NPL servicers not immune from downside risk

Firms taking on governance, rather than ownership, of non-performing loans are still taking on downside risk as part of their business operations.

Despite not taking on the ownership of large portfolios of securities, non-performing loan servicing companies are still exposed to downside risk due to the economics of their business operations. These firms do, at times, also take ownership of a small portion of the loans they’re servicing.

Pillarstone, the KKR-affiliate which has just begun servicing NPLs in Greece, takes a management fee and a share of recoveries from banks in exchange for servicing bad debt, John Davison, CEO, told PDI.

Davison says generating good recoveries for banks is crucial to the economics of how a firm like Pillarstone works. Rather than taking on fund fees in the way a private fund would, he says Pillarstone takes a management fee from banks which just about covers the firm’s expenses.

“We have just about enough income to cover our overheads. It’s very different from a hedge fund or private equity model,” he says. To make profits the firm is dependent on generating recoveries which it can share in.

Servicing firms are also exposed to other areas of downside risk. While predominantly taking on governance rather than ownership, Davison says his firm does buy a small portion of the loans it’s servicing. Banks also often have an option to sell out under the arrangement, he adds. Any cash invested in businesses to aid recoveries is also at risk.

Davison says the key thing to note about firms pursuing a business model like this is the requirement to dig deep into the underlying companies. “We are an A&E department for a business, not a structuring solution for a bank’s balance sheet,” he says.

Distressed or non-performing assets can produce significant returns for investors. One benchmark, the Barclay Distressed Securities Index, returned approximately 14.4 percent in 2016. With riskier assets, however, comes greater volatility. In 2015, a down year, the same index returned -10.1 percent. It is flat based on year-to-date returns in 2017.

A longer version of this article will appear in the July/August issue of PDI