How NPV Helps in Choosing the Best Workout Option for a Distressed Loan

In this tale that’s been crafted for instructional use, a community banker is thrown into the world of workout. Lacking experience there, he seeks help from a special-situation specialist, and learns that determining the net present value of collateral is key to a loan workout win. 

In 10 years at a mid-sized community bank, Willie Malone worked his way up from underwriter to relationship manager. Over time, and with his employer reeling from a spike in criticized assets, he unexpectedly found himself managing workouts, where he had little experience and often felt overwhelmed. The 20-plus deals on his desk languished in various stages of distress and collection as he searched for guidance on how to sort them out. 

Malone called Michael Kilroy, whom he’d met at an RMA industry event. Recently retired, Kilroy had 35 years of experience working on special-situation assets and knew a thing or two about troubled loans. He offered Malone some simple advice: stay out of lender liability situations; demand transparency from borrowers; and use Net Present Value (NPV) to get the best workout result for your bank. 

This last bit puzzled Malone. He understood NPVs but wasn’t sure how to apply them to distressed workouts. Kilroy explained that in these situations, NPV simulations could show how to get the best outcome from the loan under different workout scenarios and convince leadership of the best path forward, to boot. Malone was all ears. 

To calculate the NPV of the loan under different workout approaches, you would forecast future cash flows from each strategy, deduct the expected costs to the bank, then discount the expected cash flows back to today’s date. The scenario with the highest NPV is the approach that would win, Kilroy explained.    

The process itself had its benefits, too. First, to do the various NPV calculations the bank would need to collect and organize all the documentation relevant to the loan – a necessary but tedious task bankers would otherwise avoid. Second, the bank would begin to understand better the intrinsic value of the asset. Finally, and most importantly, by pinpointing the value of its various approaches to a workout, the bank would be in a much stronger position to negotiate. 

“Please explain,” Malone implored. 

Collecting Documentation 

Malone knew he’d need to go through the loan documentation with a fine-toothed comb. But he hadn’t considered items like the marketing time outlined in the recent appraisal document though he understood why it was important for estimating how long it would take to liquidate collateral in a foreclosure scenario. Nor had he explored items he might need from third parties, like simple market rental fees to compare against the assets’ current leased rates to assess future rental income. He realized he needed to dive deeper into the guarantor’s personal financial statements to see what assets were exempt from collection under bankruptcy or state law and estimate guarantor cash settlement payments. Malone was beginning to understand how collecting information was important to getting the full picture of the situation and how the NPV process could help him. 

Assessing the Intrinsic Value of the Asset 

Don’t confuse the intrinsic value of an asset with its accounting value, Kilroy warned Malone.  The latter is usually the legal or book balance of the loan less any mark-to-market charge-offs or reductions due to interest payments applied as principal, while the intrinsic value should only be used for internal purposes in considering the strategic value of the loan. It can influence senior leadership to consider different paths to resolving the loan that could achieve the best returns for shareholders. 

Understanding Your Negotiating Position  

NPV can be a powerful metric for negotiations, Kilroy said.  If the bank gains the most benefit from the scenario with the highest NPV, then ranking scenarios by NPV can make decision making easier. In the case where the NPVs of two scenarios are essentially equal, the bank can offer the borrower options and, based on which it chooses, understand what the borrower’s intentions are for the relationship. 

To better explain his points, Kilroy continued with examples. He cited a distressed commercial real estate loan that was habitually in default but had a loan-to-value of 60%. He ran NPV calculations considering various workout scenarios and found that selling the note at a 12% discount would yield a better NPV than either a refinance or a foreclosure. At first, his credit committee wasn’t buying it. Why would the bank sell a loan that technically was performing and was well secured? Kilroy reminded the committee that the loan was already on the books at a 9% loan loss reserve, and that to make up that 12% would take two to four years under the best of circumstances. Getting money in the door today was the better option, he convinced them, repeating the old workout adage that “your first loss is your best loss.” 

Then he described the case of a real estate investor/sponsor with several different loans at the bank. The customer had defaulted on one and wasn’t working well with the bank to resolve it.  Through an NPV analysis, the bank determined that a restructuring and a discounted payoff had the same value. It shared these options with the borrower’s attorney, in part to understand how the borrower would approach the negotiations. Selecting the discounted payoff would signal the borrower’s desire to forgo the asset and take the path of least resistance. Choosing restructuring might signal the borrower’s willingness to fight hard to keep the asset, including potentially filing for bankruptcy. It’s better to have options, Kilroy emphasized, rather than being hemmed into one.  

Getting Started 

Malone was now a believer. He was excited to bring what he learned to the bank and start applying it to those 20-plus troubled loans. Using NPV provided a solid framework for solving his problem loans and a structured approach for negotiating the best results for his bank and his customers.  

But, where to begin? Malone wondered. As in so many lender/borrower negotiations, it starts with the relationship and an assessment of the bank’s bargaining position. Collect all the loan information, ask the company for its latest financials, and order an asset appraisal. If the bank is missing information or is poor at servicing the loan, it might be better to provide a short-term forbearance on the loan to gain cooperation, fix the documentation issues, and obtain mutual releases. In some cases, the bank might even have to grant concessions to perfect collateral or get waivers of claims and defenses with servicing problems or lender liability claims. 

If the lender is in a strong position in relation to information and servicing, then the bank has the luxury of considering the pure relationship implications of the workout. Is this a customer the bank wants to keep (in which case a modification may be more appropriate) or is it an exit situation (which might lead the bank to sell the note or foreclose)? 

Building a sound model is key, Kilroy explained, especially given model validation requirements. Lean on your modeling team to support you in creating the tool, he offered. Excel has an NPV calculator, and your modeling team can add essential inputs like the discount rate. 

Now, to the hard part – developing the cash flow and other assumptions for each scenario to fill out the model. These questions must be answered: 

1. What are the viable scenarios for this asset (restructure, foreclosure, note sale, A/B/C note restructure)? 
2. How long will each scenario take to fully resolve the asset?  
3. What are the cash inflows from each scenario? Under a restructuring, for example, cash inflows would be the debt service payments and balloon payoff under a refinance. In a foreclosure, inflows might come from controlling the collateral and any rental income. In the case of a note sale, proceeds would come from the sale. 
4. What are the cash outflows from each scenario? In a restructuring, the only cash outflows would be the bank’s overhead; any expenses incurred would be collected from the customer. In a foreclosure, the cost of collections includes legal expenses, third-party reports, advanced real estate taxes, and forced placed insurance.  Make sure that common expenses, such as servicing costs and bank overhead, are included for each scenario for a true apples-to-apples comparison.  
5. What is the NPV of the cash flows for each scenario? Use the cash inflows minus the cash outflows projected for the duration of each scenario and discount each of the net cash flows back to present value. To be conservative, the discount rate should represent either the bank’s cost of capital (equity return requirement) or the loan-loss reserve of the asset.  
6. Do any of the assumptions have an outsized effect on the results for each scenario? Keep in mind that NPV, given the time value of money, reflects a greater impact from inflows or outflows that occur earlier in the projection.  

With a new outlook on his portfolio and practical steps to get started, Malone thanked Kilroy and prepared to say goodbye. Before he hung up, Kilroy left him with some final thoughts: “Finance is and isn’t simple. You can value any asset using an NPV. The problem is that it’s sometimes more art than science. Setting your assumptions, understanding the variables, and modeling the timing of cash flows can be a shot in the dark. But at least now you have the tools and perspective for tackling your loan troubles.”  

An Exercise: NPV in Practice 

Let’s look at an NPV scenario on a $1.5 million loan secured by a $2 million shopping center. with the property breaking even on a cash flow basis. We want to consider the best option among (i) deed-in-lieu settlement; (ii) foreclosure; (iii) note sale at 85% of PAR; and (iv) restructuring on an A/B Note basis. The bank’s monthly overhead is 1.5% of the outstanding loan balance and its discount rate is 17%, or its loan loss reserve.  

Major assumptions and result:  

1. 6 months to get the asset followed by 18 months of marketing / liquidation. Inflows from net rental income for 24 months until liquidation (about $10k / month). One-time legal and other costs of about $85k at start of analysis. NPV: $1,266k
2. 12 months to litigate and 12 months to market and liquidate the asset. Small guarantor payment of $50k after 3 years of litigation. $75k in up-front costs and ongoing legal of $3k / NPV and payment of real estate taxes prior to eventually collecting rental revenue. NPV of $1,073k 
3. Note sale at 85% of PAR and 3 months to market. NPV of $1,204k. 
4. A/B note restructure for three years with A note at 8% / 25-year amortization. B note accrues at 10% interest (waived if paid off by maturity). Both loans pay off at maturity. NPV $1,171k.