This story appeared in the February issue of Collections & Credit Risk.

It comes as little surprise and no comfort that the big question facing debt buyers nowadays is the same one most American businesses are asking: Where's the money?

The lack of capital available to finance debt purchases, just like any inventory, is a huge problem that has pushed debt buyers to the sidelines. The pause comes just at a time when debt prices are falling and buying opportunities are ripe as creditors seek to unload bad debts.

The traditional lenders to debt buyers are taking a pass for now. They face their own credit problems and they worry about liquidation rates as job losses mount. The bottom line for the debt-buying business is a less than rosy outlook for those firms that bought large portfolios of bad debt when prices were high.

Another concern: possible industry consolidation. On the bright side, firms with access to capital could be well-positioned to come out as winners by making smart purchases now – as long as the downturn does not last too long.

"Financing is the biggest hurdle [the debt-buying industry] faces right now," says Steve Lubelfeld, chief financial officer and managing partner at Resurgence Financial, a debt purchaser in Northbrook, Ill. "Financing sources are skittish."

Today's climate bears little resemblance to the boom times of 2004-2006. In addition to more traditional lending sources, hedge funds back then flooded the debt-buying market with capital. They were eager to profit from what had emerged as a new asset class. Debt buyers tapped into hedge funds as a financing source for purchases and prices for debt skyrocketed.

At the same time, charge-offs were performing well and the consumer could borrow against home equity to pay off debts. It created, among some big debt buyers, "a false compulsion to purchase," says Robert A. Morris, president at Oliphant Financial, a debt buyer based in Sarasota, Fla. The tendency was to not examine the deal critically, but to buy simply to "keep the animal" or the business "fed," he says.

Though the formula worked for a while, it does not anymore. Consumers are tapped out. They can no longer borrow against their homes. It is getting harder and taking longer to collect bad debt. Liquidation rates are falling. Debt buying has become a tougher business.

Sallie Mae, the student loan giant, recently shuttered its debt-buying operation, Arrow Financial, and sold its international debt purchasing operations, Arrow Global.

Then, in December, the hedge fund world was rocked when hedge fund manager Bernard Madoff was accused of running a $50 billion Ponzi scheme, resulting in huge losses for investors and another black eye for the industry. It came as many hedge funds already had pulled back on lending to debt buyers.

Hedge funds have had little choice but to curtail lending, says Peter Waldstein, managing director at Garnet Capital Advisors, a debt broker and investment banker to debt-buying companies. "What's killing hedge funds are the quarterly redemptions."

He explains that many hedge funds are structured to enable investors to redeem their shares at the end of a quarter. "Hedge fund investors are feeling the pain and the fear, and they want to cash out," says Waldstein.

This forces hedge funds to sell their stock portfolios, leaving little capital available for new investment in debt purchases. "It's a vicious cycle," says Waldstein.

But Waldstein is quick to point out that not all hedge funds are subject to quarterly redemptions. Some have annual redemptions and those that weathered a September redemption date without much damage are still lending to debt buyers.

"Those hedge funds are secure for another year," says Waldstein. But, he adds, stable hedge funds are being "highly selective" and entertaining only the right opportunities. "They have the pick of doing business with the best debt buyers with the best portfolio opportunities," he says.

Local banks are providing some funding for small debt purchases of $1 million or less, sources say. Small purchases also are being funded by personal loans from firm principals, or by private investors.

"Small contingency shops or attorneys who buy debt on the side are not affected because they have bank lines of credit," says Chris Runci, principal at the Runci Group, a portfolio broker and manager in East Greenwich, R.I. He recently hosted a panel on financing at an industry meeting, speaking to a packed room of debt buyers, all seeking ways to finance purchases now that debt prices have dropped.

Large credit facilities for purchases of $100 million are available, though certainly less so than several years ago. But the real squeeze is taking place in the middle with credit facilities ranging from $10 million to $75 million, according to Michael Taulbee.

A former executive at debt buyer Houston Funding, Taulbee still serves on the asset buyer's committee at ACA International. "Those facilities are hard to find," he says. "And they're even more difficult to get."

Lenders have become more stringent and banks are not taking new customers, sources say.

Most lenders are continuing relationships as long as the business partner's revenue still looks sound.

Resurgence Financial has a senior line of credit from a traditional bank and a mezzanine line of credit from private investors. According to Lubelfeld, the company was approaching debt purchases with caution late last year, often waiting in order to shore up the company's balance sheet to make sure bank covenants are met.

Then, he says, "We are coming out with guns blazing." Though the credit line is due to be renewed by mid-2009, he does not think the terms of the agreement will be changed, though pricing could go up.

Some banks are requiring personal guarantees, converting non-recourse loans into recourse loans. It could be a fatal impediment to a new company. "The only way credit will ease up is if businesses can show performance during this period," says Lubelfeld.

Creative forms of financing are becoming more common too. "We encourage both parties to come up with more clever purchase and sale agreements," says Runci at the Runci Group.

The firm has had some success with seller financing arrangements. The buyer puts up 50% of the sale price and the seller finances 50% over a specified period of time on the portfolio's gross net collections. Sellers typically like to get their money back within six to 12 months. "We've had some success closing these types of deals but it has to be the right seller," says Runci.

Seller-financed deals have not been done yet with credit card issuers, in Runci's experience.

Successful candidates more likely fall into alternative debt classes such as utility and telecom debt, and also in the resale debt market.

Other non-traditional forms of financing are being used. Debt buyers are tapping their own accounts as well as those of family and friends. Buyers also are doing what they can to cut costs and free up their own capital.

Lenders are seeking stable partners. And, as with all credit decisions today, the businesses least likely to need financing are the ones most likely to get it.

"Lenders are going to carefully look at the track record of the purchaser," says Stuart Blatt, partner at Margolis, Pritzker, Epstein & Blatt, a law firm in Towson, Md., and the national legislative chair of DBA International. Lenders also will carefully examine the debt purchaser's platform and strategies, he adds.

Established buyers are able to make lenders comfortable with today's market opportunities, says Richard A. Munroe, president at Capital Financial Group, a debt buyer based in Duluth, Ga. He thinks the change in the White House Administration is causing some lenders to take a wait-and-see approach. "There's a lot of uncertainty there on decisions that will be made in the consumer markets," says Munroe.

But Munroe predicts that lenders will start to realize the opportunities the market is presenting within the next six months. Munroe's company has a credit facility and he expects the firm to purchase more debt in 2009 than it did in 2008.

Debt buyers, even those that buy only occasionally, are being cautious. "We only buy when it is fortuitous and we will not buy when it is not," says Irving Levin, CEO at Genesis Financial Solutions in Beaverton, Ore., which buys bigger portfolios of older charged-off debt. "It's hard to say what we will buy in 2009. This is not our core business."

Observers agree that the debt buyers being hit the hardest are those that bought when prices were high, and they will have the most difficulty finding money to spend. That could shake up the market and signal a return of private equity to the industry.

"There's a lot of distress among the debt buyers," says Waldstein at Garnet Capital. He explains that firms that have not bought lately and continue to work off old portfolios cannot expect to generate good earnings. "The owner's equity portion of the balance sheet is looking weak. That's the time to bring equity into the business," he says.

Waldstein predicts that private equity will identify the best players and take some ownership positions in those companies.

"You'll see the best operators selling pieces of their business and bringing in new partners," he says, adding, it's an opportunity for equity players who have an appetite for consumer financial services to identify the best platforms to partner with. It also will be a chance for the better debt buyers to institutionalize their structure by aligning with professional equity firms. "The plus is [debt buyers] can upgrade their operations and banking relationships," says Waldstein.

When will the market come back, and financing become readily available? That is a question debt purchasers, like every U.S. industry, want an answer to. Debt buyers are worried that current scoring models are based on assumptions made when the economy was strong. "We have no idea if our scoring model will be accurate," says Lubelfeld at Resurgence Financial. "We've never been in this type of economic climate. Only time will tell."

Because the economy seems so fragile and no one knows how deep the recession will be, most observers expect a lot of caution on the part of buyers and lenders in the months ahead. "I don't know if things will turn in three to six months," says Morris at Oliphant.

Most observers think creditors will be forced to place or sell a lot of debt soon to remain solvent. That could force prices down further. But the expectation of further price declines has caused some buyers to hold off on new purchases. "Everyone has gotten used to not buying and everyone is scratching their heads about liquidation rates, so there's no hurry to buy," says Waldstein at Garnet.

Asta Funding, a publicly traded debt purchaser has the capital to spend $10 million to $15 million a month in 2009. "We're waiting to see what's offered. We figure every [creditor] is going to sell. The question is can [debt purchasers] participate?" says Nan Beilinson, Asta vice president. Echoing the views of other buyers, she adds: "The companies that have the funding will be in a good place to purchase in the new year."

As for other debt purchasers that still need funding, it is a wait-and-see situation, though there is hope that funding might be quicker to return to debt buying than to other industries. Says Waldstein at Garnet: "Lenders know there are big opportunities in distressed debt." CCR

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