Evaluating Distressed Debt Strategies for Private Lenders

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Private lenders nationwide will tell you that defaults have climbed in a meaningful, but not distressing, way over the past 12 to 18 months. Since 2023, Geraci LLP has fielded many questions about distressed debt strategies, including investing in non-performing loans (NPL) or acquiring distressed debt to reperform or modify loans (RPL). Other private lenders have also implemented higher-risk strategies to position themselves as rescue lenders to borrowers. All of these strategies present significant opportunities to make sizeable returns but can increase the risk profiles proportionately. There are several key considerations when pursuing any of these strategies from a fund formation perspective.

Fund Structure

From a securities law standpoint, any of the funds mentioned above can be structured under the commonplace exemptions utilized for performing debt funds including Regulation D or Regulation A. The complications come when it comes to the structure of the fund. Structuring NPL Funds can be a bit more complex than an average performing loan or RPL fund. The reasoning is that the investment thesis follows one of the growth investments in which the fund will acquire NPL (perhaps at a discount), foreclose on the collateral, and pursue a real estate investment strategy.

Generally, closed end funds are an easier approach to structuring to ensure accurate accounting and avoid valuation issues to the fund units being sold. Open end funds can be considered but will need to account for the value of the units for investors admitted towards the tail end of an investment.

RPL and opportunistic strategies are more common as these types of loans are more readily available. These funds can be structured as either as they typically mimic performing debt funds when it comes to the assets performance. One notable consideration for open-ended funds would be to create a longer lock up period to ensure it accounts for the higher risk profile of the transactions in the portfolio.

Compliance & Licensing

One commonly overlooked issue is compliance – specifically mortgage compliance. For opportunistic strategies, the licensing and compliance considerations remain the same because the thesis revolves around new origination. However, there are many flawed assumptions that licensing is not a concern when buying NPL or RPL. States like California, Nevada, and Georgia have specific regulations and compliance obligations when it comes to purchasing loans.

In addition, many NPL strategies consider purchasing distressed consumer mortgages, which raises additional questions when it comes to RESPA, TILA, and other consumer protection regulations. For these reasons, it’s important to consult with counsel regarding not only structuring the fund strategy but also the compliance associated with the business plan itself.

Risk Management

Risk management in these strategies takes two forms: asset management and risk expectation setting. Asset management requires lenders to carefully refine policies on extensions, modifications, foreclosure, and litigation budgets. This is especially true for NPLs, as they pose a significantly higher risk of litigation during or after foreclosure.

Fund managers should establish clear policies and procedures to manage these situations, providing standard guidelines to mitigate risk. Additionally, they should refine underwriting guidelines to align with these risk management philosophies and the investment thesis.

Unlocking Potential in Distressed Debt Investments

As you can see, NPL, RPL, and opportunistic strategies can be quite lucrative and present interesting investment opportunities for fund managers. The heightened risk profile should be carefully considered to mitigate investor/borrower litigation and regulatory scrutiny. The Geraci Corporate and Securities team can advise through these strategies in several ways, so please contact us for a consultation to discuss your next fund today.

Questions about this article? Reach out to our team below.
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