Opportunity knocks: purchasing distressed loan portfolios

By Adrian Jones (pictured) corporate partner, and Roger Clarke, banking and finance partner, at law firm Trowers & Hamlins – Distressed loan portfolios secured by property assets have proved an attractive investment class for private equity investors. In its June 2014 Financial Stability Report[1] the Bank of England noted that UK banks non-performing loans stood at around GBP165 billion in 2013. It is perhaps unlikely that the level of non-performing loans will decline significantly once interest rates start to rise and more bank borrowers fall into default and therefore the supply looks likely to continue for some time.

Why buy such assets? Put simply, private equity is able to realise a profit where the original lender cannot through a combination of buying the debt at a discount to face value and by understanding the realisable value of the underlying property security.

Understanding the assets

The due diligence exercise on a debt portfolio acquisition will typically include:

1. legal investigation into the legal title of the property assets which secure the borrowers' obligations and identifying any issues which may affect the sale potential such as access issues, restrictive covenants etc;
2. legal investigation into the loan, mortgage and security documents – ensuring that the lender has first ranking security over the main property asset, that the lender's rights and security (including any collateral security) are freely transferrable and that none of these rights have been waived or postponed;
3. a careful review of the lender's correspondence / creditor files is crucial to verify that the files do not contain any notes or correspondence that are materially inconsistent with the loan, mortgage and security documents; and
4. commercial investigation into the property assets to assess their condition, marketability  and potential value on disposal.

It is often the case that the lender is not aware of any matters which adversely affect the value of their security or their ability to enforce it. For example, where the lender has itself acquired the loans through merger with another lender.
The following are some of the potentially adverse issues that we have come across or would otherwise look for:

1. the lender has waived some or part of the debt or has waived its enforcement rights;
2. improperly executed security / collateral security documents  ;
3. the loan is a regulated mortgage contract (RMC). Due to the additional regulatory requirements involved in administering an RMC many private equity purchasers will not wish to acquire one;
4. the mortgage granted by a corporate borrower, although registered at the Land Registry, was not registered at Companies House within the allowed period with the result that, whilst the lending documents remain enforceable against the borrower, the security is void against a liquidator, administrator and a creditor of the company;
5. the lender has a second ranking charge but there is either no intercreditor agreement to give the lender effective priority or there is some defect in the intercreditor arrangements;
6. the lender does not have security over the whole of the property, for example part of the access may not be included, which could affect its value on disposal;
7. defects in a leasehold title, issues with rights of access, restrictive covenants, planning issues/enforcement notices or possible contaminated land issues which could adversely affect the ability to dispose of a property or the realisable value.

The purchase agreement

The lender will be understandably reluctant to offer much in the way of warranties in the purchase agreement, especially as from their perspective they are likely to be realising a significant right-off on the face value of the debt. However the purchaser should at least seek warranties regarding the enforceability of the lenders' rights under the loan / security documents to supplement its own investigations. The purchaser should also consider seeking indemnification against matters outside the ordinary course of servicing a loan book, such as claims in respect of any transferring employees, un-anticipated liabilities to borrowers etc. and ensure that any claims under such indemnities fall outside of any agreed liability caps.

Registering the transfer

The transfers of rights which can be registered, such as the assignment of security over property in England and Wales and the assignation of standard security in Scotland, will be recorded at those land registries. The transfer of some other rights, such as charges registered at Companies House in England and Wales, cannot be recorded and the purchaser will rely on the terms of the purchase agreement and its further assurance provisions to ensure that it has the benefit of such rights.

In order to perfect the assignment of the lender's rights against the borrowers, each borrower will need to be given notice of the assignment.  This is generally done as a letter from one or both of the parties to each borrower. Notification should also be given to the relevant receiver/administrator/trustee in bankruptcy and any other professionals engaged in relation to a property.

Transitional services

In order to achieve a smooth transition the parties may agree that the original lender will continue to administer the loans for a period of time until the purchaser is ready to take these over or until arrangements can be put in place with a provider of administration services. Acquiring debt and seeking to enforce security in respect of your debt is not currently an activity requiring an FCA authorisation. However some activities, such as administering a RMC, are regulated and therefore appointing a service provider holding the relevant authorisations may be required.

Leveraging the investment

A loan book purchase can be leveraged and with a non-performing book the finance provider will be looking at the underlying property value rather than the face value of the acquired debt. Security can be given to a finance provider via a mortgage over the transferred mortgages in England and Wales and via an assignation in Scotland, in each case registerable at the relevant land registry.

Conclusion

As the major UK banks continue to seek means of dealing with non-performing loans and given the likely effects of interest rate rises, we expect there to be more portfolio sales (both publicised and non-publicised) over the next few years.