NPL Funds - What Do They Do?

there's a ton of groups doing this in Europe. Dozens of FT articles talking about it. hasn't been much of an opportunity in the US lately (still TBD post-covid).

Same thing as all distressed debt. Buy turds from banks at a discount so they can delever, and then try to get borrower's to pay you off (or sell at a higher price to other turd buyers)

Personally I find the NPL model fantastically boring but to each their own

This is interesting but how are those higher returns actually achieved? By charging more interest on the debtors? Surely Cerberus etc are playing this as a way of potentially grabbing the underlying assets at discounted prices?

I don't see many replies to your question - What do they do? - so I will shed some lights.

To answer the question, let me summarise a bit the pricing logic of NPL portfolios. Depending on the portfolio, the NPLs are usually split between Unsecured loans and Secured loans. If you are talking about a mostly Secured portfolio, the breakdown would be something like 10-20% Unsecured and 80-90% Secured.

• The Unsecured portion is priced based on a curve where you assume a certain payment trend, considering the historical payment data. E.g. 10%  payers vs 90% non-payers; the 10% pay X% of the balance per year which totals to YYYY; the pricing is then the NPV of those CFs (easy-peasy!)
• The Secured portion of the portfolio is more complex. The secured loans are essentially loans backed by a collateral. Therefore, the pricing is mostly based on the value of that collateral and the expected costs. While the value of the asset is clear and might not change much, provided you did a good valuation, what can change is the costs due to changes in the legal. This is the part that bears the risk of NPLs. To cut it short, I will summarise a few secured workout strategies below:
  • Amicable Sale - In this process you pretty much don't get to the auction process and "cut a deal" with the borrower. He/She either buys the collateral from you or gets an interested party who will buy. Why is this a good strategy? Because you save a lot of costs as you don't have to pursue the legal route; also, it will accelerate CFs (great for the IRR) and close the position quick (which releases resources to workout other positions - great!).
  • Sale in Auction - In this process you simply expect a sale in auction; You can either let the asset go in auction without bidding, or bidding up to a certain amount (e.g. the perceived REV). The issue with sales in auction is that you will have to pay at least 5% legal fees (this can change depending on the country)
  • Bankruptcy REO - This is a strategy where you go to a Bankruptcy ("BK") auction and bid your own asset with the purpose of transferring it to your books to then sell in the open market. For instance, if you believe that the asset is worth €300k and there is a minimum bid of €200k, you obviously want to get the asset so that you cash in €100k. Nevertheless, in a BK the costs are extensive (e.g. 20% of the bid amount) so you really need to get it right when bidding. In addition, you might not have a good visibility on the asset condition so it might be the case that, once you get possession, you figure that you have to spend another 5% of the REV.

To conclude and answer your question: funds like Cerberus have an investment team that is constantly looking for new portfolios, following similar pricing strategies as the ones highlighted above (Unsecured vs Secured); Once the portfolios are required, they have to work them out and follow the workout strategies mentioned above. I guess that Cerberus has its own Asset Management/Portfolio Management team so that would be a different team than the ones who did the Underwriting.  

**Disclaimer: These examples are based on my experience in one of the Southern-European countries. Please note that costs, legal processes, markets etc. change dramatically between countries, even if neighbouring countries in Europe...  

I guess one dynamic that is helpful to understand in the NPL context is the treatment of these loans on bank's balance sheets.

Banks usually think in core capital requirements and return on this capital. Once a loan gets the tag "non-performing" it is worth less in terms of risk-weighted assets that dictate capital requirements and that in turn means less return on capital per dollar invested for the bank.

As a result banks are strongly incentivized to get rid of these loans which can lead to attractive pricing for NPL investors who price these assets completely differently. 

I've been working for a NPL MF for 9 years. Profit is mostly done with the discount you can get on the unpaid principal balance of the pool of loans. For CRE pools once you bought a big pool of loans you leverage the shit out of that deal and then try to reperforme, foreclose, settle a discounted payoff (DPO), hold to maturity loans one after another. Usually you'll have some huge loans that you'll try to resolve in the first year and that will essentially lock most your returns and a bunch of small crap loans that will drag your portfolio for 4+ years.For single family it's the same thing but you securitize the pool and hire 3rd party for AM to focus on reperformance and pray that HPA is going to be good.

It’s almost impossible to make money right now in this market (it’s been for the last 5 years ish). Volume of NPLs is low, discounts on UPB are low and it’s really expensive to manage.