Legal Outlook Speciality Finance Episode 2: Navigating the complex landscape of debt portfolio sales and trading

Matthew:

Hi all, and welcome to our second Specialty Finance Series podcast. My name is Matt Pentecost and I lead the specialty finance practise here at Ashurst. We've just come off the back of another really successful specialist lending conference, hosted by DealCatalyst. And, today, I wanted to pick up on one of the topics that was touched on during that conference. We've done a lot of work in the portfolio sales space and, this year, we've closed a number of deals in the debt purchase space. Today, I'm delighted to be joined by Mark Edwards, fellow partner here at Ashurst, and expert in the world of debt portfolio sales, and debt trading generally. Mark was involved in some of the very first portfolio sales arising out of the global financial crisis. And I'm grateful that he is here to give us the benefit of that deep market experience. Hi, Mark.

Mark:

Hello, Matt.

Matthew:

So within the specialty finance team, we're seeing an increase in debt purchase as an asset class. Now, we think that this can be put down to a number of factors, including a challenging macro environment leading to greater delinquencies and stress portfolios. And inflationary environments leading to capital pressures, as well as, I suppose, an increasingly sophisticated market. In the specialty finance team, we're closing transactions where organisations are buying books at a faster pace than previously. And, therefore, clearly, they need a bit of liquidity to support that growth. But I'm also interested to know whether that pace is reflective of institutions looking at larger cap portfolios.

Mark:

Yeah, of course. So from a loan portfolio market perspective, I actually think the answer is yes and no as to whether or not we're seeing that pace reflected in the larger cap portfolios. One thing we definitely are seeing is a convergence between the spec fin market and the traditional loan portfolio market. And if you've been an investor in the traditional loan portfolio market across Europe, what you have seen over the last decade plus is a shifting focus of the limelight between geographies and between asset classes. But on the whole, the last few years of activity has been comparatively subdued in the loan portfolio market, particularly in the UK. And there's a number of drivers behind that.

Firstly, higher funding costs have obviously meant that it's more difficult to get sales of large portfolios away. We've seen a reopening of the bid-ask spread, and in some circumstances and jurisdictions, pricing difficulties and mismatches. I think, thirdly, we've seen a lack of impetus on the sellers in the need to actually sell. And that's driven both from a regulatory perspective, in that regulators are not putting a huge amount of pressure on sellers to need to divest of non-core assets. And, similarly, from a capital perspective, liquidity remains strong, which, again, means that sellers are not necessarily feeling the heat to actually divest themselves of these assets. And then, perhaps fourthly, lastly, we haven't perhaps seen the deterioration in performance that we might've expected two years ago on underlying asset classes.

Bringing all that together, that's meant that transactions coming to market in the UK have tended to be smaller in terms of book value. They've tended to be more in the nature of performing books of non-core assets. And, thirdly, they've tended to be in niche lending sectors, illustratively, buy-to-let, specialist SME books and products, illustratively, auto finance. We've seen a lot traded in the last year. So that perhaps explains why the available transactions in the portfolio acquisitions markets are now playing nicely into the sites of the spec fin protagonists, who, themselves, are looking at a fast growth agenda. And the opportunity to acquire the portfolios that are available in the market plays nicely into their aims and objectives.

Matthew:

Yeah, and that absolutely demonstrates that convergence point around the large cap debt trading and the spec fin market. And we're absolutely seeing that. One of the things that is being discussed at the outset of these debt purchase transactions, clearly, pricing in order that the liquidity can be as competitive as possible. But I suppose that pricing needs to be balanced against the risk, and how that in turn breaks down against the yield profile. Now, in the spec fin space, we're seeing more and more sophisticated modelling towards into that transaction, particularly when considering that liquidity piece. And those covenants positioned against that model, rather than generally charting recoveries against notional forecast or estimated collections. Can I get a sense of where you see that going?

Mark:

Yeah, certainly. I guess, if you look back over the last decade, when the debt on debt market first emerged, that brought a range of lender approaches to this novel financing sector, the inception of the market. And the market grew quickly, as investors realised that, potentially, returns could be enhanced by providing leverage to portfolio acquirers, rather than institutions bidding to acquire the portfolio itself. So at one end of the spectrum, you had lending desks, perhaps from a securitization background, who adopted an approach of wanting quite a restrictive covenant regime. They were viewing these debt on debt transactions through the lens of a securitization. At the other end of the spectrum, you had corporate financier houses, more used to funding a platform, rather than funding the acquisition of specific portfolios. And they naturally brought a more benign approach in terms of looking at the actual assets that were being acquired.

So I think it's ultimately fair to say that the market evolved much more down the latter approach, which was largely driven by financiers having to be competitive to when mandates to finance the successful credit funds in the portfolio acquisition world. And quickly, this resulted in strategic alliances forming between purchasers and their preferred financiers. Which, generally, has meant that covenants, and the approach to DD in the large cap world, has been relatively light touch.

More recently, I'd say the market is much more in flux now. Smaller ticket sizes have meant that, perhaps, there's less need for financing in the portfolio world anyway because the transactions are smaller and debt is more expensive anyway. We're seeing smaller portfolios. We're seeing more regulated books. And we're seeing a different community of purchasers, including startup banks and platforms, which means that modelling has now been more in depth. And we're seeing a new perspective being brought to the transactions. So I wouldn't say that it's necessarily more sophisticated than it was. But I think the approach to modelling the financing and thinking about the profile of the underlying portfolio is now being done through a much more granular lens. And we're in a much more cautious market than we were. So I agree with you, we are seeing much more focus on trying to achieve an understanding of the portfolio. But still more aligned with the approach of different financing houses.

Matthew:

Yeah, I suppose that's a really interesting point because it plays through all of our different asset classes. And look, the way financiers of specialty finance deals are looking at the particular transactions is through a lens of downside protection and mitigation. And one of the reasons that those deals are taking longer to complete often is that they are making sure that those mitigants and protections are in place. And that credit teams are having a much more in depth look. I suppose in this particular market, a funder to a debt purchase of business is going to really require that purchaser to have an in-depth market knowledge. And particularly when you're talking about startups, it's quite difficult to evaluate that. But I suppose you look at the management teams to ensure that they are pricing those acquisitions correctly.

Mark:

Yeah, I think that's right in the current market. As I mentioned earlier, pricing has been a more troublesome dynamic in certain parts of the market. I'd say particularly the UK where the bid-ask spread has widened again. On the one hand, you've got purchasers who are having to price in funding costs, and bringing an expectation that the acquisition of non-core assets should come with a seller discount. Whereas, from a sell side perspective, over the last 18 months or so, we're still seeing sellers who are looking at a par, or near to par, exit expectation. And in some cases, sellers naturally come to the market in terms of thinking about a premium, in terms of viewing their non-core books as bringing the opportunity for a purchaser to expand their existing business from the borrower base that the portfolio effectively offers.

Matthew:

Yeah, and there's a very live risk reward question to be evaluated there alongside, I suppose, an opportunity cost. But that discussion leads quite neatly into what the terms of the acquisitions themselves actually are. I suppose in the granular space of speciality finance, unlike other asset classes where the underlying documentation is tightly controlled by the financier, here, there necessarily needs to be flexibility for a purchaser to make those acquisitions in terms that allow it to be competitive in the market. And a funder often will need to view the credit risk through that lens. So rather than there being standard documentation per se, you might derive comfort from the type of asset, counterparty, the regularity of sale, the historical data points.

Now, following on from that, I suppose, there will always be a nervousness as we move into subprime territory. But the enhanced FCA focus has at least helped to mitigate some of the structural risks in that market, or at least that's perception. Question for you though, are you seeing the debt purchase documentation coalesce around core terms? Or to that point around flexibility, is the opposite happening as counterparties become increasingly sophisticated and are allowed the flex to negotiate those terms themselves?

Mark:

Yeah, I think one of the observations we made earlier was that the ticket side to transactions is coming down. Sellers are feeling less comfortable. In the current market, they can get sales of large books away. For large trophy non-granular assets, that is inevitably driving a movement back towards single name, single credit trading, which is now prevalently done on LMA trading terms. Where there is, of course, a very established infrastructure and market as to what's accepted and what's acceptable in the market.

Looking at the more bespoke terms, Ashurst, back in the day, was at the forefront of developing portfolio trade documentation that combined M&A principles with established secondary debt trading practises to create a suite of documents which became prevalent across the market from around 2012 onwards, right up till the current day. And, fundamentally, the terms and the structure of those portfolio transactions remain variations on a theme now, even when you're doing deals in jurisdictions such as Greece or Italy, where you may be taking advantage of securitization legislation to facilitate sales. But those sales terms are fairly well established and really do constitute variations on a theme, as I say.

What we're seeing now is a renewed appetite on the part of the purchasers and bidders to negotiate portfolio acquisition documentation. So at the height of the market in the UK, if I look back to the 2016 era, supply was so vigorous that documentation was really only likely negotiated in terms of auction processes when you were doing the submission of the terms on which you would be prepared to close a deal as an investor. Quite often, investors were taking a very light touch, and in some extreme cases, were not marking up documentation at all. Now that we're in a world where there is less supply, more granular supply, in a world where we've got new investors coming to the market, where portfolios are smaller, so naturally your risk across the number of assets that you're acquiring is less hedged.

That, inevitably, has meant the sellers need to expect that investors will be much more focused on the terms that they can achieve. And focused upon achieving their own house points within documentation.

So I think it's still fair to say that the sale terms that we're seeing in completed transactions across the market remain variations on a theme. But there is a much stronger desire to negotiate documentation in the current market than perhaps we've seen in the last decade as a whole.

Matthew:

And I suppose that goes to one of those points we made earlier around downside protections. Because one of the things we're seeing, as we mentioned earlier, is that the financier is looking at their mitigants and protections. But in the same way, the actual debt purchasers are also looking at their downside protections. So in a sense, those two institutions are aligned on that point. And it's about choosing the right partner. Now, that's a point that came up last year. It also came up very strongly in this conference. As we enter into a time of macro uncertainty, having strong partnerships is core to having a strong business.

But adjacent to that, the last point I just wanted to make here is one of scale. Wherever you sit in the purchase market, there could well be a regulatory overlay to look through. That might be on a granular level, where the assets are consumer credit assets, and so the ongoing servicing of those assets will obviously need to be administered by an FCA regulated entity. I suppose it's also on a portfolio sales, say, much larger scale, where you've got maybe leveraged loans, where the enforcement may require an analysis of change of control provisions and consideration of regulatory approval. So the interrogation of the servicing in such instances also need to be considered. But, Mark, have you seen any other regulatory questions raised during the transaction?

Mark:

I think from a regulatory perspective, look, if you look at the granular asset classes on the consumer credit transactions, my experience is that the interested parties, the interested investors, will always have the right regulatory licences and compliance servicing capabilities already in place for the relevant target assets. What I'm not seeing at the moment, although we did see this back in the emergence of, for example, the Cypriot market, the Greek market, was a run of investors looking to get themselves set up on the ground with the right licences, the right infrastructure, in different jurisdictions.

Generally, that has all calmed down. In the UK, if you're able to take on an asset, you'll enter the arena to purchase it. If you're not, generally, you won't.

In the portfolio market generally, you talked about larger scale assets, leverage loans, et cetera. Generally, recently, we've seen a move away from loan tone strategies, which might drive more of a focused consideration of regulatory approvals for change of control. Generally, there is less distress in the market, and there's a wealth of new investors in the market with more benign investment strategies generally. So we haven't really seen so much of that recently.

I think, in my world, without a doubt, the greatest area of regulatory focus that we have seen in transactions that we've been involved in to date, relates to conduct risk and historical compliance of sellers. And this is an area where we've been acting for investors. We've been asked for a significant amount of energy and focus. There's a great reluctance on the part of purchasers to acquire regulated books where there is a risk of liability, or even just reputational tarnish from borrowers invoking regulatory complaints. So, therefore, we're seeing significant focus on regulatory DD on the compliance of a seller's loan documentation, assuming that the seller is the originator of the assets themselves. We're seeing significant focus on DD around the policies and the processes around the seller's origination.

And to the extent that there isn't a cultural alignment between an investor's approach to life and the seller's approach to life, as shown up by that DD exercise. On the approach to underwriting compliance to treatment to customers generally, we have seen a discernible reluctance on the part of investors to actually proceed with the acquisition of those assets. And I think one of the most pertinent overlays to that trend is actually consumer duty as well. And the fact that consumer duty carries with it a certain level of uncertainty has only heightened this wariness of purchasers to acquire assets where there has been a mismatch in the approach to origination generally between sellers and purchasers.

Matthew:

I suppose that compliance risk is one of the reasons why you need to have experts in both the funding, but also in respect to the acquisition agreements themselves. So, ultimately, I guess, do get in touch if you'd like to discuss debt purchase, whether that be in relation to funding debt purchases, or back leveraging portfolio acquisitions, or indeed the portfolio acquisitions and specifics of the acquisition agreements themselves. As Mark alluded to, we've got huge experience across portfolio sales, all flavours and scales. And continue to act in respect of structured financing of acquisitions, debt purchases, as well as the most cutting edge acquisitions themselves.

Lastly, thank you very much for checking in on this podcast. Our first podcast on litigation funding and the ramifications of PACCAR with Disputes Partner, Anna Morfey, is still available. And we'll be back again soon on another topic in the space. If you would like to volunteer a topic or ask a question, please let me know. Otherwise, we look forward to doing another one for you soon.