The New Demand for Charged-Off Debt

  For bad-debt buyers, memories of staging dog-and-pony shows just to attract a few dollars from timid moneymen are fading fast. Investors are now swarming into the industry, eager to drop money into buyers' hands-a trend that is
  turning the business into a $100 billion-plus industry.
  With consumer debt at all-time highs and countless sources of delinquencies, from credit cards to medical bills to abandoned cell-phone contracts, there's plenty of debt for buyers to pursue. Wall Street and private equity
  investors are taking notice. And buyers of charged-off credit card debt also are regularly pooling funds to buy large portfolios that, alone, they couldn't afford.
  Arguably, the funding floodgates opened in November 2002 when Wall Street floated a $45 million initial public offering for Norfolk, Va.-based Portfolio Recovery Associates, a major player in the market for charged-off
  credit card debt. While capital ebbed and flowed since the industry's start, the successful public offering came in the midst of a tepid market for IPOs.
  Other large buyers of charged-off credit card debt are following suit. Asset Acceptance LLC, a veteran debt-buying firm based in Warren, Mich., and led by industry pioneer Bud Reitzel, followed PRA's lead. Asset Acceptance went public
  Feb. 4 in a deal that raised $98 million. General-purpose and private-label receivables account for 56% of Asset Acceptance's portfolio of $14.8 billion of face-value receivables.
  Other publicly held buyers include Baltimore-based NCO Portfolio Management, Asta Funding in Englewood Cliffs, N.J., and Encore Capital Group, the San Diego-based parent of Midland Credit Management.
  "When companies go public, it can't help but attract investor interest from other circles. But this business isn't for the faint of heart and it's still risky," says Stacey Schacter, chief executive and general counsel of debt
  buyer EMCC Inc., Pembroke, Mass. "The public companies have public company problems. By necessity, they worry about the short-term view and not the long-term view. They worry about the next quarter and that kind of shortsightedness doesn't always make sense in the world of debt buying."
  Investors often want fast results and the nagging pressures to perform can prove too much in a business where-by industry standards-buyers need at least three years to see a profit on any given deal. For every success story, the
  industry's brief history is littered with heartbreak, including dozens of ma-and-pa shop closings and high-profile flops-Commercial Financial Services, ContiFinancial Corp., and Creditrust Corp. among them. Even Midland Credit rebuilt after a merger three years ago with troubled West Capital
  Financial Group. Overall, many people have lost fortunes after being burned by unscrupulous buyers or, simply, bad decisions.
  But nothing has dampened long-term investor enthusiasm. Part of the reason is that sellers refused to abandon the exit strategy, even if they were unhappy about tactics used by some buyers.
  Another reason? The market for charged-off credit card debt alone is booming. Total sales in 2003 were expected to hit $43 billion, up 19% from 2002, says Louis C. DiPalma, managing director for Keefe, Bruyette & Woods Inc., a New
  York-based investment banking firm. About 6% of accounts per year are charged off and half of that typically sells, he says. Overall, in 2003, debt sales by card issuers, insurers, utilities and others were estimated to range from
  $72 billion to $75 billion.
  Those numbers can't help but spur investment from not just public sources, but also private ones. Says Jack Lavin, chief executive of Arrow Financial Services, Niles, Ill.: "The market is maturing and credit grantors are outsourcing a lot more of what they do in general. It comes down to
  either servicing in-house, outsourcing to a third party, or selling debt. Everyone is searching for the right balance."
  Alfred Brothers, senior vice president with Phoenix-based buyer Cavalry Portfolio Services, says successful IPOs and secondary offerings have forever changed the business. "After a company raises $100 million dollars, they're simply much stronger and stable with more cash to purchase portfolios and to invest in technology and their overall business," he says. "I think it's such a positive for the industry."
  But for all the glitz and glam of the IPO, private equity may actually be what's building the industry. Such investment is taking one of two routes: either funding the buyer-...la Quad-C Management's large interest in Asset
  Acceptance, Parthenon Capital's small role with Arrow, and Bear Stearns' large minority stake in Cavalry; or lending money for specific portfolio purchases.
  Merrill Lynch is the latest to commit. In December, accounts receivable management giant Outsourcing Solutions Inc., which was emerging from bankruptcy reorganization, announced that Merrill Lynch is providing a $90 million
  credit facility to OSI's debt-buying arm, OSI Portfolio Services. The money will be used for debt portfolio
  purchases, says OSI Chief Executive Kevin Keleghan. "While we were going through the restructuring process, one of the things we were clearly looking for was a replacement for our old conduit," he says. "The challenge you have in this
  segment of the industry is that it's not well understood by Wall Street, particularly since Moody's and Standard & Poor's don't rate this paper."
  But a strong bond between Merrill Lynch and OSI's majority owner, Madison Dearborn Partners, led to the funding. "One of the advantages ... is we have much more autonomy to make decisions about what we purchase. Our old
  agreement had a focus on fresh bank card paper," Keleghan says.
  While returns are more predictable on fresh bank cards, diversifying into medical debt or service industries can offer better opportunities because they are less competitive, he says.
  Yet even as investor interest in debt buying soars, there are reasons to be skeptical, some say. Since the early 1990s, when the Federal Deposit Insurance Corp. kick-started the business by orchestrating asset sales from failed banks,
  the industry has had a rocky affair with outside money.
  In simplest terms, investors largely hated the business when it started- the idea of spending money to buy debt that another company took for a lost cause. But when buyers showed they could make a profitable go of it, investors came
  around.
  Then, when CFS began paying prices that were far more than the market could bear, investors again shied away. CFS closed months after an anonymous letter sent to ratings agencies revealed the firm had inflated its returns. At the
  time, CFS had a stranglehold on the industry thanks to purchasing contracts with most of the top 15 banks and card issuers. The scandal damaged the young market's credibility with investors.
  Some companies, many no longer around, engaged CFS in bidding wars. Most of today's largest firms wisely sat out the contest. As sellers shied away, most investors also took a hands-off approach and stuck to it through the early days
  of the economic downturn. Some 18 months ago, however, with the earlier turmoil fading and scads of consumer debt available, investors perked up.
  Now, the business is a bona fide component of the financial industry. "Debt sales has become a very important part of the recovery strategy for creditors," Brothers says. "And there's simply much more confidence in the whole
  process and the pool of buyers."
  More Hype
  While the Merrill Lynch/OSI union stole headlines at the end of 2003, companies such as Varde Partners and Cargill Value Investment are two high rollers that have funded portfolio purchases for years. And Arrow Financial also
  began dabbling with funding purchases for other buyers, lending funds to a select group for about 18 months, Lavin says.
  Cargill's role began in 1990. Through partnerships with buyers such as Risk Management Alternatives, Atlantic Credit, Collect America, NCO Portfolio, Midland Credit, and Worldwide Asset Management, the company acquired more than
  $450 million in bad debt within the past 12 months, says Gregg Haugen, Cargill's senior vice president.
  The market is strong, but Cargill officials believe there may be a little more hype about the industry than actual investment. "Over the past year, we have seen many new capital sources who appeared highly interested in
  pursuing charged-off consumer debt. We believe that they were attracted by the success of PRA's IPO and the allure of deep discounts that seem foolproof at first glance," Haugen says. "To date, only a few are actually participating and
  even then to a somewhat limited extent."
  But that doesn't seem to matter, given the involvement of commercial banks and private equity. Venture capitalists clearly are looking for fresh places to park money, seeking high-yield opportunities after the dot-com implosion. "The
  equity markets have been down in recent years, so they've been chasing yields," Haugen says. "Capital from hedge funds looking for opportunities in the Far East have all come back, too. It's easier to sell a story that non-performing
  assets are a hedge to an economy in a down cycle."
  OSI's Keleghan says private equity is by nature going to be more aggressive about going into new markets whereas traditional banks and Wall Street tend to be a little reluctant. "They (private equity firms) want to be leaders,
  not followers, in new investment opportunities," he says. "If you have one or two or three private equity firms that have had success ... soon you have eight or 10 involved."
  Another popular funding choice, especially for small and mid-size buyers, is to partner with other buyers to pool resources. Such marriages help both sides compete in the big-money arena, where rewards can be greater.
  Mid-size Houston Funding Corp. adopted this approach as a way to stay competitive for larger portfolios, says company President Robert Cagle. "We never used to have to do it, but we need to be fleet of foot now," he says. "There's more money changing hands in this market than there used to
  be, and we've got to do our best to find ways to compete with the purchasing power these big buyers have."
  Reselling helps, too. Nashville, Tenn.-based Phoenix Credit Solutions buys portfolios with a line of credit. The company began buying in 1999 and started reselling a year later. "We made a decision to do that because there are just
  more and more people interested in buying pools of debt that had not been inspired to do so before," says Ron Barnes, company executive. "That's because there's some money out there and a lot of investors who are eager to give this
  business a shot. And why not? You can see the progress on the portfolios, you get decent returns and good reporting.
  It's not any riskier than investing in the stock market."
  It's common for buyers to simply wait for financiers to call. PCS recently bought debt for a couple of investors who called them. "We've never tried to solicit that and we weren't looking for anyone this time either," Barnes says.
  "Years ago, when you talked about charged-off debt, that scared the dickens out of most investors."
  Lessons Learned?
  Some observers fear buyers may not have learned enough from the CFS and Creditrust examples, even if they now know money invested with them isn't always smart money.
  Overall, Cagle has a positive view of the industry's future, but he believes there could be some trouble brewing with all the new capital. "It seems like every three or four years Wall Street comes into the picture and spreads the
  money around. Then, always, the price of paper jumps and causes a big headache for us," he says. "The industry has been through this a couple of times and the result is the same. A big company overloads and gets into trouble. Seems
  like we never learn."
  Cagle wouldn't be surprised to see more fatalities among firms buying too much and lacking the internal structure to handle it. "They sometimes go for instant growth but lack the expertise to pull it together," he says. "But everybody learns a different way, sometimes the hard way."
  If there were more closings, it's doubtful that veterans would be shocked. Most agree that companies rise and fall in a growing industry. The reality is that everyone, at some point, has to put on a strong enough performance to keep the audience-or in this case the moneymen-happy.