In recent years, many hedge funds have purchased distressed debt as an investment. Much of it consists of commercial and real estate loans originally made by banks and other financial institutions, which are now in default— either because the borrower is not making payments as agreed or because the borrower is in default on other covenants in the loan documents. Many of these loans will ultimately be paid in full.
Acquisitions of "problem loans" can be excellent investments, yielding above-market rates of return. If a borrower is paying a default rate of interest of 14% on the outstanding principal of a loan, and a hedge fund purchases that loan for 80% of its face value, the hedge fund can realize a rate of return of 17.5%. Borrowers also often are obligated to pay various fees under the loan documents, which can make the rate of return even higher. Banks are often willing to sell these loans for less than face value because, for regulatory reasons, they want to reduce the number and amount of problem loans on their books.
As with any investment, however, buying a problem loan entails certain risks. The most obvious risk is that the borrower will not repay the loan and the hedge fund will be unable to collect the loan in full from the collateral or guarantors. A hedge fund may also run the risk of becoming liable to the borrower, other creditors or the government if it acts improperly in managing the loan after it has acquired it. Adequately evaluating a problem loan before purchasing it, and managing it properly after purchasing it, are critical to minimize these risks.
Purchasing the Problem Loan
A hedge fund considering the purchase of a problem loan should, of course, evaluate the underlying strength of the borrower, the quality of its management, the value of its assets, and the likelihood that the borrower will have the financial capability to repay the loan. That is, however, not all that it should do. The fundamental nature of a problem loan is that the borrower is in default on its obligations and the loan will usually have to be restructured. The evaluation of this "restructuring risk" should be a critical part of any assessment of a problem loan.
A legal analysis of the loan documents and the lender's legal position with respect to other creditors is an important step in this assessment. The terms of many commercial and real estate loans are heavily negotiated at the time they are made, with the result that the lender may have made concessions which will limit its ability to recover from the borrower or give other creditors priority against some or all of the borrower's assets. Also, many states have laws that affect what the lender may do to recover the loan from the borrower, notwithstanding what the loan documents say. California's one-form-of-action, security-first and anti-deficiency laws, which apply to loans secured by real estate, for example, are particularly problematic and are different from those of any other state.
If the borrower is in bankruptcy, or is likely to go into bankruptcy, it is also important to consider the status of the bankruptcy proceedings and what may happen to the debt in bankruptcy. The Bankruptcy Code contains many provisions that supersede terms in loan documents affecting (among other things) the amount that a borrower is obligated to pay and the timing of such payments. A loan purchaser ignores these provisions at its peril.
It is also important to evaluate the terms of the purchase agreement by which the hedge fund purchases the problem loan. These agreements tend to be fairly standard in many respects, but an area in which they may vary is in the representations and warranties made by the seller, and the remedies available to the purchaser if those representations and warranties turn out to be incorrect. The representations and warranties can be important in the restructuring process, since many facts are not apparent from the face of the loan documents (e.g., whether the borrower has asserted claims that, if correct, would reduce its liability on the loan), and the purchaser often will be subject to any defenses that the borrower has against the original lender.
Managing the Problem Loan
The acquisition of a problem loan should not be viewed as a passive investment. The hedge fund should remain continually informed about circumstances that impact the ability of the borrower to repay the debt, because they can change dramatically. Also, within the constraints of what is legally permissible, the hedge fund often will want to be proactive to increase the likelihood of being repaid. Almost all loan agreements allow the lender (or its successor) to recover from the borrower its costs and attorney's fees incurred in managing the problem loan.
The hedge fund's role will differ depending on whether the borrower is in bankruptcy. In a non-bankruptcy restructuring, there is no court oversight and the parties have substantial freedom in deciding what to do. This freedom comes with significant legal risks if the lender acts inappropriately, however, and a prudent investor should not make any major restructuring decisions without legal advice regarding the propriety and structure of the proposed course of action. If not handled properly, a restructuring decision may have the effect of absolving guarantors from liability on their guarantees or causing the hedge fund's security interest to lose priority as against other creditors. Also, if the hedge fund becomes too deeply involved in the management of the borrower, it may incur liability to the borrower if it makes bad business decisions, or it may incur liability to governmental agencies if the borrower fails to pay taxes or violates environmental laws or other government requirements. Furthermore, if the hedge fund decides to foreclose on its collateral, it may incur liability to the borrower and other creditors if it fails to act in the manner prescribed by law.
If the borrower is in bankruptcy, restructuring and other significant decisions almost always require bankruptcy court approval. Bankruptcy courts have considerable discretion to make decisions, but that discretion must be exercised within the constraints of the Bankruptcy Code. A hedge fund that is considering asking a bankruptcy court to approve a course of action should always keep in mind what the bankruptcy court likely would or would not approve, and devise a strategy taking that into account. Also, a bankruptcy court has the power to make decisions that will jeopardize the hedge fund's position against the borrower and other creditors, and the hedge fund should monitor, and participate in, the bankruptcy proceedings to minimize the chances that anything like that will happen.
Buying distressed debt can be a lucrative investment for a hedge fund. It involves certain risks, however, and a prudent investor can, and will, act to minimize those risks.
Neil J. Rubenstein is a shareholder in the San Francisco office of Buchalter Nemer, a professional law corporation. Mr. Rubenstein represents financial institutions, private investors and loan servicers in a wide variety of financing transactions. He can be reached at (415) 227-3559 or .
