How Banks should approach the offload of Non-Performing Loans
The sale of non-performing portfolios has dominated the European market in recent years, where overleveraging due to cheap available debt, the credit crisis and the subsequent economic downturn has led to constrained debt financing environments and downward pressure on income.
Greater deal volumes should ensue for the many European banks who are getting to the stage where they are fully provisioned against their non-performing loans (NPLs) – a key determinant in their desire and ability to sell them but for those who aren’t, NPLs can prove to be a thorny issue.
NPLs can depress profitability and constrain new lending, they do not generate cash interest revenues and require funding at market rates. They also tie up staff resources and capital.
By dragging on the valuation of a bank, they also raise interest rates on performing loans and leave the bank exposed to shocks. It is therefore indeed desirable for banks with high levels of NPLs to sell them, but in order to extract maximum value when doing so, they need to understand and evaluate the types of NPL sale and the sales process itself.
There are three primary methods by which NPLs are sold:
Private selling offers the chance to sell quickly and to supply tailored information to the buyer, yet the price achieved may not be optimal given the lack of competition. In an auction scenario, it is important to recognise that no one method can guarantee full sale value under all circumstances. When buyers are ex-ante symmetric, first or second price auctions with optimally chosen reserve prices are revenue-maximising, whilst techniques such as price-discriminating against bidders known to have a higher valuation of the lot will yield higher returns.
Securitisation will reach the widest possible investor base, however, rating and information requirements lead to higher initial and ongoing management costs. It is crucial for banks to have clarity over what type of sale will fit with their strategy.
The Sale Process
Determining the overall strategy of the bank regarding its NPL portfolio is the first step in the sales process. Banks need to determine their transaction goals, undertake due diligence, understand the options available to them and identify which align with firm objectives.
Preparing the transaction to maximise sale value potential is the second step in the sales process, with activities at this stage including:
Deal structuring techniques are employed to create an environment that maximises value through attracting relevant investors who are suited to the NPL portfolio and to provide enough organised information to them – allowing a close alignment of buyer/seller needs, providing appropriate information to overcome information deficiencies, and reducing buyer/seller price variance in order to maintain high prices.
Sales can be structured in various ways, the most common of which is profit sharing, due to the relatively simple nature of the structure. It involves the setting of a benchmark price for the NPL portfolio, which is often paid up-front in cash. An initial minimum acceptable return (MAR) to the investor is set and an agreement to split profits above this is implemented.
The sale of jumbo portfolios is also commonplace for banks – it enables a mix of performing and non-performing assets to be sold together and provides pricing visibility for the benefit of smaller portfolio sales.
The final step of the sales process is the continued management of the portfolio: investor contact (invitation and qualification) is a key part of the sales cycle that requires oversight, as is the design of appropriate bidding / sales procedures, the evaluation of investment proposals and the negotiation of detailed terms.
Understanding the types of NPL sale available to them, and the process which they must undergo in order to sell them, is crucial for banks who are looking to offload them. An awareness of their own circumstance, the conditions under which they are approaching the sale and the objective that they hope to achieve is crucial to pair with this.
If banks are able to achieve this, they will put themselves in a strong position to extract maximum value from sales of NPLs.