KPMG Ireland has reorganised IBRC’s legacy circa €18bn UK and Irish commercial real estate portfolio into three separate portfolios, codenamed projects Rock, Sand and Salt, as PricewaterhouseCoopers continues the assembly of updated loan valuations ahead of this October’s open-market loan portfolio sale process.
Project Rock is comprised of IBRC’s circa £6bn UK commercial property loan book, the majority of which is matured and impaired, with a proportion of sub-performing and performing loans making up the balance.
The performing loans in the Project Rock pool is likely to be refinanced at par or sold at a shallow discount, rather than transferred to NAMA.
Projects Sand and Salt are two separate Irish commercial property loan pools: one is comprised of granular loans and the other consists of loans to real estate companies secured by office, retail, industrial, leisure assets – including hotels and pubs – as well as investment residential property.
The new Projects Sand and Salt are the combination of the old €4bn Project Delta loan book, a loan pool sales process which was already put in train by IBRC prior to the Ministry of Finance’s 7 February liquidation order over IBRC, as well as the remaining Irish commercial property loan book which had not previously been parcelled up for sale.
In aggregate, Projects Sand and Salt amount to around €11bn, based on IBRC’s last-ever published half-year results, as at 30 June 2012, comprised of €10.25bn in Irish CRE exposure and €846m in residential investment and development loans.
Project Taylor, the codename for IBRC’s corporate loan book, is still underway as before with the sales process managed by UBS.
PwC, appointed by IBRC’s special liquidator KPMG around five to six weeks ago, is responsible for the loan valuation work for projects Rock, Sand and Salt, with the loan portfolios expected to come to market for sale during October after fresh loan valuations have been determined, in a process which has been entangled by some controversy.
Analysis: setting a floor price for private market loan sales
Six weeks ago, Michael Noonan, Ireland’s Minister for Finance, mandated a discount at which all assets and cash flows from the securing loans must be valued.
Noonan’s Ministerial order, on 17 May, decreed that all loan assets must apply a 2.32% discount to arrive at a valuation price, while all loans must apply a discount rate of 4.5% on the cash flows of all IBRC loans to arrive at a price at which loans can be sold.
This ultimate new loan value – known as the “present value” – is effectively a hurdle price the Ministry of Finance wants to achieve for the sale of these legacy loans, as part of the accelerated liquidation of IBRC.
PwC’s job is, first, to calculate a cash flow forecast for all properties – based on the input from the valuation firms across projects Rock, Sand and Salt – and then to estimate a projected end sale price of each property, or pool of properties secured by each loan.
Then PwC must determine each loan’s present value – the price at which KPMG is permitted to sell – and these cash flows must be discounted by 4.5%.
The controversy is in the fundamental assumptions within KPMG’s Ministerial mandate: that the 4.5% discount rate to annual cash flows is a fair reflection of the risk inherent in these, largely secondary and tertiary, capex-starved properties.
For those who believe the 4.5% discount rate on cash flows insufficiently reflects the risk, the expectation is that there will be a gap between the average market pricing offered – from bidding private equity funds, hedge funds and wider property investors – and the hurdle price arrived at by the Ministerial-mandated parameters.
Compromise through the eye of a needle
There are a number of ways events could unfold from here.
Firstly, the bridge between market pricing and the hurdle price could prove so wide that virtually no loans are sellable to bidders, and the vast majority of IBRC’s property loan book is transferred to NAMA.
This is unlikely to happen for a couple of political reasons: this loan portfolio sales process has not been set up to fail and, to a significant extent, there is a huge will on the part of the Ministry of Finance and the Irish government to show there is a liquid market for these assets.
Ireland’s government needs to repay Germany and Europe for the vast bailout of its domestic banking sector during the global financial crisis, and these IBRC proceeds form a significant part of that repayment process.
Furthermore, NAMA is unlikely to be able to comfortably absorb the entire €24bn worth of loans, and if the market will not pay the determined present value, based on the 4.5% discount to annual cash flows, why should NAMA, which is supposed to acquire loans at market prices?
The second possible permutation from here is through a bridging of the gap between market pricing and the net present value of the legacy IBRC loan book.
Possibly PwC’s most significant decision in calculating loans’ net present value, within the parameters of the Ministerial order, is in whether to forecast cashflows on a conservative or aggressive basis.
Under a conservative set of cash flow assumptions, PwC could project a cash flow over an extended period of years, say four or five years. This would provide bidders with a flexibility to aggressively model their own cash flow analysis inside those parameters, by assuming a higher end sale price than PwC and, say, selling in year three instead of year four or five.
The combination of a higher projected end sale price, and over a smaller number of years than is assumed by PwC, could bridge this bid-ask spread and effectively enable bidders to buy according to the decreed present value.
However, to add a caveat, PwC is unlikely to disclose the cash flow forecasts which underpin each loan’s properties. Selling banks never offer to show their hand, so to speak.
By contrast, under an aggressive set of cash flow assumptions, PwC may project a small number of cash flow years and a high price, on which basis the gap is more likely to be too high to bridge.
Until bids come in for projects Rock, Sand and Salt – or sub-pools therein – it is not clearly foreseeable the extent to which there will be gaps. Indeed, it is possible that some sub-pools, or individual loans, sell with less complexity.
But in the scenario where there are a raft of bidders and all consistently bid some way below loans’ present value, determined by PwC’s instructed methodology, there may prove yet to be a greater flexibility on the part of the Ministry of Finance to trade at a below this hurdle price, given its own political motivations to repay its European paymasters.
There may well prove to be some combination of conservative-enough cash flow forecasting to provide bidders with flexibility to meet the loan hurdle rates and – possibly, just possibly – some easing up of the shallow 4.5% discount rate on annual cash flows.
If so, there could yet be some material NPL activity in the fourth quarter of this year. Such a result would, no doubt, please NAMA considerably.