Who Owns Your Loan?

Entrepreneurs are negotiating with tough new creditors as banks look to ditch troubled loans

by Amy Barrett

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Hendrickson's turnaround plan bought him time. Jason Halley/Chico Enterprise Record

Got a good relationship with your banker? Well, if you're late with your loan payments, it might not matter. Banks looking to spruce up their balance sheets are selling off problem loans, particularly if payments are overdue or borrowers are in violation of bank covenants. (Such covenants often stipulate how much cash a company must have on hand or the percentage of cash flow that can be used to pay debt.)

As of Mar. 31, 2008, problem business loans—those more than 30 days past due—totaled $22.6 billion. That's up 45% over the same period last year, according to the Federal Deposit Insurance Corp. Banks wanting to sell off these loans are finding ready buyers in hedge funds, private equity firms, and finance companies. That means an increasing number of entrepreneurs are getting a nasty surprise: Their bank loan has been sold to a third party they've never heard of.

As the economy struggles, the pace of such transactions has picked up. Kingsley Greenland, chief executive officer of the Boston-based Debt Exchange, a marketplace for bank loans, says that since December sales of business loans of $10 million or less are up "a couple hundred percent" compared to last year. Craig Noell, managing director and CEO at Sherman Oaks (Calif.)-based hedge fund Signature Capital Partners, which buys distressed loans, predicts sales of these loans will soon accelerate significantly.

A Dime on the Dollar

When a loan is sold, the borrower's obligations, and those of the lender, are still governed by the original bank loan agreement. But while a bank may look the other way if a company is briefly in violation of a loan covenant, the new creditor won't necessarily do the same, says Howard Brod Brownstein, principal at Narberth (Pa.)-based workout firm NachmanHaysBrownstein. And if a company is struggling, says Dan Cadle, chairman of distressed-loan specialists Cadle Co., the business owner is often expected to agree to "a lower salary, to live more frugally, and quit living the high life." Federal law protects consumers from overly aggressive collection efforts, but those rules don't necessarily apply to entrepreneurs who have personally guaranteed business loans, say attorneys. "It can be more rough-and-tumble than the banking world," says the Debt Exchange's Greenland.

Dealing with a hedge fund or other private firm is very different from working with a bank. While some creditors will be willing to work out a deal for companies that seem healthy, others are likely to move quickly to foreclose if a company seems vulnerable. The third option is "loan to own," in which the loan holder typically agrees to some concessions in return for a sizable chunk of equity.

The world of trading in distressed loans is invisible to most entrepreneurs. Smaller loans are sold in pools; larger ones (usually with unpaid balances of at least $1 million) sell individually. The buyers study each borrower's file and usually acquire the debt for a fraction of its face value. A loan to a borrower in decent financial health or one that is well collateralized may sell for 90¢ on the dollar, while others may fetch only 10¢. The borrower learns of the transaction via a "goodbye" letter from the bank, which says the loan has been sold. The new holder then sends a "hello" letter announcing the acquisition.