1. UK pension funds and other long-term investors invest in Asset Resolution Corporation (ARC) with equity funding substantial enough to make a dent in the €61bn in property loans given out by foreign-owned banks in Ireland. These investors are looking for returns over a 7-10 year horizon, according to ARC director Mark Duffy, and are prepared to wait for the market to recover before taking gains. But the opportunity to buy is at the bottom, which Duffy and his partner Kevin Warren believe is now.
2. ARC augments the equity funding by securing vendor finance from a customer bank to scale up the initial investment for larger purchases. While some deals will be 100% financed with ARC funds, others will be part funded by the banks themselves. This is similar in conception to what Barclays is doing with Protium, the debt acquisition vehicle it funds to buy its own bad assets, except ARC is a third-party.
3. ARC buys a loan portfolio from the customer bank. Warren gave an illustrative example at ARC's press conference last week: ARC acquires an impaired book with an original value €100m and a written down value of €50m. ARC takes it over using €25m of its own money and a €25m loan from the bank. In this way, ARC gets an asset, plus access to its collateral, at a discount while the bank turns a non performing €100m portfolio into an income stream on a €25m loan.
4. ARC, like Nama, will put the portfolios it acquires into bankruptcy-remote entities called special purpose vehicles (SPV). This isolates the distressed debt, allowing for the kind of focused work-out the banks are unable to provide while the bad loans are mixed with the good.
5. The original borrowers start paying their restructured loans or lose control of the underlying asset to the SPV. There is a possibility borrowers will be "cut in" on deals if this makes financial sense.
6. The SPV returns interest income to the vendor bank, which also benefits from a smaller balance sheet and a lower risk-weighting. Although the bank will probably have taken an intitial capital hit to get the loans off its balance sheet in the first place, the new income should compensate over time as the bank rebuilds its operating profit.
7. Once the market is stabilised and/or some portfolios begin performing better, the SPV can package and sell loans to secondary buyers for a profit. In the medium to long term, ARC will probably mature into a significant holder and manager of commercial property, deriving income from fees and rents rather than loans and disposals.
8. Any gains are returned from the SPVs to the original long-term investors in the form of dividends or capital gains, with a slice going to Duffy and Warren, naturally. Reinvestment could enlarge ARC's scope over time, too, although for now the company has not mapped out a vision beyond about a decade.