How Private Equity Funds Price Non-Performing Loans

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📑 What are Non-Performing Loans?

Non-performing loans (NPLs) can be unique (though complex) investment opportunities for those prepared to tackle extensive datasets and tight due diligence timelines. At their core, NPLs are loans where borrowers have stopped making payments — typically for 90 days or more — and are categorized as defaulted.

These loans, whether backed by assets or not, are considered non-performing because they are unlikely to yield the expected returns under their original terms (sub-performing and re-performing loans are related types of problem loans).

Financial institutions usually sell NPLs to reduce risk and free up capital to generate more loans (performing, hopefully). Regulatory requirements, such as those imposed by Basel III, encourage banks to maintain leaner balance sheets, avoiding non-core assets that weigh them down.

Holding non-core assets hampers the banks’ ability to lend and meet liquidity ratios. As a result, they often sell NPLs to opportunistic investors (the so called “vulture funds”) at significant discounts, creating opportunities for savvy buyers to profit by restructuring loans, reaching deals with borrowers or simply repossess and sell the underlying collateral.

💼 NPL Market: Who Sells and Why?

The primary sellers of NPLs are banks, financial institutions, and sometimes government agencies. In recent years, we have also seen more secondary deals, as private equity funds that require cash sell select assets to generate liquidity. They often “cherry-pick” the assets they want to sell from the original portfolio, creating a “sub-portfolio” by bundling them together.

But why do sellers offload NPLs at prices well below their original loan value? Regulatory pressure and lengthy recovery timelines are often key drivers. Banks are not equipped to handle collections, foreclosures, or distressed borrower negotiations effectively and, as their defaulted books grow, they face mounting pressure to lower their NPL ratios.

At the same time, investors require a high IRR for these investments, factoring in workout complexity, operational risks, long payback timeframes, and inherent uncertainties. As a result, the expected net present value for these portfolios often hovers at a fraction of their loan balances — think 40-50% for secured loans and 1-10% for unsecured loans.

👔 NPL Sales: How is the M&A Process?

NPL portfolios can be sold via bilateral agreements or competitive processes. A typical M&A process in Europe unfolds as follows:

1. The bank decides to offload a specific pool of defaulted loans and collateral, which is usually real estate owned by the banks (REOs).

2. The bank then asks an advisory firm or investment bank to perform a preliminary valuation.

3. Once the valuation is agreed upon (an exit range expected for the portfolio), the advisor might do a "market sounding" to gauge investor interest.

4. After that, the advisor will launch the formal process, which is composed of two main phases:

   • Non-binding offer (NBO) phase: The first phase where all investors are invited to bid for the portfolio with their highest possible number.

   • Binding offer (BO) phase: The second phase in which the investors who (usually) bid the highest are selected, and where an updated bid is expected from them.

5. Once the BO phase has been finalized, in theory, the highest offer is selected, and the deal is sealed subject to deal-closing activities.

At this stage, the winning bidder might walk away with a portfolio of assets bought at a 40-50% discount to the outstanding balance (or less if mostly unsecured). But how can funds buy portfolios at such discounts? Well, the following section will provide more context.

🔍 Valuing an NPL Portfolio: Key Factors

Like any other investment, NPL investors typically evaluate multiple metrics. However, two stand out in these investments: IRR and WAL.

• IRR (Internal Rate of Return): Choosing the IRR is straightforward — it measures the potential return over time.

• WAL (Weighted-Average Life): The WAL of the portfolio gauges how long it will take to receive proceeds.

These two metrics are important given the sensitivity of NPLs to timing. For example, assuming an exit in year 4 instead of year 6 might lead to an excessive acquisition price.

Regarding the actual valuation, from a high-level perspective, the portfolios are typically split into two segments:

1. Unsecured Loans - these loans are priced based on expectations of the borrower repaying. Funds tend to use proprietary or external data to categorize borrowers by age, geography, income, etc., and then assess how likely they are to pay. A rule of thumb suggests that unsecured loans should be valued anywhere from 1% to 10% of the outstanding balance (OB).
   

2. Secured Loans - slightly more complex. Here, the valuation depends on collateral analysis and the chosen workout strategy, such as (non-exhaustive):

   • Auction Sale: Selling the collateral at a public auction to recover the outstanding debt.

   • Repossession: Taking possession of the collateral, often with the intention to sell it privately.

   • Debt Restructuring or DPO (Discounted Payoff): Negotiating new terms with the borrower, possibly reducing the debt amount or extending the payment period.

   • Deed-in-Lieu: The borrower voluntarily transfers ownership of the property to the lender.

   • Amicable Sale: Collaborating with the borrower to sell the collateral property on the open market to repay the loan.

Another important factor (mostly for secured loans) to consider is whether the loan is under a foreclosure or bankruptcy process. Foreclosures, while slower in some European countries, tend to be faster and less costly than bankruptcies. Misjudging this can distort portfolio value and lead to overpaying or underbidding.

And why is this relevant? Well, costs and timelines affect the loan’s Net Present Value (NPV) and acquisition price. Mispricing a foreclosure as a bankruptcy can make your bid uncompetitive, while the reverse risks overpaying for the portfolio.

✒ To Wrap Up

Ultimately, successful loan pricing comes down to deeply understanding three key elements: income, costs, and timing. These factors are influenced by several variables, including:

• Loan Type and Ranking: Secured vs. unsecured and senior vs. junior liens

• Collateral Value: Liquid vs. illiquid often based on asset type and location

• Workout Strategy: Amicable, foreclosure, bankruptcy or others

I hope you found this overview helpful. As always, feel free to reach out with any questions or share your own insights — it’s always good to hear your experiences!

Until next time,
PE Bro

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Disclaimer: The views and opinions expressed in this article are based on my personal experience with non-performing loans (NPLs) in Southern Europe. This content is intended for informational purposes only and should not be considered financial advice. The numbers and examples provided may vary and might not reflect all scenarios or regions. Always consult with a qualified financial advisor or professional before making any investment decisions.