European Banking Authority (EBA) to establish new capitalisation guidelines for banks. On 8 December 2011, the EBA set requirements that would require European banks to raise more than €114bn by June 2012 (based on their current loan books). This will put pressure on banks to raise cash and dispose of assets against which they will need to hold capital.
This situation has already led to €1.2trn of asset sales by European banks, with some industry experts predicting that those sales will increase to €3-5trn in the coming years. A significant amount of these asset sales have included commercial real estate loans. In recent months, Royal Bank of Scotland (RBS), Bank of Ireland, Lloyds/HBOS and Société Générale have sold or put on the market large portfolios of commercial real estate loan assets.
All of the large portfolio sales of commercial real estate loans that have occurred in the past six months have been made to private equity buyers. Almost all of these transactions were financed with debt, with only one transaction involving vendor financing by the selling bank. Most selling banks have preferred cash sales for their assets, and given the recent EBA requirements the market expects this to continue. These circumstances have led to significant demand for third-party debt capital to finance loan portfolio acquisitions.
While the market anticipates that more portfolios of commercial real estate loans will be offered for sale, there has been little discussion as to the opportunities this may present from an investment perspective. As stated above, all of the current portfolio sales have been made to private equity firms. However, these loan sales will give rise to a number of potential investment opportunities for other participants in the market.
For one, there has been a demand for third-party debt finance to fund these portfolio acquisitions. It has been reported that one large third-party debt financing for a European commercial mortgage portfolio has recently been syndicated and it is likely that over the course of the next six months these facilities will increasingly be offered for syndication in the market.
Debt finance for non-performing loan (NPL) portfolios is similar to other forms of warehouse finance but contains certain unique features. In particular, NPL financing requires each loan asset to have a specific realisation strategy, typically in the form of a business plan, with the lender having significant control over any deviations from such business plan. Also, NPL facilities usually have financial tests that will need to be satisfied within specified time periods, thereby putting pressure on the equity sponsor to realise quickly on assets or otherwise cause deleveraging against the portfolio. Given the underlying loans are in actual default and enforcement of the same is likely, NPL financing facilities have to allow specific mechanisms for the equity sponsor to become the direct owner of the related commercial real estate. Finally, NPL financings have to allow mechanisms (including inter-creditor arrangements) for equity or debt to be injected to fund capital expenditure to re-let vacant properties.
Another potential opportunity for investors could be through investment in an NPL securitisation. Such a securitisation could be structured in a number of different ways. However, any such structure would be consistent with respect to certain key elements.
In particular, the NPL portfolio will either be acquired directly by the securitisation vehicle or, instead, the vehicle will acquire debt secured on the NPL portfolio. The securitisation vehicle will issue bonds secured against the NPL portfolio, with the senior bonds being sold to third-party investors. The equity investor in a NPL portfolio may hold the subordinate bonds in the securitisation in addition to any equity position in the portfolio.The equity behind the NPL portfolio will typically manage the portfolio. The NPL portfolio will be managed pursuant to an asset management agreement and will be required to meet certain financial covenant thresholds during its term.
In many ways, a NPL securitisation will look very similar to any syndicated debt secured over an NPL portfolio. However, the bond structure will likely keep the third-party investors further removed from the day-to-day management of the portfolio than if they held direct interests in a loan secured by the NPL portfolio. Also, it is likely the securitisation bonds will be rated. The listing and rating of the securitisation bonds should make them more liquid than an interest in a syndicated loan.
An NPL securitisation can be arranged by either the bank that holds the NPL assets on its balance sheet or by a third party that has acquired the NPL portfolio from the bank. An NPL securitisation is seen by many banks as an attractive means to raise cash against assets without having to take an immediate loss based upon the current market value of such assets.
In the current cycle, Europe has not yet seen any NPL securitisations in respect of commercial real estate assets. However, the early 2000s saw limited issuance of European NPL securitisations backed by Italian and German mortgage loans with Lone Star's €1.34bn Bluebonnet transaction in 2006, which securitised a debt facility financing a German NPL portfolio seen as a potential template for future transactions. In addition, JP Morgan has announced that it plans to securitise NPL portfolios in the US.
While securitisations are one way to package-up interests in NPL portfolios for investors, another is mortgage real estate investment trusts (REITs). While mortgage REITs are not currently possible under the REIT laws in the UK, mortgage REITs are a very popular means of investing in mortgage debt in the US. There has been much discussion in the press in recent weeks as to whether mortgage REITs should be introduced in the UK. While there seems to be some support for this at government level, the necessary changes in law are unlikely to occur before 2013.
A mortgage REIT could be formed by either the originating bank or the investor. A REIT is effectively a tax pass-through vehicle which would not tax the income from the underlying mortgage assets in the hands of the REIT; instead, tax would accrue on the payments made by the REIT to its investors, so only the investors would be liable to pay such tax. The REIT would issue interests that effectively represent an ‘equity' ownership in the NPL portfolio to its investors. The REIT would be allowed to incur debt to help finance its acquisition of the NPL portfolio. In any event, such mortgage REITs would permit a more widespread syndication of the equity in the NPL portfolio without having the added drag caused by the varying tax treatments required by the various REIT investors. Unlike a securitisation, the REIT interests held by the REIT investors would not be rated investments.
In conclusion, investors interested in European NPLs should expect a variety of different opportunities for investing in NPL portfolios to become available in the coming months. Given the limited availability of traditional bank finance in the current market, it is likely that NPL investments will become a significant focus for a number of market participants.
Charles Roberts and Conor Downey are partners at Paul Hastings