Distressed Debt in Germany: What’s Next?Possible Innovative Exit Strategies

During the past two years, private equity funds have acquired substantial portfolios of nonperformingloans from banks in Germany. Typically a private equity investor does notcommit funds unless exit strategies are clearly defined. The usual exit strategies for distresseddebt investors are “fix it” (restructuring and turnaround), “sell it” (sale of debt or equity), or“shut it down” (liquidation). A new alternative exit strategy for NPL investors consideredhere is the “transfer” of credit recovery risk.The structure “Sector Focus Fund” (SFF), which corresponds to the credit risk transferstrategy “Triple Play”, is a partially funded synthetic securitization of non-performing loans tosmall and medium-sized enterprises in a specific sector. The SFF special purpose vehicle sellsprotection up to specified forward recovery rate to the NPL investment fund in the form of acredit recovery swap and buys this protection through a three-tranche, partially fundedsynthetic collateralized debt obligation (CDO). Title to the loans remains with the NPLinvestment fund, but responsibility for performance of the portfolio passes to the specialists ofthe SFF.Equity investors, who take the first loss position in the Sector Focus Fund’s CDO, providefunds for the collateral account held by the SFF by paying a premium to go long in a calloption on the excess spread which accumulates when the realized recovery rate exceeds theforward recovery swap rate. Bondholders, which assume a mezzanine position, also providefunding for the collateral account, which serves to support the counterparty rating of theSector Focus Fund. Repayment is assured as long as the shortfall in the recovery rate does notexceed the net premium paid to the SFF for the call option. The senior position is occupied byreinsurers, which are exposed to a short recovery option position. Their exposure is limited toextremely unlikely large shortfalls in the realized recovery rate below the forward recoveryrate. A liquidity facility bridges the SFF’s transitory cash flow short