In the context of the COVID-19 pandemic, we are observing lenders in Australia and globally make provisions for bad debts arising from actual and forecast adverse impacts. We anticipate that some overseas lenders will also reduce their exposure to the Australian market or segments of it, either as a consequence of focusing on other core markets or because they are over-exposed to specific market sectors in Australia. These actions, combined with other negative consequences of the current pandemic on lenders, mean it is more likely that sales of loan portfolios in the market will increase as lenders seek to offload loans.
In this article, we consider the commercial issues that potential purchasers of loan portfolios should take into account when weighing up whether or not to put in a bid and discuss the criteria that will impact on the pricing and terms offered.
In any loan portfolio sale process there are inevitably a range of bidders including banks and non-bank lenders, distressed debt entities, conglomerates and market competitors to the underlying borrower businesses. Each may have a different motivation, whether it is acquiring the debt at a favourable discount and holding it, breaking up the portfolio and selling the loans on, restructuring the loans, pursuing a loan to own strategy or any combination of the foregoing. We haven’t contemplated the individual objectives of such bidders in this article, nor have we covered a host of other issues that may be specific to an individual bidder such as the Foreign Acquisitions and Takeovers Act 1975 (Cth), Australian credit licence requirements or other regulatory approvals, tax and duty, funding requirements or structuring. Instead, we discuss the key items that are universal to all bidders arising from the sale agreement and legal due diligence process to which additional consideration should be given in light of COVID-19 and the resulting economic climate.
The draft sale agreement, or agreement for transfer, will usually be made available by the seller at an early stage of the process. This discourages bidders from requesting too many changes as they are required to submit their comments on the sale agreement together with their indicative offer before they proceed through to the next round.
While keeping in mind that it is likely to be a competitive scenario, key issues that a bidder needs to take into account when reviewing the sale agreement are outlined below.
It is worth noting that any sophisticated seller will be expected to have already addressed each of these items in the draft sale agreement in one form or another. The issue for the bidder will be in negotiating terms that reflect their requirements.
1. Effective time of the transfer: The economics may transfer at the completion date under the sale agreement but they might also occur at an earlier date due to a number of factors. In the current environment bidders should seek to push back the effective date of the transfer to as close to the completion date as possible. As underlying businesses may be deteriorating, this will allow any adverse effects on loans to arise and be reflected in the purchase price adjustment mechanics (together with the usual adjustments for repayments and prepayments) and reduce the likelihood of any further mandatory relief in favour of borrowers being announced between the effective time and completion. Further, swift decision making may be required and the purchaser would want to be directly involved from the date at which they have effective ownership. The sale agreement will allow the purchaser to give directions to the seller in any event from that date but establishing direct communication between the purchaser and borrowers in the portfolio avoids the need to relay instructions and information through an additional party.
2. Transition/servicing arrangements: Bidders may require transitional assistance to be provided by the seller. This might include:
- access to personnel such as loan relationship managers;
- handover meetings to ensure an orderly transition;
- provision of any notices or information received after completion; and
- provision of records and possibly continued hosting of data or processing on information technology platforms.
If extensive transitional support is required these issues may be dealt with in a separate transitional services agreements rather than the sale agreement – this may not be required for corporate loans but would be necessary for consumer loans, such as auto or other personal lending, where there is a large volume involved and more extensive support is required. This will be a particularly sensitive issue at this time where working from home arrangements broadly apply and face to face meetings with customers are difficult. At the same time, borrowers may be benefitting from some form of repayment relief or discussions about this may be ongoing between the lender and borrower – if that is the case the option of using existing relationship managers will be beneficial to any purchaser.
3. Decision making: Bidders will usually seek to include restrictions on the seller dealing with the loans between entry into the sale agreement and completion occurring without the bidder’s consent. This includes restrictions on disposing of assets, settling disputes, making available further funding, waiving defaults and enforcement action. Waivers of breaches and repayment relief requests will need to be considered carefully, especially if legislation has been introduced to offer mandatory rights to borrowers as failure to observe such rights could impact on the value of the relevant loans.
4. Time limits and caps on claims: These are often consistent with what we commonly see in many sale agreements – a de-minimis limit on single and aggregate claims with a relatively short time limitation. Typically, the maximum claims will be capped at the purchase price, for critical title warranties such as ownership and good title, and a lower amount for other warranties. In addition, claims relating to a specific underlying loan will likely be capped at the assigned purchase price for that loan. The issue arising from the current pandemic and ensuing economic crisis is that some issues associated with a deterioration of the borrowers’ economic position may not yet have come to light – these may only become apparent over the next 12 to 18 months as financial reporting for this period is completed. Bidders would therefore be well advised to push for the longest possible time periods for claims, which may prove to be a delicate balancing act as sellers usually seek a ‘clean’ exit.
Legal due diligence
To encourage higher bids, it is in the interests of the seller to make underlying loan information available to bidders in an organised manner and to offer to provide a vendor legal due diligence report (vendor LDDR). Different approaches are taken with the vendor LDDR depending on the profile of the underlying loans. For example, if there is a large volume of retail or consumer loans then the report will likely only include a review of the template documents and perhaps a sample of the loans. In contrast, where the underlying loans are corporate loans then a review of the actual documents will be expected given they are generally bespoke documents. If only samples of loans have been reviewed, a purchaser should seek appropriate warranties as to the loan and security documentation for the balance of the portfolio conforming to the sample (subject to any exceptions notified in writing). In any case, the bidder should ensure sufficient financial information has been made available so it can evaluate the performance of the entire portfolio.
In the case of either a comprehensive or more limited vendor LDDR, bidders need to consider what level of due diligence they themselves will complete. While a minimal approach could be taken by relying solely on the vendor LDDR, this would be unusual as the vendor LDDR will not take into account the individual requirements nor circumstances of the bidder. For example, if the bidder is considering a loan-to-own strategy for distressed loans this is unlikely to be covered by a vendor LDDR in any real detail, if at all.
We recommend that bidders have their own lawyers complete an exceptions based review of the vendor LDDR and complete a separate purchaser legal due diligence report to address any gaps. While only a review of samples of loans has been an acceptable approach in some previous loan portfolio acquisitions, additional due diligence may need to be undertaken as a consequence of the economic impacts of COVID-19. With sub-par loans it is likely that a more comprehensive review will be required. Regardless of who completes the review, a bidder will need to identify and ensure it is comfortable with the following information in relation to the underlying loans:
1. Syndicated loans – size of participation and voting/decision making and enforcement: In an environment where lenders will be receiving consent waiver or variation requests and hard decisions may need to be made in relation to borrowers, it is vital that a bidder considers in advance and fully appreciates the decision making process from the lender group. This isn’t an issue for a bilateral facility, but for syndicated loans we typically see majority, super-majority and all lender decisions and the bidder needs to consider whether it would be content for the majority or super-majority to make decisions without it or against its interests if it doesn’t have a blocking stake. In the present climate, financial covenant and repayment waivers are an area that bidders should pay close attention to. The usual position for enforcement decisions is that majority consent is required.
2. Future funding obligations: Bidders should be wary of undrawn facilities in loan portfolios at this time as a borrower, if it has not done so already, may seek to draw down available facilities to ensure it has sufficient liquidity – particularly if it has any concerns about the intentions of the party purchasing the debt and whether it is going to be supportive of the borrower. If the borrower is in default, then this will be less of an issue as we would expect default to act as a drawstop. Regardless of a drawstop however, a bidder may need to consider if funds should be made available to a borrower to ensure it can meet working capital requirements so it doesn’t go into administration (if that is not the bidder’s preferred outcome).
3. Defaults, waivers and forbearance arrangements: The due diligence process will identify any existing defaults, waivers and forbearance arrangements which will be particularly crucial in relation to the events which have occurred as a result of COVID-19. Bidders should also be asking whether any waiver or amendment requests have been made by the borrowers which have not been accepted, as these may be indicative of either existing or anticipated problems. Where requests for waivers have been made, bidders should consider these in detail. For example, a financial covenant waiver request may have been given for one test date but it should be queried if this is the result of a problem which has not yet fully come to light and whether the problem is likely to get worse before it gets better.
4. Lender transfer provisions – both now and for any sell-on: Due diligence will typically consider the flexibility lenders have to transfer their debt under a loan agreement. Where there are restrictions on transfer (e.g. a consent required) these will not usually apply if a default subsists. Bidders should be mindful though that even where they have the flexibility to transfer the debt to third parties at a subsequent date, liquidity may continue to be adversely affected by the present situation.
5. Intercreditor arrangements: If a bidder is buying into a senior debt position it needs to be aware of any subordinated debt and specifically consider:
- Do subordinated creditors also have consent rights?
- Can they cross-default the senior debt?
- Can they buy-out the senior debt?
- Do standstills apply to senior lenders taking action?
This is always something that needs to be considered but if a subordinated creditor has indicated it is no longer supportive of lending as a result of COVID-19, their motives and potential actions will need to be carefully analysed and market diligence completed to determine how they are responding more generally to their customers and how they are otherwise acting in the market.
In addition to the above, there are numerous other considerations to be taken into account when considering a bid for a loan portfolio at this time, such as the relevance of historical financial information and performance prior to the effects of COVID-19.
While no significant sales of loan books have yet come to market in Australia as a result of the economic consequences of COVID-19, we anticipate that there will be a marked increase in activity with respect to potential sales, which would see with certain lenders seeking to offload loans combined with a competitive appetite from prospective bidders.
This publication is introductory in nature. Its content is current at the date of publication. It does not constitute legal advice and should not be relied upon as such. You should always obtain legal advice based on your specific circumstances before taking any action relating to matters covered by this publication. Some information may have been obtained from external sources, and we cannot guarantee the accuracy or currency of any such information.