June 15, 2012
At the 34th Annual NYU International Hospitality Industry Investment Conference, Latham & Watkins partner Gary Axelrod participated in a panel discussion “Loan to Own: Navigating Hotel NPLs — Moving from a Shunned Strategy to an Active One.” The conference was held June 3-5, 2012, in New York City.
Axelrod and his fellow panelists discussed whether 2012 will be the year where tight credit markets and a wave of loan maturities create an environment for opportunistic investing in loan-to-own strategies. They also talked about the approach investors should take as they look to employ a loan-to-own strategy.
What are the Top Ten issues when buying loans?
- Understand the reason for distress and the extent and use that information to help confirm the value of the collateral
- Understand the loan structure and the position in the debt stack you are buying
- Review the intercreditor, participation and related co-lender agreements to understand control rights, cash flow distributions and other rights and obligations
- Prioritize diligence (loan, borrower/guarantor, property) as if you were acquiring the underlying asset
- Review the guaranty and other potential sources of recovery
- Consider lender liability issues and other potential borrower defenses
- Consider possible exit strategies and understand the driver of the investment
- Analyze foreclosure process, timing, impediments and costs
- Possibility/impact of bankruptcy filing
- Identify issues specific to hotels (SNDAs, franchise restrictions, development and mixed use issues)
What are some of the most common mistakes you’ve seen investors make in regards to understanding the loan structure and acquired position in an non-performing loan (NPL)?
Axelrod: The most common mistake we see is investors purchasing pieces of debt in a structured transaction without appreciating their rights or lack thereof. We have seen circumstances where an investor has bought a subordinate piece of debt that gets extended beyond the maturity date because they did not appreciate that they had no control over the decision to grant an extension.
We also see investors unaware of the significant cost and delay that can result from a loan-to-own scenario that turns hostile, whether as a result of the borrower filing for bankruptcy or simply the judicial foreclosure process required in many states, which can, in some instances, take more than a year to complete.
What can you tell us about the importance of reviewing inter-creditor, participations and co-lender agreements — and the potential impacts to would-be NPL investors?
Axelrod: Understanding the documents that create the distinct piece of debt you are buying is absolutely critical, whether it is a participation interest, a subordinated B-Note or mezzanine debt. These agreements impact every element of the debt an investor will be purchasing, including provide for the sharing of cash flow and collateral, setting forth which holder of which piece of debt can make decisions and in many cases control the fortunes of the entire capital stack, purchase options and cure rights, and the mechanics by which a debt holder can enforce its documents.
To bring this to a finer point, there are now a number of situations that have been litigated where a mezzanine lender thought that it could foreclose on its equity collateral and restructure the senior mortgage loan through a bankruptcy proceeding, all in accordance with the terms of the intercreditor agreement. However, several courts, interpreting very similar language, have ruled that in a circumstance where a senior mortgage loan has been accelerated, the mezzanine lender must first cause the mortgage loan to be satisfied prior to completing the foreclosure of its equity collateral. Obviously, such a result is not what the investors had in mind when they acquired the mezzanine loan.
An investor that does not comprehend the documentation that it will be subject to after buying a non-performing loan will be in for a rude awakening.