For the last few weeks, I’ve been writing about investing in distressed bank assets, with a particular focus on the European markets. As you know, we think there are huge opportunities as the European banks disintermediate to meet capital thresholds, while the economy in Europe grinds slower and slower. Last week in this blog we talked about considerations on the sell side. Now, near and dear to my heart; the buy side.
First, we can start by thinking about everything said in last week’s article on the sell side and turn it over and look at it from the buy side. The asset pools will continue to be heterodox. The collateral, the loan documents, the economic terms of the loans will all be heterodox. Notwithstanding my plea to the sell side to get their house in order before pools are exposed to the marketplace, you should anticipate that pools will not be cleaned up for prime time before being exposed for sale. Files and data tapes will be incomplete and will be corrupt, documents will be missing, and underwriting information will be woefully hard to come by.
That’s what it is, get over it. We play the cards we’ve been dealt and we bid on what we got.
If it’s an auction environment, you’ll have no idea how many serious bidders there are. As we mentioned last week, pulling a confi and looking at a pool for sale is a little like financial porn. Everyone does it. How many serious bidders there are will be unclear. That means you’re confronted with a massive diligence project with an uncertain likelihood of success.
So the first major issue is to see how you can winnow the buy side without spending a fortune on diligence. Hopefully, the sell side will set up at least a two-stage auction, where indicative pricing can be provided without hard commitments before real heavy lifting on diligence will be due. If it’s a one-stage affair, you need to think long and hard about willingness to spend enormous money on what amounts to a flier. You may also think through the strategy of lobbing in a bid without complete diligence and assuming you’ll be able to work out a diligence protocol once you win, notwithstanding the sell side protestations that such a post-bid diligence process was not the deal. You’re retrading! I’m shocked, shocked!
Of course, if it’s a negotiated transaction, these problems will be avoided, but don’t bet on seeing many negotiated transactions in this environment. The herd is following the bell cow of the Irish auction deals. It is darn hard for a bank to embrace a negotiated transaction when the siren song of the “You will never get fired for running an auction” is blaring loudly in their ear.
Getting one’s arms around a relationship lending product is hard, complex and time consuming. It’s certainly possible to substitute some level of rep and indemnity protection for diligence, but this is usually the structural equivalent of spitting into the wind. Pool sellers have been uniformly allergic to strong reps and, frankly, in some cases there is a serious question as to what the reps are worth. Are the reps provided by the parent, or by a U.S. subsidiary? If it’s a U.S. subsidiary, will it remain in business? Will the parent remain solvent? For some institutions that are national “champion” banks, sovereign immunity could become an issue. So, I have a breach, I have a claim, I have a solvent counterparty, but, I’m unable to maintain the suit without the consent of the sovereign. Pretty useless set of reps. On European assets, all of this is made more complex by bank privacy laws and a penchant for extraordinary confidentiality. In some cases, it just may not be possible to obtain all the diligence one would typically see on a U.S. domestic transaction.
Buyers' diligence process is often flawed. Figure out what you need to know and how information will be socialized with the deal team before you launch. We have seen many Ready, Fire, Aim diligence initiatives. Members of your business side diligence team and counsel should have to hit the files once, not repeatedly, as new issues and concerns, not identified up front, are now raised. Moreover, how does critical information get to the deal team decision makers? The diligence team of business and legal does a deep dive. They know everything. But the senior deal team has barely a clue. If you lack a process to transmit information cogently and efficiently to the deal team decision makers, then there was no diligence. If a tree falls in the forest but no one hears it, did it happen? The fix seems simple, right? Maybe, but this is a recurring problem; we have the data, but cannot retrieve it nor analyze it in an efficient manner nor have it accurately and thoughtfully reflected in deal negotiations.
The biggest single substantive problem in deals we’ve seen is restrictions on transfers contained in the underlying loan documents. There may be transfer restrictions in the actual loan documents themselves, or in the swaps and hedges which are an integral part of the credit and where a substantial part of the value of these financial assets may lie.
It is not unusual to find a swap requiring a bank as a counterparty. If the buyer is not a bank, it will need a bank to play a role in the transaction. Either way, some form of a back to back with either the seller, which stays in the deal nominally to hold the swap position, or with a substitute bank, which meets the transfer restrictions of the swaps, will be necessary. All these workarounds have flaws, all these workarounds are complex and all these workarounds are time-consuming and expensive. On the other hand, broadly, they can work.
Some transferability issues simply cannot be fixed without going back to the borrower. One could hope that seller had done that, but so often it has not. The only fix for dealing with this type of restriction is some form of 100% participation or total return swap between seller and buyer so that seller can nominally stay in the transaction. This, once again, raises counterparty credit issues and sovereign immunity issues and everything else discussed above. A better fix is to get the seller to sell the asset on a deferred closing date and get the seller to go back and fix the transferability problem. This, of course, raises a host of questions, even if the seller will agree, including allocating risk of loss, hedging, etc.
A final issue worth talking about today is financing the position. There are buyers that need and want no financing, particularly on a par product which is simply adding to the portfolio of a buyer which is, itself, an insured depository institution. But many buyers want or need financing. What we’ve seen in the past is a financing auction as bidders run multiple lenders against each other to provide financing. This, of course, is a painful exercise for the lender. Bidding to back a party which is itself a bidder starts to look like a sucker’s bet. Nonetheless, to date, there has been a robust offering. Will that continue? Good question. My advice to bidders needing leverage is to pick a lender quickly, get the lender comfy with the trade, the transaction, the quality of the diligence, what’s doable and not doable, what needs to be achieved, etc., all as early as possible. Do not let the perfect be the enemy of the good. That early coordination with the leverage will pay enormous dividends if you are so lucky (lucky?) to win the bid.
Have at it. We’re all going to get a lot of practice buying these pools over the next 24 months.
By: Rick Jones