Possibility of buying back cash flow based loans?
I've always been curious what happens when a sponsor is at risk of defaulting on a cash flow based loan in an asset light business (for lower middle market deals $5M in value and below).
I'm guessing the bank would rather try to liquidate the business than actually take the keys. Is it a negotiation between the sponsor and the bank about potentially buying the loan back for some premium over liquidation value then just so the bank gets something and avoids the liquidation hassle?
Based on the most helpful WSO content, here's what you need to know:
When a sponsor is at risk of defaulting on a cash flow-based loan in an asset-light business, particularly in lower middle market deals valued at $5M and below, the situation can be complex. Here are some key points to consider:
Bank's Preference:
Negotiation:
Special Servicer Involvement:
Creative Structures:
Risk and Return Considerations:
In summary, while liquidation is an option, banks often prefer to negotiate with sponsors to find a solution that maximizes their return and minimizes hassle. This can involve buying back the loan at a premium or restructuring the loan terms.
Sources: Alternative Lenders & the End of Risk Taking for Banks - Opportunity or Risk?, So you want to work in CRE Debt? Here are the options..., LBOs - Why repay debt instead of keeping cash flow?, Investment Sales Vs. Debt/Equity Brokerage, CMBS B-Piece Buyers
There is quarterly covenant testing, so the bank will only liquidate the business if it trips the covenant. If the business trips the covenant, sometimes there could be a forbearance period if its temporary. If business keeps down turning, the bank then goes into a liquidation scenario to get repaid back.
Sure. But is there a negotiation with the sponsor for buying out the debt? For example if it's a cash flow based loan for $5M and the liquidation value is only $2M, doesn't the bank have an incentive to entertain an offer from the sponsor to sell the loan for something like $2.5M vs. liquidation? Who handles that? Special Assets?
Negotiation is waiving the covenant compliance for temporary period from a bank's perspective. I'm not sure I am understanding your part on selling a loan to another fund / bank; no one would want to refi in this situation unless the Sponsor puts more equity in the business.
Sure. I mean the lender selling the loan directly back to the sponsor for a discount but something still higher than liquidation value. The bank would be getting more than liquidation and the sponsor would have the incentive to have a reduced debt load. I've heard this is much more prevalent in real estate deals but was curious if it's common in cash flow based deals where asset values aren't going to cover loan value.
Agreed that another lender or bank buying the loan wouldn't really be feasible given the current credit situation.
Typically it’ll be a special credit/asset group that manages those discussions. The bank will either work with the client and present options like PIK interest, adjust covenants during a work out period…etc. it largely depends on the collateral base and what route is most cost effective. In some cases the market for an individual company is high, so a lender may look to take it over with intent to sell, or facilitate a sale to a PE firm. However, in that $5mm market a large bank may be more likely to just eat the loss. This would be assessed in their PD/LGD calculations and often times these lower MM portfolios are assigned fairly high LGDs. A handful of these are expected to go bad and it’s already built into allowances, but that doesn’t mean if it’a easily recoverable they won’t try but special credits/assets typically is involved in higher dollar workouts.
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