In the current market conditions, opportunities are arising to invest in, or divest from, assets across all industries with financial experts expecting an increase in M&A activity.
In the debt finance space, lenders are finding that loan assets may be non-performing or have become distressed as borrowers struggle to manage increased interest rates, inflation and the expiry of temporary measures implemented at the peak of the pandemic. One example was an increase in the threshold for creditors to make a winding up petition in relation to a borrower in default.
The measure was phased out in October 2021, and many borrowers with non-performing loans are inching closer to defaulting on their loans once more. It is no surprise that the third quarter of 2022 saw a 40% increase in company insolvencies compared to the same period in 2021.
Consequently, we expect the volume of loan portfolio sales to increase noticeably this year as lenders look to free up capital by offloading defaulted loan portfolios, and buyers interested in entering the debt market look for opportunities to purchase assets at a discount.
We have set out five key considerations when buying or selling loan portfolios, or lending businesses.
1. Due diligence
The first stage of a transaction is due diligence. This will be significant for both the seller and the buyer in assessing the viability of a sale and will consist of legal, financial and commercial analysis. In terms of legal due diligence, the following are important:
Findings in the due diligence process will drive the purchase price a buyer will offer for the portfolio.
Disclosure will be one of the primary obligations for a seller. The seller should make full disclosure of relevant events relating to the portfolio i.e. any defaults, waivers, amendments and extensions relating to each loan, or any adjustments made in respect of the Covid-19 pandemic. Sellers should also disclose any insolvency or bankruptcy actions taken against any borrowers whose loans are being transferred.
It is crucial that sellers verify what information can be disclosed. In syndicated loan documentation the borrower’s consent to disclosure to potential purchasers of the debt will usually be built into the documentation, but in bilateral facility agreements this may not be the case. Finance documentation and any relevant reports will need to be reviewed.
Where a seller discloses information it was not permitted to, this can give rise to litigation risk, particularly where a borrower is unhappy at the proposed transfer of its loans to a third party, leading to significant reputational risk to the seller. Under English law, a bank will owe a common law duty of confidentiality to its customers and should not disclose information on a customer without its consent.
Where an entire portfolio is being acquired, the buyer should request all financial and commercial information in respect of the borrowers in the portfolio.
Document collation will be important and is time consuming – the seller should populate its data room in a timely manner.
A seller should be clear on whether any of the loan assets are regulated agreements; if any customers with loans are individuals, the loans are likely to be regulated by consumer credit laws.
The buyer will need to ensure that the seller, and any person broking the loans, had the relevant permissions when the loans were originated and the seller has adhered to relevant regulations and guidance on how the loans are serviced. This is vital as non-adherence to the relevant rules and regulations would render the loans unenforceable.
Likewise, the buyer should ensure that it has the requisite permissions to service the loans (if it intends to service the loans itself). The buyer should also ensure that the seller originated the loans in compliance with relevant ‘know your customer’ and anti-money laundering laws and regulations.
4. Ongoing restructurings of the loans to be sold
If a loan is currently being restructured, this can add complexity to the process, raising questions on whether the seller entered into any documentation relating to the restructuring and if so what additional rights and obligations are conveyed.
These additional obligations may place limitations on the buyer in how it intends to manage and service the loans. In particular, if the seller was supportive of the restructuring, it may be reluctant for reputational reasons to allow buyers to change the approach followed to the date of the sale of the loans.
Buyers (and their lawyers) should carry out a thorough analysis of any intercreditor arrangements in place, if any, relating to any loans in the portfolio. This is to identify any restrictions on enforcement placed on each lender, such as standstill obligations preventing a subordinated lender from taking any enforcement action. These considerations may impact the buyer’s overall valuation of the assets being acquired.
5. Tax, TUPE and Transitional servicing
All areas mentioned above will influence the form, and feed into the substance, of the required sale documentation once parties have committed to proceeding with a sale and purchase.
As with any other sale, the transfer of a loan portfolio is documented in a sale and purchase agreement which transfers title to the loans from seller to buyer in consideration for the purchase price.
If a spot sale is preferred and practical for both parties, both legal and beneficial title to the loans is transferred at the time of purchase. However, it may be the case that the buyer would prefer to split the timing of transfer of the beneficial and legal title to the loan portfolio (or a subset of loans at a time) if, for example, transitional servicing is required.
What option is taken will influence the price offered for the portfolio and the structure of the operative sale provisions.
When negotiating the sale and purchase agreement, the warranties provided by the seller should address any issues that arise from the due diligence process in relation to the loans, as well as the circumstances of the seller.
In an auction sale, a seller will draft the initial version of the sale and purchase agreement, and would look to tighten the scope and period of time within which it gives certain warranties to the buyer.
As mentioned above, it is important that the loans to be transferred are free from encumbrances, and that there is no legal or regulatory restriction on the seller’s ability to transfer the loans – a buyer should ensure any concerns made apparent in disclosure are satisfactorily warranted against.
As the sale and purchase agreement includes ‘promises’ from the seller as to the characteristics of the loans to be transferred and the terms on which it does so, there is a balance to be struck between the seller protecting itself from future liability and ensuring that a buyer has adequate recourse to the seller for any breach.
From the seller’s perspective, a number of protections should be considered, including time limitations and minimum amounts for claims by a buyer for breaches of representations and warranties, both in relation to the loan assets, and to the status of the seller. The duration and minimum amounts may vary depending on the subject, for example a seller can expect that a buyer would want warranties relating to TUPE matters to be for a lengthier period than a warranty relating to the financial position of the seller at the time a sale. There would commonly be an overall cap on the amount of the seller’s liability for any claims under the sale purchase agreement.
The process of selling and buying loan assets can be complex. If portfolio sales and acquisitions are of interest to you, please contact Jonathan Segal from the Fintech team, or your usual Fox Williams contact.
You can register online or follow us on Twitter or LinkedIn to receive our latest news, events and publications.