NPLs and distressed assets as an upcoming asset class in private equity

September 2021  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2021 Issue

Historically, investments in early stage and unlisted companies were the focus for venture capital and private equity (PE) funds. However, the strategy to analyse, pick, develop and finally sell or float enterprises also applies to distressed enterprises. The investment in distressed debt and, where possible, the management of the turnaround of the (distressed) debt issuer is a business strategy especially suitable for economic crisis scenarios, such as the 2008 financial crisis and now the COVID-19 crisis.

This article briefly discusses the market environment for distressed debt (non-performing loans (NPLs)), the types of NPLs and the need for restructuring, the PE fund set up for NPL business and selected legal, regulatory and tax issues related thereto.

Market environment

The current low or even zero interest rate environment presents challenges to institutional investors to identify investments with an attractive return on investment (ROI). Historically, institutional investors are risk averse and their preferred asset class is fixed income, in particular, government bonds.

However, since the 2008 financial crisis, interest rates have been reduced to zero or close to zero and the COVID-19 crisis is likely to perpetuate this situation. Correspondingly, real estate and listed shares see one all-time-high after another and institutional investors are more and more concerned that these asset prices are at a peak, and investing in real estate and listed shares needs to be thoroughly considered with regard to the ROI.

There is a flipside to the low interest rate environment. Borrowers have little difficulty in raising debt irrespective of their economic situation and, given the absence of relevant interest payments, the level of indebtedness has virtually no adverse impact on their cash-flow situation. The obligation to file for insolvency in the event of overindebtedness or illiquidity has been (at least in Germany) suspended during the COVID-19 crisis and certain relaxations applied until recently. There is an expectation that, despite heavy stimulus by central banks, distress is inevitable, and a certain portion of the outstanding loans will not be repaid when due, turning these loans into NPLs. While lenders may suffer losses, an opportunity for investments in distressed assets may arise. Market disruptions may be disastrous for lenders on the one hand, but present attractive opportunities for investors on the other hand, which, at the end of the day, will also support lenders and help them to overcome the crisis. So, there is a benefit for all involved: minimising the damage, at least.

Types of NPLs and restructuring

Loan facilities are granted to borrowers when the lender is confident about the borrower’s ability to repay the debt, including interest. There are different forms of financing. The most secure asset class are loans collateralised by a first-ranking land charge or comparable encumbrance. So long as the value of the underlying collateral does not deteriorate, these senior secured loans are less likely to turn into NPLs because, if needed, the lender can enforce the land charge.

Basically, the same holds true for other senior loans sufficiently collateralised by other assets, for example pledges of shares, accounts, trademarks, and so on, or parent or third-party guarantees. Absent collateral, senior unsecured, second lien or mezzanine or hybrid financing may more easily turn into NPLs if the borrower’s economic situation deteriorates. This decline may not necessarily result from bad management, but instead be caused by a crisis, such as the pandemic.

NPLs are not expected to peak in the middle or near the end of the COVID-19 crisis, but rather months after the crisis when central banks terminate or at least significantly reduce unlimited cash provision and interest rates rise again.

In this scenario, the lender needs to engage in the restructuring of the borrower to protect its initial investment. However, quite often lenders do not have the resources to enforce collateral, if any, or restructure the borrower.

This is where PE comes into play. PE funds with a focus on distressed assets would usually acquire the NPLs at a significant discount from the lender. Depending on the facts and circumstances, the PE funds would also acquire a portion of the equity of the distressed borrower.

Depending on the type of borrower and its stress, there are several strategies for a PE fund. If the borrower is only temporarily in a stress scenario, the PE fund will probably just suspend interest payments for a certain period. If the borrower’s strategy needs some readjustment but is otherwise sustainable, the amount of the outstanding loan might be reduced in addition to the suspension of interest payments.

The more difficult cases are where the borrower does not have a sustainable business model and significant restructuring is needed. This usually involves the conversion of NPLs into equity, known as a debt-to-equity swap. In a worst-case scenario, there is no rescue for the borrower and the only thing the PE fund can do is to liquidate the borrower’s assets.

PE fund structuring and formation

To be in a position to acquire the NPLs and achieve the necessary flexibility to operate the business, PE funds need to consider a number of criteria. In the following, these criteria are discussed from a German perspective, but the aspects are the same for other jurisdictions.

From a regulatory point of view, the PE fund needs to consider its own licensing situation. If the fund is established in Germany, the European Alternative Investment Fund Managers Directive (AIFMD) will apply and require the PE fund to be administered by a licensed (or registered) AIFM. Furthermore, the restructuring of the acquired NPL might fall within the scope of the banking privilege under the German transposition of the Capital Requirements Directive (CRD) and the Capital Requirements Regulation (CRR). In particular, the banking privilege applies if the loan amount is increased. Other loan restructuring might be entirely outside the scope of regulation, or it might at least be permissible for an alternative investment fund manager.

A number of tax issues also need to be taken into consideration. One important aspect is that initial losses at the beginning of the restructuring may later be offset against profit from the sale of the restructured loan or target. Another important criterion is whether and how the fund and its investors are taxed on profits upon exit.

Aspects related to NPLs with an impact on the PE fund business

Beyond the fund structuring aspects referenced above, the NPL asset class presents a number of challenges.

One major challenge is that NPLs are often subject to legal, regulatory or other transfer restrictions, including banking secrecy and data protections laws. In Germany, there are certain types of loan receivables that must not (or at least not without debtor consent) be transferred.

In this case, the due diligence process is complicated because the PE fund cannot obtain the relevant data as to whether and at what price it should purchase the receivable. A solution to this may be delegating the due diligence process to a lawyer or auditor subject to professional confidentiality. Later on, the seller of the NPL will need to act as a servicer for the PE fund and channel results to them.

Another aspect to be considered is legal privilege when enforcing receivables. The process may require a licence or the involvement of a lawyer admitted to the bar. Transferring monies may fall under ‘payment services’ in the German transposition of the European Payment Services Directive, which requires a licence.

Conclusion

It is likely PE funds focusing on NPLs will soon see strong market opportunities as the economic crisis following the COVID-19 pandemic evolves. Structuring and fund formation for PE funds must take into account a number of regulatory, tax, civil law and other legal aspects. Depending on the number of NPLs acquired, organisational aspects should not be underestimated and licensed service providers may need to be involved.

Martin Krause and Nils Rahlf are partners at Norton Rose Fulbright LLP. Mr Krause can be contacted on +49 69 505 096 490 or by email: martin.krause@nortonrosefulbright.com. Mr Rahlf can be contacted on +49 69 505 096 290 or by email: nils.rahlf@nortonrosefulbright.com.

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Martin Krause and Nils Rahlf

Norton Rose Fulbright LLP