July/August 2011

When Selling Charged-Off Loans and Leases Makes Smart Sense

Finance executives often bristle when they first hear the prices offered by a debt buyer for their charged-off accounts, or they operate off of a general notion that selling their debt just doesn’t make economic sense. What they are often missing, however, is a deeper analysis of their actual overall bad debt liquidation costs and assumptions.

More often than not, an objective net present value analysis will enable a financier to determine if, and when, selling charged-off assets is beneficial. In most instances, credit issuers discover that selling charged-off debts as quickly as possible yields more than the lender’s own recovery efforts using internal staff and third parties over time.

In this regard, a net present value analysis by a qualified debt buyer is a powerful tool that can raise awareness among leasing and finance companies and commercial credit issuers that want to know how the sale of stagnant equipment leases and business loans can refresh their bottom lines.

Intersection of Debt Purchasing and Equipment Leasing Industries

Before a net present value analysis of their debt comes into play, finance companies should know a bit of background about the $100 billion asset recovery and management industry.

There are an estimated 1,000 debt purchasing participants in the domestic accounts receivables industry, according to published industry reports. The largest U.S. debt purchasers typically buy accounts on a national basis and have their own collection operations, which they may supplement with contingency collection agencies and collection law firms. Other debt purchasers may outsource collection tasks.

Credit card debt comprises about 70% of the accounts sold to debt buyers, with the remainder made up mostly of automobile loans, telecommunications debts, retail accounts, personal loans, utility bills, medical bills, and primary and secondary mortgages. Business loans and commercial equipment leases are a smaller but growing segment for debt purchasers.

Different debt buyers typically focus on various stages of non-performing or charged-off accounts. Even though these accounts are written off, they are still legally enforceable and collectible over time.

“Fresh” charged-off accounts are generally 180-210 days past due at the time of sale and have not been placed with third-party collectors at the time they are sold. For these reasons, such accounts have higher recovery rates than older accounts subject to previous collection attempts by collection agencies. Overall, a debt buyer may acquire charged-off receivables that can vary dramatically in age, product type and debtor profiles.

Some debt buyers will purchase loans and equipment leases with or without collateral still in place, although prices will vary dramatically based on that fact. Because of the variation, prices paid for debt also will vary greatly, but generally speaking, the debt will garner anywhere from 2% to 12% of the debt’s face value. This figure will be based on the age, remaining balance, collateral status and credit scores or other debtor profile data that the debt buyer may use to compute an anticipated recovery rate for the debt.

Say, for example, that a commercial finance company averages a 20% recovery on all charged-off accounts across a three-year period. A debt buyer’s offer to purchase the distressed assets today instead of three years from today may be equal to or better than the recovery when considering the time value of money.

Why Explore Further? In a Word: Benefits

While selling charged-off consumer assets to a debt buyer is common practice for large banks and credit card issuers, it is much less so for the commercial finance or leasing industry.

Delinquent and/or charged-off accounts, which may be small business term loans, equipment leases or lines of credit, normally require bank-owned lenders, independents or captives to attempt to recover the asset through internal efforts or third-party collection agencies.

But while many leasing and finance companies mistakenly believe charge-offs deemed “uncollectible” have reached the end of their road in terms of value, others are discovering how these accounts are an untapped revenue stream, among other advantages.

For example, selling distressed assets to a debt buyer can:

  • Create much-needed liquidity through a cash infusion from the sale of the distressed debt
  • Bolster the bottom line now versus waiting months or years for collection efforts to take effect
  • Reduce ongoing costs associated with internal collections as well as management of third-party agencies
  • Lessen or eliminate reliance on third-party collection agencies
  • Eliminate months or years of waiting without a guarantee of a return — a major benefit when factoring in the time value of money
  • Protect your brand — this is typically the effect of a debt buyer owning the purchased accounts outright, having a longer time horizon, and, therefore, a strong incentive to work professionally with debtors and obtain repeat business from you

Now Is a Good Time to Sell

Against a backdrop of a slowly stabilizing economy, charge-offs are declining and businesses are regaining financial stability, which is causing debt prices to climb. For that reason, banks and finance companies are selling more of their non-performing assets. In fact, some of the largest banks and credit card issuers now sell a majority of certain charged-off debt portfolios to debt buyers.

In equipment leasing and finance, economic progress also remains slow, but businesses are beginning to address pent-up needs for equipment and are gaining more access to credit to fund their capital needs. As our country slowly returns to a healthier pre-recession environment, the value of charged-off loans and leases also is improving, yielding even better immediate returns for lenders and lessors interested in selling their debts today.

But will more lessors and business banks take advantage of this good timing to realize better returns and the cash flow they really need? That depends.

Some commercial lenders and equipment leasing and finance companies have yet to fully consider the prospect of selling charged-off accounts to a debt buyer. Others may have some awareness of the option but are unsure how to compare the real costs of current approaches to charged-off receivables to the value of selling the accounts to a debt buyer.

Either way, deeper knowledge of the debt purchasing process can add one more tool to a financial manager’s toolbox when it comes to recovering distressed debts.

That knowledge begins with a financier’s initial evaluation of the company’s charged-off accounts and/or with a net present value analysis provided by the debt buying partner.

Questions to Ask When Evaluating a Sale of Charged-Off Accounts

How do you currently recover your charged-off accounts? It’s important to understand the larger picture of the resources involved in managing and pursuing charged-off accounts, because the total costs of those efforts may surprise you.

What are your true net collection rates from your efforts?  To determine your true net recovery rate, compute a benchmark history by determining your gross recoveries less overhead from operating your own post-charge-off collections department, or gross recoveries from collection agencies less each agency’s collection fees plus your own cost of engaging these collection agencies including: reconciling accounts, supplying loan/lease documentation and affidavits, establishing settlement parameters and posting remittances, as well as your firm’s management time combined with the potential reputational damage these processes may cause to your brand over time.

What is the value of your debt?  This is where good record keeping plays a big role. You’ll want to identify a number of variables to prepare for a debt buyer’s evaluation, including:

  • How many accounts are in your charged-off portfolio?
  • How old are these accounts?
  • How many parties have attempted to collect the debt?
  • Are any account still collateralized?
  • Are portions of your portfolio concentrated in certain geographies or industrial segments?
  • Which, if any, are supported by corporate or personal guarantees?

How well does your recovery rate compare to the price offered by a debt buyer for the same accounts?  If the purchase price for your non-performing portfolio today exceeds your projected net recoveries as determined from a net present value basis, selling some or all of your portfolio may make sense.

What are the other considerations?  Other variables may weigh into your decision process as well. Some financiers prefer to keep their options open and, as such, maintain a regular relationship with a debt seller in order to monitor market prices as well increase their debt sales when market conditions, internal changes and/or current period financial objectives warrant a change in strategy.

Additionally, many lenders opt for a “forward flow” agreement in which the debt buyer agrees to purchase a steady periodic flow of non-performing assets of a comparable profile for an agreed price over an agreed timeframe. In this manner, lenders are able to manage their recovery rates and earnings in a more predictable way and ensure that the debt buyer has scheduled appropriate resources to manage forecasted purchases over time.

What to Look for in a Debt Buying Partner

After you’ve found a potential debt buying partner, be willing to open your books and provide comprehensive information. The more information you are able to provide, the more completely the debt buyer can evaluate your portfolio to provide the best pricing proposal. Reputable debt buyers have legally binding practices and data security measures in place to protect your important customer information.

A debt buying partner should also provide:

  • A net present value analysis and any other information so the client can better understand the debt selling option
  • A track record of protecting a client’s brand: “Our customer is your customer”
  • Quick turnaround on pricing and funding, and highly competitive bids
  • The ability to close quickly within agreed timeframes, on a regular basis, as a result of being well capitalized
  • A single point of contact from business development to make all processes flow smoothly
  • Strong asset analysis and modeling capabilities to enable smart decisions about debt purchases
  • A direct contact in client services to work with the finance company to coordinate the transfers of accounts and data — known as “media” — that follows the purchase of assets
  • Account servicing. As a best practice, opt for a company that has tight control over its collection network. You want to work with a company that is interested in preserving your reputation
  • Nationwide operations or a presence in the regions you require. In addition to national regulations, many states have specific laws regulating debt collection. Make sure your debt buyer understands and operates within these parameters
  • References and testimonials

With these aspects in mind, commercial finance and leasing companies of all sizes can feel ready to seek out a net present value analysis so they can make sales of charged-off accounts to a well-capitalized debt buying partner a regular feature of their business plan. Doing so can produce an untapped revenue stream, much-needed liquidity and brand protection, while generally easing the burden of dealing with distressed debt so there is time to focus on more enterprising business tasks.

Mark D. Erickson is senior vice president and commercial business leader at SquareTwo Financial, a Denver-based provider in the $100 billion debt purchasing industry. He can be reached at 303-713-2005 or merickson [at] squaretwofinancial [dot] com.