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Buying loan portfolios

Why bidding for loan portfolios is a risky strategy

Spring 2014

1 March 2014

One theme in the debt markets over recent years has been sales of bank loan portfolios. As an asset manager, Sequoia is reluctant to get involved in these auctions.

Firstly, the sale process may not allow sufficient time for a thorough credit review. This is especially important when bidding for unrated loans such as infrastructure or real estate loans, where the only way to assess credit quality is a detailed analysis of each individual loan. Without this, it is likely that mistakes will be made.
 
Secondly, there is an ever-present danger of adverse selection. There is an information asymmetry between sellers and buyers and, even in an apparently high quality portfolio, there is a real risk of the seller including some loans that it knows or suspects will have problems in the future.
 
Thirdly, the bidder is exposed to the bank’s origination and credit criteria which will be undisclosed and which may have systematic problems. Banks make loans for many reasons, including relationship reasons, and this is something we want to avoid. Something like this only comes out after a thorough credit review. 
 
Fourthly, the portfolio is likely to have undesirable concentrations in the bank’s preferred sectors and clients.
 
Fifthly and finally, the bidder may experience winner’s curse. By definition, in a competitive auction, the winning bidder would have paid more than anyone else is willing to and so may have overpaid. These portfolio sales also usually have “reserve pricing” where the reserve price is undisclosed. In this case the bidder may do a significant amount of credit work and pricing work, usually under a time constraint, and still not meet the seller’s reserve price.
 
In conclusion, whilst we acknowledge that not all of these factors are present in every portfolio sale, buying portfolios is inherently risky. When done via a “bid wanted in comp,” as most are,  it is very time consuming and is unlikely to result in a trade at an optimal price. Often there is no or inadequate compensation for this risk.
 
Sequoia’s preferred approach, when buying secondary market loans, is to talk to a wide range of banks and then acquire individual loans from them, following a detailed credit analysis of that loan and price negotiation. Whilst this requires from us a greater investment in time and effort, we believe it serves our investors much better than any alternative.

 

       

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Sequoia Investment Management Company specializes in infrastructure debt and structured finance asset management

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