Mergers and acquisition transactions for securitization sponsors and servicers present unique issues that require in depth knowledge of the underlying securitization structures and risks, as well as related financing, regulatory and technology issues. M&A lawyers and business teams should maintain a holistic view of how M&A affects past and future securitizations by both the seller and the buyer, what financing plans are likely for the buyer, what consents are needed and how the securitization transactions and securitization systems will be integrated post-closing. Some of the more prominent issues are discussed below

Issue 1. Is it a Securitization? Is it a Whole Loan Deal? No, it's an M&A Deal!

Where the buyer's primary goal is to purchase a large portfolio of loans, leases or other receivables, a threshold issue for the acquisition of a securitization sponsor or servicer is whether the transaction will be executed as a portfolio sale or a platform sale or both. The securitization sponsor's "platform" includes the assets needed to operate the finance business, including employees, facilities and real estate, information technology and contracts. If the sponsor's platform assets include state licenses, change of control consents and other state agency notices and approvals may be required. These approvals can create uncertainty and increase the time required to close the transaction. Many buyers are already in a finance company business and do not need the facilities, people and information technology assets that may be offered as part of a platform sale along with the loans, leases or other receivables and related rights included as part of a loan portfolio. These buyers may only be willing to purchase the platform (other than the licenses) as a reduction to the purchase price for the portfolio or may view the platform as a very small part of a much bigger asset play. This view by buyers is more likely where the seller is a large commercial bank that either cannot offer its information technology assets in the transaction or its information technology assets represent older and less versatile solutions than buyer's existing technology

M&A Deal or Loan Portfolio Sale?

If a valuable operating platform is being sold along with loan assets, a traditional M&A structure, such as a merger or a stock or asset purchase, will typically be used, and the purchase agreement will likely contain traditional M&A representations, covenants and indemnities. On the other hand, if only or predominantly loans or other financial assets are being sold, the parties may opt for execution of the transaction in a manner that is more typical of a capital markets trade and follow a whole loan portfolio format. The decision to structure the sale using an M&A or a loan portfolio sale format may depend as much on the experience of the deal team executing the transaction as anything else. It may also depend on whether the buyer intends to immediately finance the loans in the capital markets after the purchase, in which case a whole loan portfolio execution may be more desirable for the buyer. Finally, the valuation method being used (whole business versus loan portfolio or assets under management) may lead to a particular type of execution.

Advantages and disadvantages of M&A execution include the following:

  • Ability to divest an entire business. A seller that desires to divest an entire business line may find the M&A-style execution more favorable for avoiding trailing liabilities of the business and allowing a "clean break." If the seller divests only the portfolio of assets (and not the platform that supported the operation of those assets), it will be left with a platform (employees, office leases, etc.) that it no longer needs. The buyer will need to consider what effect its acquisition of the operating platform has on value.
  • Ability to limit indemnification remedies. An M&A indemnity regime may allow the seller to cap certain of the buyer's indemnification remedies to a relatively low threshold, such as 10% to 20% of the purchase price, and to require a relatively high deductible, such as 1% to 3% of the purchase price, before certain of the seller's indemnity obligations kick in. This may contrast favorably for the seller with a more typical loan portfolio remedy, which is to repurchase individual loans on a loan-by-loan basis if the seller's representations are breached. The warranty repurchase is a remedy borrowed from capital markets transactions, such as securitizations. The buyer may seek a warranty repurchase remedy the terms of which mirror as closely as possible the repurchase remedy imposed on the buyer in the capital markets transaction it executes to finance the loan portfolio purchase. However, if the seller is divesting an entire business line, it may no longer be able to service repurchased loans or may find it cost prohibitive to do so. These differing indemnity regimes have tended to infiltrate both types of deals, with warranty repurchases cropping up in M&A-style transactions and caps and deductibles cropping up in the warranty repurchase remedy of loan portfolio sales.
  • Ability to limit representations and warranties. M&A representations tend to be more general and qualified as to materiality or a "material adverse effect" and knowledge than representations in a securitization or whole loan transaction. The spectrum of representations that can apply to financial assets ranges from the detailed and numerous representations found in capital markets/securitization transactions (e.g., 20 to 30 representations covering the financial assets being financed) to a medium number of representations in performing whole loan transactions to very limited "as is, where is" representations contained in nonperforming loan sales to what may only be a single paragraph of loan representations in an M&A transaction qualified by materiality and knowledge. Where the buyer has the ability to do extensive diligence on the loan portfolio, an "as is, where is" or more limited M&A-style execution may be possible
  • Risk of receiving a lower purchase price for the portfolio. A disadvantage that may come hand in hand with the limited recourse and limited representations points discussed above is that the buyer may pay a lower price for the portfolio. In effect, the buyer may "price in" the cost of its limited rights.

Advantages and disadvantages of a whole loan portfolio style of execution include the following:

  • Faster execution and lower cost. Because only financial assets are being purchased in a whole loan portfolio sale, it is typically quicker and has lower legal and other transaction costs than an M&A-style transaction.
  • Ability to quickly finance or securitize the loans. Execution as a whole loan portfolio sale will be preferred if the buyer plans to finance or securitize the loans immediately after or simultaneous with the closing of the purchase. The buyer's goal will be to match to the greatest extent possible the representations, warranties and covenants it receives from the seller to those demanded by its underwriters and investors in the capital markets.
  • Ability to accommodate a forward flow arrangement. The whole loan portfolio style of execution is better suited to a forward flow arrangement, which is a loan sale program that will involve multiple loan sales over a period of time. The seller may seek a forward flow sale arrangement where it has a large portfolio of financial assets for which it can obtain better value by selling in blocks over time.
  • Retention of post-closing liabilities for individual loans. The seller may achieve higher pricing in a whole loan portfolio sale, but it will retain trailing liabilities for the portfolio, typically on a loanby-loan basis. As discussed above, the buyer in a portfolio sale typically seeks to obtain a warranty repurchase remedy to sell individuals loans back to the seller if the seller's representations relating to the loans are breached.
  • Importance of data tape. The data tape for the portfolio of loans takes on heightened importance in a loan portfolio execution. The data tape typically is a large excel spreadsheet that contains hundreds of line items. It may be difficult to verify the accuracy of each and every line item in the data tape, particularly for an older pool with multiple servicers and information technology systems over time. On the other hand, the buyer must have a high degree of confidence that the loan data is accurate if it intends to launch a capital markets deal immediately after or simultaneous with the closing. As discussed below, an accurate data tape will be essential to the buyer's financing plans, as well as its compliance with the securities laws in capital markets transactions going forward.

Whole Business v. Assets Under Management Valuations.

The negotiation and drafting of the purchase price for the acquisition of a securitization sponsor or servicer can be quite complex and require a deep understanding of the securitization business being purchased. Once the valuation and purchase price mechanics are set, the rest of the transaction terms should support the valuation and pricing methodology.

The pricing for the acquisition of a securitization business falls into two primary categories: (1) pricing based on a valuation of the business as a whole; and (2) pricing based on the "assets under management" or "AUM," which are the loans, leases or other financial assets or rights comprising the bulk of the assets being sold. Some transactions share elements of both the whole business and AUM approach. The whole business valuation approach is likely to lead to an M&A platform sale execution while an AUM approach lends itself to a whole loan portfolio execution.

  • When to Choose a "Whole Business" Valuation. Where a business is thriving and purchasing the entire operation, including hiring substantially all the employees, is attractive to the buyer, a "whole business" valuation may make sense. The buyer may also be more likely to desire the simplicity of a stock acquisition or merger as opposed to an asset acquisition, and may be willing to assume all of the liabilities of the business without cherry picking assets and liabilities.
  • When to Choose an AUM Valuation. If the buyer of a securitization business perceives the business as risky, the buyer will more likely structure the deal as a loan portfolio transaction or as an asset acquisition and refuse to assume specified or unknown liabilities. A typical valuation formula for a loan portfolio or an asset acquisition would be some percentage, e.g., 105% or 95%, depending on the perceived risk of the financial assets, of the outstanding principal balance of the portfolio of loans, leases or other assets. Similarly, in the acquisition of a servicing business, if the servicer receives a 100 basis point fee in the servicing agreements being assumed, the buyer may offer a price equal to the 100 basis points (or 95 basis points again based on the perceived risk of the servicing rights) times the outstanding principal balance of the loans, leases or other assets being serviced. An asset acquisition may become a loan portfolio purchase that is much more similar to a whole loan purchase or a securitization than a traditional M&A deal. The buyer may close the transaction in multiple closings for tranches of assets as consents to transfer become available, using a structure that is more akin to a whole loan flow purchase or a securitization.
  • Combination Type Valuations. Acquisitions of securitization sponsors and servicers may combine aspects of both types of valuation methods. For example, a financial buyer like a private equity firm or hedge fund may need the origination and servicing platform to run the target business as well as the financial assets of the business. A financial buyer may initially value the business on a portfolio basis and then add a premium for the whole business and assume various employee, IT and other assets and liabilities, such as litigation tied to the financial assets that may be more effectively handled by the owner of those financial assets after closing. In a distressed situation, a financial buyer may insist on buying the portfolio at a portfolio valuation price only and essentially purchase the platform for "free" or even value the platform as a subtraction to the purchase price.
  • Effect of Valuation Method. The decision to value a whole business versus a portfolio will generally affect all the deal terms, including the representations, covenants and of course the purchase price mechanics. For example, a portfolio-based valuation will lead to more extensive representations as to the financial assets being purchased and the financing agreements with customers and lenders related to the financial assets. Operations-based representations, such as, for example, these relating to real property and real property leases, employees and employee benefits or environmental issues of the business, will be less important. Some representations, such as those relating to the financial assets themselves and information technology, will likely be relevant to the securitization business regardless of the valuation method. Similarly, covenants between signing and closing will vary depending on whether the focus is the entire business or the portfolio alone.

Whole Business Valuations and Working Capital or Net Assets Adjustments

Closing and post-closing adjustments will vary depending on the type of business being purchased and the valuation method used in calculating the purchase price. If the purchase price is based on a valuation of a whole business, the purchase price may include a traditional adjustment for changes in the working capital (current assets less current liabilities) or the net assets (total assets less total liabilities) of the business from the last audited balance sheet prepared prior to closing or the balance sheet on which the valuation for the buyer's initial offer was prepared. A typical mechanism would value the working capital or net assets as of the specified balance sheet date and base a preliminary purchase price for the closing on that amount. The parties would calculate an estimated closing date purchase price based on an estimated working capital or net assets amount a few days or the last month end date prior to closing. Within some period (e.g., 60 to 90 days) after closing, a final closing date balance sheet would be prepared and a true up payment made by either the seller or the buyer based on the difference between the estimated and final working capital or net assets.

AUM Valuation and Adjustments Tied to Portfolio Fluctuations.

Where a portfolio valuation method is used, the purchase price will be tied to the fluctuations in the portfolio. Thus, if the purchase price is 105% of the aggregate outstanding principal balance of the loans in the portfolio, the price will go up or down based on the size of the portfolio. The parties may prefer a closing date, such as a month-end or weekend date so that back office systems personnel can freeze the portfolio as of a "cut-off date" that can be calculated precisely. For a healthy business, new loan originations may equal or exceed the loans being paid down so the purchase price will likely go up. In a distressed situation, the portfolio typically will decline as loans pay down or are written off. More complicated mechanics may include an audit of the loan portfolio to ensure that the loan amounts are correct and are being properly serviced. The deal negotiators will need an intimate familiarity with how the loan portfolio performs, and any financing or securitization agreements related to the portfolio, to negotiate the purchase price provisions effectively. Classic areas for dispute may be inadequate or overly generous loan reserves or changes in the collection strategies or advancing practices by the seller or the buyer. The seller's compliance with its financing or securitization agreements can also affect the portfolio valuation.

Issue 2: How Will the Purchase be Financed?

A key consideration for the buyer of a securitization sponsor or servicer is whether and how the business and financial assets will be financed. A related question is whether the current financing on the financial assets placed by the seller is attractive to the buyer or whether the buyer would like to pay it down. A strategic buyer, such as a large bank or finance company, may not need financing or may find the seller's financing less attractive than what it could raise itself. A financial buyer typically will seek financing in part to increase its rate of return on the investment by adding leverage. The buyer will need to do careful diligence of the seller's existing securitizations and other financings as well as any impediments to financing the financial assets. Financing conditions are very unusual in the current M&A environment, but the buyer can reduce many of the risks of financing by obtaining representations and covenants designed to cover their risks. A financial buyer will often negotiate a "reverse termination fee" whereby it pays the seller a termination fee (currently approximately 3% to 5% of the purchase price) as the sole remedy for the seller if the transaction does not close because the buyer fails to obtain financing.

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