MODERN METHODS OF MAXIMIZING RECOVERY RATE OF NON-PERFORMING CORPORATE LOANS

ABSTRACT

The article dwells upon the issue of the optimal corporate debt recovery strategy for a commercial bank amid the ongoing economic challenges. The article provides comparison of the three major non-performing loans settlement instruments viz. financial restructuring, bankruptcy proceedings and debt assignment.

АННОТАЦИЯ

В статье представлена проблематика выбора оптимальной стратегии для урегулирования коммерческим банком корпоративных долгов в условиях современных экономических вызовов. Проведено сопоставление трёх основных типов урегулирования проблемных долгов: финансовой реструктуризации, проведения процедуры банкротства и цессии долга.

Keywords: distressed assets, bankruptcy, financial restructuring, non-performing corporate loans, debt assignment

Ключевые слова: проблемные активы, банкротство, финансовая реструктуризация, проблемные корпоративные кредиты, цессия долга

It is common knowledge that the composition of a credit portfolio of a commercial bank as well as its quality are contingent upon borrowers’ creditworthiness and industry, their financial standing, the ongoing market sentiment and many other factors. Apparently commercial banks always make every endeavor to maximize debt recovery (i.e. are intent upon achieving a 100%-BSRR benchmark [2]).

The objective of the article is to study the modern methods of corporate non-performing loans settlement as well as to determine the most beneficial ones for commercial banks. In order to achieve the aforementioned objective we will review the modern analytical publications and will resort to the author’s practical experience in the sphere of financial restructuring and distressed assets management.  

Bankruptcy proceedings are considered to be the oldest method of corporate debt settlement [3]. Yet, conducting bankruptcy proceedings in most cases nowadays does not allow the bank to achieve the return of all funds, largely due to the peculiarities of legislative frameworks. Therefore, credit institutions are developing new and enhanced instruments when dealing with distressed assets that allow minimize losses. In particular, debt restructuring mechanism includes a plethora of instruments [1], i.a. debt refinancing, novation of debt, debt conversion, debt rescheduling. It would not be far-fetched to mention that financial restructuring is considered to be a ‘milder’ debt settlement strategy that provides reviewed and more beneficial terms of debt service both for the lender and the borrower [2]. Assume the following examples in detail.  

A well–known Russian timber processing company (hereinafter referred to as the ‘Company’) attracted funds in 2016 under a loan agreement with a major Russian bank (hereinafter referred to as the ‘Bank’) in the amount of 25 billion rubles. Due to various unfavorable circumstances, the Company faced significant operational and financial difficulties, that resulted in accumulating significant sum of outstanding debt amounting to 40 billion rubles (incl. principal debt, accrued interest, fines and penalties) as of April 1, 2021.

In order to save the Company and prevent insolvency, a group of independent financial consultants elaborated a debt restructuring strategy, based on the following assumptions:

1. The Company expects that, while maintaining current prices for its final products and cost components, the target value for EBITDA in the long run will amount to 2.6 – 3.1 billion rubles (see Diagram 1).

Diagram 1. Company’s EBITDA forecast for 2018-2032.^[1]

2. The company is able to allocate the following funds for debt service (CFADS): 2021 – 600 million rubles, 2022 – 1.5 billion rubles, 2023 and further – 2.4-2.9 billion rubles. Such low values of the Company's CFADS in 2021-2022 in comparison to its high EBITDA value are attributable to additional investment expenses in this period (Investment CAPEX). (see Diagram 2).

Diagram 2. Company’s CFADS forecast for 2018-2032^[2]

3. Basing on the business profitability (EBITDA margin in 2017-2020 was 23-26%), the debt burden cannot be fully serviced, therefore, a tool that implies conversion of debt into equity (Debt-for-Equity Swap) is needed for restructuring.

According to the financial modelling results, the Company will be able to service (repay interest and principal debt) 18.2 billion rubles at a rate of 5.5% per annum during the timeframe from 2021 to 2031. In order to repay the remaining part of the outstanding debt in the amount of RUB 6.8 billion, the Company evaluates 100% of the capital (EV) at market value and transfers part of equity to the Bank. At the same time, the Company, at its discretion, signs an option to repurchase the transferred equity share (as per the valuation) after a certain time.

It would not be far-fetched to mention that the mentioned above instrument of ‘debt corporatization’ is a very common financial restructuring tool in the USA, Great Britain, Germany and France [4]. Debt-for-Equity Swap is of a particular interest to those creditors whose claims comprise a significant share in the company's total debt portfolio. Unfortunately, Russian commercial banks tend to neglect proposals to convert debt into equity, since in most cases they seek to receive payment in the form of cash and are simply unable to dispose of new stakes. Yet, the use of this tool will allow lenders to improve their credit portfolio in a qualitative way, since it involves the termination of overdue debt obligations and the replacement of debt relations with corporate ones.

Assume another case. In 2016 one of the grandest Russian state-owned banks granted a loan in the form of four separate credit lines to a major producer of chemical fertilizers viz. carbamide, saltpeter, ammonia and methanol. Due to unfavorable market sentiment and lackluster demand for chemical fertilizers, the company was unable to cover its debt liabilities amounting to 1.7 billion USD (i.e. 94% of the aggregate credit line) and hence, the loan was deemed as a non-performing one. Moreover, the company accrued overdue debt under that loan agreement in the sum of approximately 360 million USD.

The initial approach of the bank’s credit committee was either to restructure or refinance the existing liabilities by prolonging the repayment terms, changing the sum of the ‘balloon payment’ and implementing the ‘cash sweep’ mechanism – i.e. all the cash flow available for debt service (CFADS) is transferred to repay the debt outstanding. Besides, the bank was ready to obtain the controlling stake in the company by converting 50% of the principal debt into equity. However, due to the peculiarities of the Russian fertilizer market, the debt might have been repaid by 2040 at the face value. The estimated threshold of debt recovery amounted to 799 million USD. The management of the bank was reluctant to wait that long and had certain concerns about the market value of company’s equity in 2040.

Thus, another option to recover the debt was initiating bankruptcy proceedings. As per the independent appraiser’s valuation report the residual value of company’s PP&E (incl. non-operational equipment) amounted to 1 billion USD as of March 31, 2019. The bank estimated that legal actions under the ‘bankruptcy scenario’ would take approximately two years, which corresponded to the bankruptcy legislation of the Russian Federation (see Table 1).

Table 1.

 Indicative terms of bankruptcy proceedings

Moreover, in order to determine the level of economic return of this scenario, the bank took into account the most substantial costs that would have been incurred during its implementation, viz. the remuneration of the bankruptcy trustee, which was calculated in accordance with Federal bankruptcy law No. 127-FZ. The bank assumed that the bankruptcy trustee would be able to satisfy more than 50% and less than 75% of the total amount of claims, thus his remuneration would be equal to a 6% share of the register of creditors’ claims [5] i.e. 0.1 million USD.

Taking into account all the aforementioned assumptions and having discounted the residual value of PP&E with WACC (13.5%), the total economic return for the ‘bankruptcy scenario’ equals to 860 million USD. 

Although the second scenario looked far more beneficial for the creditor, there was still room for improvement. Hence, the bank also considered another option – debt assignment. A debt assignment is a transfer of the right to claim a debt i.e., the assignor (lender) enters into a deal with the assignee (new owner) to assign ownership of the debt [2]. In this case, the consent of the debtor is not required.

The management of the bank clearly understood that it would be hard to control the company and, in the meantime, to enhance its financial gauges on their own. Therefore, the bank arranged auction for the debt assignment and eventually managed to obtain four non-binding bids from investors that represented the same industry as the distressed borrower. The maximum bid value equaled to 920 million USD and the bank won it successfully and closed the deal during the following five months.

Having analyzed the above-mentioned cases, we can summarize that indeed bankruptcy proceedings, financial restructuring and debt assignment can be deemed as the three major tools to settle the non-performing loans. When it comes to assessing and maximizing debt recovery ratio, we should always take into account the current market sentiment, the purposes of the lender as well as the time frame within the which the bank is ready to keep the debt on its balance sheet. Should the bank want to obtain cash as soon as possible, the debt assignment option will be the most suitable one. If the bank expects borrower’s stable cash flows in the short run, then financial restructuring instruments seem to be the most lucrative ones. Finally, if the lender is pessimistic about the asset, reluctant to gain control over it or expects that the borrower will be at a low ebb in the long run, bankruptcy proceedings might be a proper solution.

On balance, it is vital to understand that any non-performing loan and distressed borrower require quite a meticulous approach from creditor, with the latter elaborating a sophisticated strategy to maximize debt recovery. There are at least three key instruments that should be taken into consideration when calculating recovery rate viz. financial restructuring, bankruptcy proceedings and debt assignment. Depending on the case, one of them will without any doubt back up the creditor and help him recover the funds.

References:

1. Кулик В.В., Ведяхин А.А. Основы риск менеджмента: учебное пособие для программ Корпоративного университета Сбербанка. М.: АНО ДПО «Корпоративный университет Сбербанка», 2016.
2. Куркулин И.А. Современные стратегии урегулирования корпоративных долгов. Международный научный журнал «Современная школа России. Вопросы модернизации», №5 (42, т.2), май 2022.
3. Мазурин В.В. Механизм работы с просроченной и проблемной задолженностью в розничном кредитном портфеле российских банков.  Журнал «Вестник университета», 2016; (6):119-125.
4. Морсман Э.М. Кредитный департамент банка: организация эффективной работы. – Москва, 2003. – с. 133
5. Федеральный закон Российской Федерации от 26.10.2002 № 127-ФЗ (ред. от 27.12.2018) «О несостоятельности (банкротстве)».