In May, KKR affiliate Pillarstone received approval from the Bank of Greece to begin servicing a slice of the country’s mountain of non-performing loans. But, unlike distressed or special situation debt funds playing in the space, Pillarstone’s business model doesn’t involve the acquisition of portfolios of loan assets.
Instead, Pillarstone takes on the governance of the non-performing assets on behalf of a bank. In return, the firm gets a management fee and enters into a profit-sharing arrangement should the loan recover its value above a “par” amount determined by the impaired value of the loan on a bank’s balance sheet.
Pillarstone has a similar arrangement in Italy where it oversees the governance of NPLs for three local banks. It’s a different method to how many debt funds approach the NPL space – which generally involves taking full ownership of large portfolio credits that banks are removing from their balance sheets.
The Greek central bank moved to begin the process of granting licences to service providers last year, aiming to attract companies keen to find opportunities in servicing non-performing debt held by Greek banks. Early reports suggested as many as six service providers were seeking to gain approval to start such operations, Pillarstone among them.
It’s not just the ownership question which distinguishes firms like Pillarstone from fund managers. The latter, when they acquire portfolios from banks, take on a huge number of credits.
“Usually the NPL strategy is focused on buying a portfolio,” Peter Schwanitz, managing director at Portfolio Advisors, tells PDI. This means that funds purchasing NPLs from banks need specialist teams able to assess the portfolio holistically rather than taking a deep dive on individual credits.
“It’s more an industrial approach to managing larger portfolios,” Schwanitz says. “It’s almost like an insurance approach. You almost need actuarial knowledge.”
In the absence of such teams in-house, funds have to reach out to service providers. The fees from such arrangements are often passed on to investors, Schwanitz notes.
ONE LOAN AT A TIME
By contrast, John Davison, CEO at Pillarstone, tells PDI his firm’s business is predicated on taking on the governance of individual credits. This involves carefully assessing each lender behind the loan rather than data-crunching an entire portfolio.
“We usually do it on a loan-by-loan basis,” Davison says. The exception might be when servicing loans of particular asset classes or sectors, such as shipping and real estate, where certain factors affect the whole industry. Pillarstone is looking for opportunities in these sectors, Davison notes.
Another difference between the two business models is the way in which opportunities are identified. Schwanitz notes when funds are seeking to purchase portfolios of NPLs the origination process isn’t too different from that of other loan-focused funds. “It’s quite similar,” says Schwanitz. “Ten years ago, when things were different in the market, the GPs reached out directly to the banks.”
In contrast, Davison notes one way his firm finds opportunities is being approached by management teams of the companies behind the NPLs. From there, his firm can approach a bank about servicing a non-performing asset, sometimes before a problem has been identified by the original lender.
Working with the bank, rather than looking to acquire assets from it, creates a different dynamic, Davison continues. “[Purchasing NPLs] is a zero-sum game,” he says. “If the buyer does a good deal the banks lose out.”
While banks are likely to continue to sell non-performing assets – bringing themselves in line with regulations such as Basel III – Davison believes his firm’s approach can better help these institutions recover losses and reverse impairments.
“The reality is, for a market-clearing transaction for an NPL for a bank, they are always going to have some impairment,” he says, adding once assets are sold losses have to be accepted. “They have no potential to recover the loss from that position.”
Sales of NPL portfolios also take time. Once a fund acquires the loans some of the situations affecting the underlying borrowers may be irreversible. Taking on governance rather than ownership therefore buys time. “The problems haven’t been as longstanding,” says Davison. “It doesn’t take as much money to fix it or as much time to fix it.”
The expected performance from NPLs is one thing that’s up in the air at the moment, according to Schwanitz. “There’s a steady supply of NPLs,” he says. “The key question is what the outcome is. And I think we’ve seen a normalisation of returns.” 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 – and it’s flat based on year-to-date returns in 2017.
For his part, 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.
Davison also notes Pillarstone is exposed to other areas of downside risk due to an approach which distances itself from other service providers. 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 capital invested by Pillarstone to aid recoveries is also at risk.
Pillarstone’s Greek venture will focus on individual companies rather than large portfolios of NPLs. The firm announced its first deal – restructuring the pharma firm Famar – shortly after receiving its licence from the Greek authorities.
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.”
October 2015: Pillarstone established in partnership with Italian banks Intesa Sanpaolo and Unicredit. John Davison, previously at RBS, joins as CEO and co-investor.
May 2016: Pillarstone announces partnership with Greek banks Alpha Bank and Eurobank to service non-performing debt. The partnership pends licensing approval from the Greek banking authorities.
May 2017: The Bank of Greece grants Pillarstone its licence. Shortly afterwards, the firm takes on the governance of debt from pharmaceutical firm Farma.