A clever financial instrument has emerged in the realm of distressed dept, colloquially known as recovery notes. These are specialized debt securities, whose value is intrinsically tied to the recovery of a defaulted or “bad” debt. While the term may sound esoteric, recovery notes offer a unique approach to monetizing non-performing assets, providing both opportunities and risks for investors.
At their core, recovery notes function as a securitization of bad debt. A lender or institution with a portfolio of defaulted loans or bonds bundles these non-performing assets and transfers them to a Special Purpose Vehicle (SPV). The SPV then issues the recovery notes, which are essentially claims on the future cash flows generated from the collection of the underlying defaulted debt. This structure allows the original creditor to offload the headache of collection and potentially realize some value from a seemingly worthless asset.
Two Structuring Varieties
Recovery notes are not a one-size-fits-all solution; their structure can be tailored to the specific needs of the transaction. There are two primary structuring varieties:
Type 1: The Zero-Cash Issue
In the first and more common variety, the defaulted debt is transferred to the SPV, and in exchange, the SPV issues the recovery notes to the original debt holder. No cash is paid at the time of the issue, as the notes are simply a representation of the value of the underlying bad debt. The recovery effort is outsourced to a specialized contractor. This contractor is either paid from an outside source or, more commonly, is compensated on a contingent basis—they only get paid a percentage of the recovered proceeds. This model aligns the contractor’s interests with the noteholders’ and is particularly useful when the original creditor has a large portfolio of defaulted assets they wish to get off their balance sheet without injecting new capital.
Type 2: The Funded Recovery
The second variety is more complex and involves an element of fundraising. Here, the defaulted debt is transferred to the SPV at a pre-determined speculative value. Simultaneously, the SPV issues recovery notes to new investors in exchange for fresh capital. This capital is then used to fund the recovery effort. These issues are trickier because they involve a valuation of the defaulted debt and the placement of notes to external investors, who are essentially betting on the success of the recovery process. This model is useful when the recovery effort requires significant upfront capital, such as legal fees or operational costs, to maximize the chances of success. It introduces a new layer of risk for investors, who are not only speculating on the recovery but also on the efficiency of the recovery team.
The Utility of Recovery Notes
For the original creditor, recovery notes offer a way to clean up their balance sheet and free up capital tied up in non-performing assets. It transforms a dormant liability into a potential revenue stream without the operational burden of debt collection.
For investors, recovery notes present a high-risk, high-reward opportunity. They offer exposure to the distressed debt market, which can yield significant returns if the recovery efforts are successful. The notes can be sold on a secondary market, providing liquidity for a typically illiquid asset.
In essence, recovery notes are a sophisticated tool for managing financial distress. They democratize access to the distressed debt market, offering a structured and tradable way to invest in the turnaround of bad debts. While they carry significant risk, their innovative structure provides a valuable mechanism for extracting value from the shadows of the financial system.
Tiner Wernow, formerly John Tiner & Partners, designs and creates securities and other financial instruments. We help our clients raise capital, sell managed trading strategies, and securitize all types of assets.
We provide a complete service, from developing the initial structuring concept to its full implementation, which includes ISIN, issuance, global clearing, exchange listings, and placement routes. We help to package any asset or investing idea into easily tradable, globally cleared securities. We offer issuance, brokerage, and SPV maintenance services in various jurisdictions.
Our global services platform is 208Markets (https://208markets.com).
The educational materials found on the internet under the “Tiner Educational Hub” are intended to increase the awareness of professionals regarding the securitization tools available to help them more efficiently achieve their business objectives.
