The Way Forward for Turkish Distressed Loans and Assets - Resolution Alternatives May, 2019

Foreword 4

1. How we got here? 6 Capital flows to emerging markets: a historical perspectiveRecent developments in TurkeyGrowing debt stock in TurkeyPast experiences in bank restructuring

2. Status quo 10 Substantial growth in NPLs in 2018Distressed (stage II) loans’ trend in 2018Regulatory reforms on debt restructuring

3. The way forward 16 Internal wind-down structures and future of debt restructuring in TurkeySale of NPL via SecuritizationSale of NPL to “Asset Management Companies”“Debt for Equity” Swap and subsequent sale of equity“Private Equity” involvement through PEIFsNew Economic Program introduced in April 2019

4. Conclusions 22

Appendix 24

Index

4 5

2018 has been a very challenging year for Turkish business world forcing corporates and financial institutions to manage their foreign currency exposures and liquidity position. Since early 2000’s, external capital and financing have been important catalysts for the economic growth in Turkey. Therefore Turkish corporates’ leverage has increased over time particularly in foreign currency – which resulted in a financial distress that needs to be carefully managed and resolved. At the same time, in order to sustain economic growth banks in Turkey should continue their lending activities despite the sharp decrease in credit demand since the 2nd half of 2018.

One way to deal with the distress in corporate sector by banks is the restructuring concept. Successful restructuring is not an easy task where the viability assessment of the company is critical. It is also crucial to agree on the optimum solution acceptable for lenders, borrowers, investors, regulators and other stakeholders. A fine balance needs to be agreed on to sustain the borrowers’ financial health but at the same time provide the necessary liquidity to the lenders.

While providing relief to the borrowers via debt restructurings, it is also important to deleverage bank balance sheets so that banks can continue disbursing loans and generate reasonable margins. Resolution of distressed loans and assets from bank balance sheets can only be accomplished by taking the expectations of investors into account, in particular the international investors which will bring fresh capital into the financial system as well as transparency and governance around the model in place. From our point of view such a resolution program should also aim to outline an assessment as to the soundness of the corporates and cleaning up the so called ‘zombie companies’ where necessary.

After the Asian crisis in 1998 and then the global crisis in 2008, many countries, such as China, South Korea, USA, Italy and Greece also had to deal with similar issues. Experience shows us that ‘taking things easy’ and ‘hoping things will get better in time’ proves to be the worst strategy. Yet, “one size fits all” solutions no longer apply to the current market dynamics and tailor-made unique solutions are required for each country considering the country specifics. The world of restructuring has verged towards a different stage with more innovative techniques than direct sale of debt, such as swap of debt with equities, securitizations.

Serkan TarmurPartner Transaction Services

Umurcan GagoPartner Tax and Legal Services

Mevlüt AkbaşPartner Business Restructuring Services

Independent and capable asset managers with expertise in the turnaround of distressed companies will also be critical in the execution of the resolution program.

We believe that Turkey needs to act decisively to protect its financial and real sectors with the participation of state, banks, asset managers and investors under a customized program. This will ensure the flow of credit to the corporates and resume the growth of the overall economy.

We hope that this report will provide the reader an outline of the current environment in Turkey and an overview of potential resolution alternatives to all the stakeholders concerned.

Foreword

4 5

6 7

Advanced economies started to normalize their monetary policies since they have experienced a relative improvement in the economic activity until the 3rd quarter of 2018. The US has been the pioneer within the context of interest rate hikes, as its economy reaped the benefits of the expansionary policy that was implemented right after the global crisis in 2008. Bank of England also engaged in rate hikes to keep inflationary concerns under control despite the ambiguities regarding Brexit. The EU economies also posted a recovery and an upsurge in the policy rates in the region was expected in the 2nd half of 2019, ceteris paribus.

Normalization in the developed countries meant that splendid days for emerging markets in terms of capital flows are over. Decreased global liquidity has led emerging markets to struggle with funding concerns in addition to the rising global geopolitical risks. Emerging economies with relatively higher external debt were affected more significantly. The shift in capital flows has brought a significant devaluation of the currencies in emerging markets in 2018 which put downside pressure on their economic activity.

In the last quarter of 2018, global economic outlook rotated 180 degrees as the leading indicators demonstrated a slowdown in advanced economies that became particularly eye-catching in Europe. Therefore, respective central banks inclined to change their monetary policy stance towards a more dovish outlook (Fed’s zero rate hike projections for 2019, ECB’s consideration to restart stimulus mechanism and no interest rate hike until 2020) which will enable emerging markets to experience higher capital flows. Nevertheless, emerging market currencies (particularly with external vulnerabilities) continued to be under pressure since increasingly volatile global capital markets are unwilling to fund heavily credit-dependent growth models as Institute of International Finance (IIF) stated.

It is imperative to understand the background of the current macroeconomic environment and the reasons of financial distress in order to define viable solution alternatives to the existing problems.

Following an elevated growth in 2017 that mostly stemmed from a large credit boom (driven in part by the Credit Guarantee Fund scheme) the pace of growth started to decline in Turkey after the 2nd quarter of 2018. In seasonally adjusted terms, Turkish economy technically entered into a recession which exhibited negative growth in the last 2 quarters in a row as of 4th quarter of 2018. Not only the New Economy Program (“NEP”) of the Government, but also market consensus anticipated Turkish economy to grow below its potential until 2021. Inflation became eminent after 3rd quarter of 2017 (a double digit inflation for the first time since 2011) and Turkey completed 2018 with an annual CPI of 20.3%.

The need for external funding is mainly driven by import dependency, insufficient savings and foreign debt stock of private sector. Since external vulnerability is a nuisance for Turkish economy, import dependency gradually widens the Current Account Deficit (“CAD”) not only within the context of consumer goods, but also inputs that are used in industrial production. Mainly due to inadequate savings, high economic growth in Turkey was at the expense of high CAD through increased private consumption and thus, imports. In addition to this, on top of the current account deficit; high foreign debt is another major issue. 70% of the foreign debt of the country is owed by the private sector, but also the non-financial corporates have more than USD 200 billion net open FX position.

The loss in the value of TL brought about a trade rebalancing where lower import demand (due to lesser appetite for consumption & investment) following the sharp depreciation in 2018 lowered the CAD (from 5.6% to 3.5%). However, funding and commodity prices are among the risks for the liabilities with international lenders. Within the challenging global environment and taking local developments as given, cost of (external) funding will be an issue for corporates where downside revision in Turkey’s credit rating made it more expensive.

1. How we got here?

Capital flows to emerging markets: a historical perspective

Recent developments in Turkey

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8 9

Turkish corporates still use traditional methods to raise finance, such as bank loans, corporate bonds or even IPOs. Raising finance in Turkey has become harder (and more expensive particularly since the 2nd half of 2018) in recent years due to increase in CPI, depreciation of TL, financial constraints of local lenders and lack of appetite from international lenders for Turkey.

CBRT implied material rate hikes on overnight lending and one week repo after the general elections in June, 2018 (from 8% to 24%).

As of 2018 year end, foreign debt of the private sector in Turkey is USD 226 billion, approximately 30% of the country’s Gross Domestic Product (“GDP”). USD 115 billion relates to Financial Institutions and USD 111 billion to the corporates. Corporates with high open positions have started to face with liquidity issues, following 32% devaluation in TL against USD since the beginning of 2018.

Source: CBRT, Ministry of Treasury and Finance, PwC Analysis Source: CBRT, PwC Analysis

As an emerging market Turkish financial markets are materially affected both from the domestic economic conditions and from the global macroeconomic developments. Since 2012 foreign debt stock of both public and private sectors substantially increased whereby on average %69 of the foreign debt is undertaken by the private sector.

Corporate bond market has almost disappeared in 2018. There is no major new issuances either in TL or in hard currencies. In the 1st half of 2018, IPO market was active with 9 companies (from energy, healthcare, real estate, transportation, software sectors) being traded at Istanbul Stock Exchange between January and May. After May 2018 the IPO market has gone silent and the current situation is expected to continue in 2019.

Together with the downgrades in the ratings and the depreciation in TL, local banks also get their share from the economic downturn. Since the beginning of 2018 loans under watch list grew significantly (see section 2). Additionally, funding costs of deposits, syndications and bonds have also been increased. Top tier local banks have successfully closed their syndications, but with higher costs.

Growing debt stock in Turkey

Public and Private Sectors Foreign Debt Development (billion USD) FX Rates & Benchmark Bond

-

50

100

150

200

250

300

2012 2013 2014 2015 2016 2017

96

226

2018

Public Sector Foreign Debt Stock Private Sector Foreign Debt Stock USDTRY TL 2 yr benchmark bond

5.3

20.9%

10%

15%

20%

25%

30%

3.03.54.04.5

5.5

6.5

5.0

6.0

7.0

Dec-17

Jan-1

8

Feb-18

Mar-18

Apr-18

May-18

Jun-1

8Ju

l-18

Aug-18

Sep-18

Oct-18

Nov-18

Dec-18

Restructuring of the bank balance sheets is a well-tried and tested approach for Turkey. In the aftermath of the 2001 crisis in Turkey, several measures were taken and policies were put in place to reinforce the financial system. For example, among other measures such as establishing a credible macroeconomic framework, ensuring fiscal discipline and solvency in the public sector, state banks were successfully rehabilitated to operate as commercial banks, ensuring equity in the form of treasury bills, as needed and replacing distressed assets with high yield ones (back then mostly low yield government debt instruments) through an effective debt swap program.

Past experiences in bank restructuring

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Banking industry enjoyed a remarkable loan growth over a decade in line with the growing credit demand. That said with the adverse macroeconomic conditions, Turkish banks were also negatively impacted which manifested itself as increasing Non Performing Loans (“NPLs”) and distressed (stage II) loans.

Total performing loans’ volume reached to TL 2,395 billion as of year-end 2018 with c. 21% CAGR over a decade. Main drivers of the growth have been corporate and SME loans. Infrastructure projects mainly PPPs and Turkey’s Treasury backed- Credit Guarantee Fund (with more than c. TL 250 billion) supported this growth in recent years.

2. Status quo

Substantial growth in NPLs in 2018

10

Source: BRSA Monthly Bulletin

Source: BRSA Monthly Bulletin

Performing Loans Volume Trend - TL bn

NPL Volume Trend - TL bn

Retail SME Corporate

117.1 129.9 172.6 223.9 265.9 331.9 356.1 384.9 420.0 488.4 504.2 84.6 83.3 125.5 162.8 199.7 271.4 333.3 388.7 420.5 513.2 612.4

165.7 179.5 227.8

296.2 329.1 444.0

551.4 711.3

893.8

1,096.6 1,278.1

367 393526

683795

1,0471,241

1,4851,734

2,098

2,395

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

CAGR (2008-2018)21%

4.4 8.3 7.4 6.6 8.1 9.8 12.4 17.2 18.9 17.5 17.84.36.9 5.9 5.2 6.5 8.7 11.3

15.9 21.7 25.343.9

5.36.7 6.7 7.1 8.8

11.112.7

14.517.7 21.1

35.0

14.121.9 20.0 19.0 23.4

29.636.4

47.558.2

64.0

96.6

3.7% 5.3%

3.7% 2.7% 2.9% 2.8% 2.9% 3.1% 3.2% 3.0% 3.9%

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Retail SME Corporate NPL ratio

12 13

18.7 27.9 35.9 65.1 17.0 18.8 14.7 15.4 26.5 27.4 35.1 47.1

60.9 87.1

237.9

4.6% 4.8%

2.8% 2.3%

3.3% 2.6% 2.8% 3.2% 3.5%

4.2%

9.0%

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Q318

Restructured Loans Loans Not Subject to Restructuring WL ratio

In banking, total NPL stock equals to TL96.6billion as of year-end 2018. NPL volume showed a significant increase by 51% over the last year. On the other hand, corporate NPLs alone, increased by c.65% during the same period. Based on the results of stress test undertaken by BRSA, the NPL ratio of the Turkish banks is expected to reach c. 6% in 2019.

NPL ratio of 3.9% is still at a low level, indicating a relatively good asset quality. Yet, this low level is essentially a result of two key factors:

i.) Regular NPL sales,

ii.) Regulatory ease on local restructuring practices.

Turkish Banks have sold c. TL 35.6 billion NPLs between 2008 and 2017, mainly unsecured stage V loans.

Pursuant to Turkish Financial Reporting Standards 9, banks set aside provisions for 3 different categories of loans:• Stage I - Loans where the credit risk has

not raised significantly

• Stage II - Loans where the credit risk has raised significantly (“Watch List”)

• Stage III - Loans which are “credit-impaired” that are categorized as group 3, 4 and 5 under the BRSA communiqué

In this report, NPL term is used to refer to stage III loans.

Watch list (Stage II) loans were on the rise in 2018 as illustrated in the graph on page 12, partly resulted by the transition to IFRS 9 and partly due to the deterioration in the financial health of corporates and general macroeconomic conditions. Stage II loans in Turkish Banking Industry, excluding participation banks, reached a new level of c. TL 237.9 billion as of the 3rd quarter of 2018. Out of the total stage II loans, TL65.1bn has already been restructured.

Total Stage II loans in top banks (13 largest banks) reached to TL 238.5 billion as of year-end 2018. Total of Stage II loans in the banking industry exceeded TL 275 billion in 2019 indicating a ratio of over 11%. The rapid increase in Stage II loans gives a clear indication in regards to the deterioration in the asset quality of the industry.

Distressed (stage II) loans’ trend in 2018

Source: Turkish Banking Association (excluding participation banks)

WL-Stage II Volume Trend (TL bn)

Source: Banks’ independent audit reports

(*) Top Banks: 10 Largest Private and 3 State Banks

Top Banks(*) Total Watch List Volume - TL bn

Restructured Loans Loans Not Subject to Restructuring WL ratio

38.3 36.1 51.3 59.9 62.3

86.6

152.3 171.8

217.8 238.5

4.6%

7.8% 8.2%

9.5%

11.2%

Dec-17 Mar-18 Jun-18 Sep-18 Dec-18

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In order to avoid large-scale bankruptcies certain measures are taken in 2018 similar to debt restructuring mechanisms brought in the past in Turkey, largely influenced by London Approach.

15.03.2018 Law no.7101 changes concordatum procedures and invalidates postponement of bankruptcy

15.09.2018 TCC Communiqué brings obligations for capital companies under capital loss or financial distress

19.09.2018 Restructuring Framework Agreement approved by BRSA comes into force

29.01.2019 New version of the Framework Agrement permitting the involvement of foreign banks is released

15.08.2018 Restriction for swap transactions are eased

Provisions Regulation is amended and restructured loans are re-classified

Restructuring Regulation setting rules for loan restructuring is published

13.08.2018 Banks’ swap transactions are restricted

KEY

08.09.2018 Further ease for restrictions on swap transactions

21.11.2018 Restructuring Regulation is amended easing involvement of foreign banks

26.04.2019 A new draft law on restructuring is shared with banks.

14.09.2018 The draft law on restructuring is distributed to the banks and financial institutions

Similar to Istanbul Approach in 2002 and Anadolu Approach in 2006, BRSA has announced a new regulatory framework in 2018: Regulation on the Restructuring of Debts Owed to the Financial Sector (“Restructuring Regulation”). Subsequent to the Restructuring Regulation, a Framework Agreement is prepared by the Banks Association of Turkey (“Framework Agreement”) which also allows foreign credit institutions to be involved in the process (Please see the Appendix for details). Yet, the Framework Agreement applies only to the borrowers with an aggregate debt of more than 100 million TL. Furthermore, some changes are made in the concordatum procedures aiming to have a more effective process and limited circumstances to benefit from the protection.

A draft law regarding restructuring has been circulated with the banks in mid-September 2018, and a revised version in late April 2019 but it has not come into force, as the discussions in the sector are going on since then. The draft law is expected to introduce new provisions, such as a stand-still process that will be binding for all creditors and tax exemptions for restructuring related transactions.

It is also emphasized in the NEP announced in mid-April 2019 that, a new legal framework is intended to be drafted with a view to improve and expedite the debt restructurings and enforcement-bankruptcy proceedings.

Regulatory reforms on debt restructuring

Grand National Assembly of Turkey Banking Regulation and Supervision Agency Ministry of Commerce

15

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Debt restructuring has been a hot topic not only for lenders and borrowers but also for the regulator during the 2nd half of 2018. A number of legal arrangements were introduced to the market aiming the corporates, which are temporarily suffering from the market volatility, to get relief from their creditors.

The debt restructuring is not a new concept in Turkish debt markets, however, the volume and number of transactions have increased recently, mainly in energy, construction, real estate and retail sectors. Global best practices and our experience in Turkey prove that creating a stable platform, providing breathing space to borrowers and allowing them to focus on their operational efficiency, is to the benefit of all the stakeholders. Fair and equal treatment of all parties, aiming to reach a consensual solution and delivery of information with good quality and in a timely manner increases the success potential of the restructuring and the value created.

Although the financial restructuring regulation is now in place, an accompanying law would be key to enable further restructurings.

The stakeholders engaged in the process have become more educated and experienced in each and every transaction. The process takes longer than expected compared to similar deals in the developed markets, simply due to the learning curve. Majority of the transactions are closed through amend and extend model. The terms of the facility agreements are amended and the original tenors are extended with additional grace periods. This is a reasonable and common market approach for the first round of deals providing borrowers a breathing space and time to fix the issues they have direct control on.

Having said that, this heavily depends on the recovery of macroeconomy and financial markets, specifically the demand of products and services produced, interest rates and value of TL against hard currencies. In case the markets further deteriorate in short to medium term, the rescheduled debt repayments may unlikely to be done and second round of restructuring requests may arise. In such a scenario, restructurings may go beyond amend and extend route and alternative models like haircuts and debt for equity swaps may be considered which have been introduced in the local regulation.

In 2018, the focus was on easing collections by more efficient and less time-consuming enforcement procedures. In other words, so far Turkish banks have primarily been focusing on internal wind down structures with respect to their NPLs. However, a fundamental, fresh approach is needed since the internal wind down structures do not bring new funding to the banking system, hardly bring fresh funding to borrower companies, and often do not include corporate restructuring (i.e., management and/or operational changes, M&As, spin offs). On the other hand, the corporate restructuring methods are key techniques for a sustainable economic recovery of the real sector; yet implementing these methods is not the mandate of commercial banks considering their core activities and inadequate expertise.

At this point, portfolio/asset managers should come into the picture where restructuring does not solely aim to collect the receivables of the bank, but also to protect and enhance the creditworthiness of the indebted company. This requires involvement of independent asset managers with specific skill sets and expertise in turnaround management and operational restructurings. Operational restructurings usually involve carve-outs, divestments, right-sizing, product and cost optimizations and asset sales, which enable to generate cash and a productive allocation of capital.

The banks are required to collaborate with the portfolio/asset managers who will work cooperatively with the shareholders of the indebted companies. As a result, the banks will have time and opportunity to focus on new financings, reaching their growth targets, improving their productivity and thus focusing on existing and potential customers rather than debt collection. This, at the same time, allows the banks to use their risk management skills preeminently to minimize the risks for new funding and thereby gain control over the utilization of loans that are unlikely to be repaid.

In international practices, banks often securitize their NPLs to provide liquidity and to clean their balance sheets. Securitizations remove the assets from bank balance sheets quickly, allow banks to receive cash (which could be used for new lending) and to transfer debt to privately managed specialist vehicles who could have a more bankruptcy remote structure, clearer mandate and expertise to engage in corporate restructuring and/or collections. Yet, securitizations may make debts harder to restructure (as they are not converted into equity, need to deal with many creditors), especially if there is a lack of depth in domestic institutional investor base, no good supporting legislation and they may transfer risks outside the regulated financial sector to the entities less able to absorb losses1.

In the case of NPL securitization, customarily, credit enhancements are necessary to attract investors. This entails banks to maintain some exposure to the underlying assets. As such, a relatively large part of the credit risk will continue to be retained by banks (which might hinder deleveraging as per IFRS), which could increase the attractiveness to investors, but will be costly to banks, unless credit enhancement is sponsored by the state. Furthermore, some banks raise concerns on the legality of banks using their unimpaired loans, which in our view is something BRSA should be able to clarify, as long as it can be verified that the pricing is made on an arm’s length basis.

In the current Turkish law, asset backed securitization is possible for corporate loans, but only for stage I loans. Securitization for stage II, let alone stage III loans is not legally permitted. Plus, currently domestic institutional investor base is rather limited. Therefore, currently such securitizations can only be made outside of Turkey, which often bring relatively higher transaction costs and higher haircuts, making securitizations seen as the “last resort” for many Turkish banks.

1 Italian Garanzia Cartolarizzazione Sofferenze system and Korean “Korea Asset Management Corporation” are successful examples of such securitizations.

3. The way forward

Sale of NPL via SecuritizationInternal wind-down structures and future of debt restructuring in Turkey

16

In 2018 the focus was on easing collections, internal wind-downs and debt restructuring. However a fundamental fresh approach is needed involving asset/portfolio managers.

“Currently, securitization is possible only for stage I loans and domestic institutional investor base is rather limited. Securitizations outside of Turkey are costly, making them seen as the “last resort” by most of the Turkish banks.”

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To get the assets off their balance sheets quickly and to achieve liquidity, from time to time, Turkish banks sell their NPLs to AMCs.

As we have mentioned above in Turkey, banks have so far been selling their NPLs arising from unsecured-stage III-retail loans (consumer loans or credit cards) to AMCs (totaling c. TL35.6 billion between 2008 and 2017). Figures of last decade indicate that, while loans to SMEs and corporates have increased significantly over time, the NPLs sold to AMCs are mainly from the unsecured retail and credit card segments.

AMCs are joint stock companies, regulated and supervised by the BRSA, core business of which is acquiring impaired bank loans, making the collections, restructuring and resale of debt. Yet, the literal English translation of their names as “asset management companies” often causes misunderstandings. In the current Turkish practice, AMCs are currently specialized in collections and predominantly collection of retail loans, although the current legislation gives them a broader authority to engage in larger asset management activities (including debt restructuring). The reason for this is that so far the Turkish banks have mostly preferred to sell their stage III unsecured retail loans to AMCs rather than secured corporate/commercial or stage II loans.

Under the current legislative framework, AMCs are not designed solely to be management platforms but they are also the investment platforms holding the legal title to the underlying assets themselves (i.e. the “dual mandate”). In other words, they are self-managed investment platforms. However, investors typically tend to prefer the legal title of the underlying assets (NPLs) to be ring-fenced, set apart from management/collection platforms, much like the commonly used distinct ‘fund’ and ‘portfolio management company’/‘collection service provider’ model.

Often times, investors question whether a Turkish AMC, that has the legal title to the underlying assets is absolutely necessary for acquiring NPL portfolios. Yet, using non-Turkish SPVs instead of Turkish AMCs bring significant withholding, VAT and transactional tax burdens. Using non-regulated Turkish SPVs instead, pose legal concerns on the capacity of such entities to engage in certain activities such as debt restructuring, in addition to foregoing the transactional tax incentives AMCs are granted with.

On the other hand, by way of design of the tax legislation the transactional tax incentives granted to AMCs expire 5 years after the establishment of an AMC. The fact that expiry date is linked to the establishment date of the AMC (being both the management as well as the investment platform), rather than portfolio acquisition date basis, is often considered as another handicap, resolution of which requires change in the law.

Shortly, under the current Turkish legislation and tax rules, for NPL acquisitions using AMCs as the investment platform seems to be the most viable structuring solution, but the current design of the rules does not entirely address expectations of the investors.

Sale of NPL to “Asset Management Companies” (“AMCs”)

Turkish dual mandate model of AMCs creates difficulties for foreign investors

Debt for equity swap can play a role in addressing the problems of impaired corporate bank loans, but it is not a solution per se. It is a preliminary step for banks to reduce the borrowers’ debt level and to improve their financial stance, especially for their corporate borrowers, who have the potential future prospects, if they are appropriately managed and restructured. Essentially, it serves for the disposability of such viable assets.

In a securitization, the asset is aimed to be taken out of the balance sheet whereas in a debt-equity conversion, the NPL is transferred into a different asset class that remains with the bank. Thus, the ownership structure of the debtor company is not directly affected in a securitization, but it is in a debt-equity conversion. Therefore, such swaps on their own do not help the commercial banks much to achieve their goals as otherwise, the loans now converted to equities would continue to remain in the balance sheets and to create the additional liabilities/limitations (e.g., reserve requirements), until they are sold to potential investors.

Moreover, debt for equity swap requires an assessment of business solvency (true economic value of assets as compared to liabilities) and viability (ability to generate an economic surplus). A company that is solvent and viable, but has excessive leverage, could be eligible for such conversion, and therefore an independent process to assess the viability and solvency is necessary. In addition, if the business of the indebted company is not well managed, banks in their role as new equity holders should have the ability to replace the management, if necessary.

However, commercial banks are not well-placed to understand or to have influence and responsibility over entities that are unrelated to banking. Owning businesses or performing business turnarounds can distract banks from their core functions, and raise conflicts of interest issues. Hence, banks’ holding of equity should be limited in time, practically depending on the industry where the firm is operating and its capability to achieve recovery.

IPOs or resale of the equity of such viable companies to their original shareholders are among the disposal methods, but in international best practices banks more commonly sell such equity directly to private equity/distressed asset funds and/or other institutional investors which are often investors of such businesses (e.g., sovereign wealth funds, family offices, investment banks, pension funds, etc.). It is usually only such asset managers who have the potential to drive a faster and more sustainable turnaround of the debtor company. In this context, for investors the capability of fund managers in terms of managing such equities, restructuring of the debts, operations and other corporate affairs of such companies, their industry expertise, their independence from banks, the level of their remuneration being linked to their performance, are all of paramount importance.

“Debt for Equity Swap” and subsequent sale of equity

“Private Equity” involvement through PEIFs

“AMCs seem to be the most viable investment platform but the current design of the rules does not entirely address expectations of the investors.”

“Commercial banks are not well-placed to understand or to have influence and responsibility over entities that are unrelated to banking. It can distract them from their core functions, and raise conflicts of interest issues. Banks’ holding of equity should be limited in time.”

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Yet born after the 2014 legislative changes in the Turkish capital markets legislation, Turkish asset management in alternative investment space is at its crawling stages. Currently, there are only a handful of offices equipped with necessary human capital, organization and infrastructure in the management of private businesses. Furthermore, half of them are either the subsidiaries of banks or controlled by banks, whilst from the investors’ perspective, independence of such asset managers from the banks has a significant importance.

Asset managers should be independent in selecting their portfolios and allocating those to various funds they establish and manage, depending on the nature of the asset, size, industry, performance and viability. Funds that are platforms used by banks to dump their unwanted assets would otherwise require substantial discounts, which the banks may not be happy to give. Various fund structures may allow banks to have skin in the game and/or share some of the potential future upside, all of which would need to be worked on with asset managers independently measuring the pulse of investor expectations.

Thus, the alternative asset management space could offer a good investment potential for new players offering traditional value creating asset management services, including restructuring, if the Turkish banks decide to take action any time soon to do something about restructuring.

In Turkish practice, one of the potential candidates to play such role could be the “private equity portfolio management companies” (private equity houses) which have the means and legal authority to set up Private Equity Investment Funds (“PEIFs”)2. PEIFs in turn can invest into equities of indebted companies (e.g., corporate borrowers with stage II loans) with good future prospects, once the banks convert debt for equity. Certain features of the PEIFs provide substantial benefits to investors, thus increasing the disposability of such NPLs for banks. For example:

• PEIFs provide the optimal Turkish tax implications for their investors (PEIFs are exempted from corporate tax and distributions to corporate investors is subject to 0% withholding tax),

• Being inspired by international market standards and customary practices, they permit the separation of investment and management functions,

• Ownership of the underlying assets belongs to the fund, not to the management company, and ownership of the fund represented by fund units are collectively owned by the fund investors.

Number of PMCs in Turkey 54Number of PMCs which manage PEIFs 12Bank subsidiary/controlled 6Independent 6

Source: https://www.kap.org.tr/en/

2 For further information on PEIFs, you can check the following bulletin of GSG Attorneys at Law:

https://www.gsghukuk.com/en/publications-bulletins/announcement/finance-law-announcement/turkish-private-equity-investment-funds-gsg-bulletins.pdf

More on PEIFs• They can be established and managed by

Turkish PMCs,

• Their assets are safe kept by an independent portfolio custodian bank,

• They are lightly regulated -as they can only be invested by qualified investors,

• They can provide mezzanine financing,

• They are not subject to extensive public disclosure requirements,

• They are not subject to restrictions of the Turkish Commercial Code. As such, investments and divestments into PEIFs is relatively flexible,

• There is the flexibility to design the governance model of the PEIF in line with the expectation of the investors.

The New Economy Program of the government, announced by the Minister of Treasury and Finance in mid-April 2019, addresses the resolution of distressed loans/assets of the banking system. Key elements of this program are:

• Government would deliver debt securities worth TL 28 billion (c. $5 billion) to capitalize state banks and would also raise capital levels at private banks.

• In order to increase the asset quality of the banking sector, some NPLs are planned to be transferred to “PEIFs” and or Real Estate Investment Funds (“REIFs”) which shall be managed by national-international investors - not public-, following the convergence of debt for equity and these will thus be taken off from the balance sheets of banks.

• A new legal framework will be created to make debt restructurings and enforcement-bankruptcy proceedings faster and more efficient.

The details of the above plan are not yet disclosed. Yet, the emphasis made with respect to the management –not by public means (e.g., the Turkish SWF, Saving Deposit Insurance Fund, Development and Investment Bank of Turkey) – was critical, as independence of asset managers with proven skill sets and credentials are important for investors.

New Economic Program introduced in April 2019

21

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Experiences from 1998 and 2008 show that ‘taking things’ easy and ‘hoping things to get better in time’ is the worst strategy. Therefore we believe that Turkey needs to act decisively to protect its financial and real sectors with the participation of state, banks, asset managers and investors under a customized program. This will ensure the flow of credit to the corporates and resume the growth of the overall economy.

In 2018 the focus was on easing the collections by more efficient and less time consuming enforcement procedures. In other words, so far Turkish banks have primarily focused on internal wind-down structures with respect to their NPLs. However, a fundamentally fresh approach is needed, to address corporate restructuring for a sustainable economic recovery of the real sector, as this is not the mandate of commercial banks. At this point, it seems necessary to bring asset managers with necessary skill sets and credentials into the picture, as restructuring should not solely aim on improved collection of banks’ receivables, but also on protecting and enhancing the worthiness of the indebted companies in a sustainable way.

For borrowers the debt restructuring is a priority for the improvement of the liquidity thus there will probably be a strong will from borrowers’ side to complete the transactions quickly in the upcoming period. However, in the long term the borrowers would seek for sustainable solutions.

For lenders, deterioration in the repayment capacity of the debtors is the main concern going forward. This creates additional pressure on bank liquidity thus forcing banks to be more selective when entering into new transactions and it is possible that they demand more recourse structures from borrowers. Lenders should seek for long-term solutions in transactions in order not to face with additional restructuring requests from the borrowers in the short term.

From the investors’ perspective, NPLs are attractive, if offered with handsome haircuts creating an opportunity to generate high returns, or if NPLs are secured by assets with viable prospects. In case of secured corporate loans, investors who are willing to invest in NPLs would need a legally robust and optimal tax structure where the viable assets can be appropriately managed by specialized professionals.

The Restructuring Regulation and the Framework Agreement gave the start signal in the market, however the lack of an underlying law and the need for recent changes to be reflected in the Framework Agreement keeps especially lenders from taking action.

Under the current Turkish legislation and tax rules, NPL acquisitions using AMCs as the investment platform seem to be the most viable solution, but the current “dual mandate” model does not entirely address expectations of the investors, apart from using them as collection platforms. A regulatory and tax reform is needed for AMCs.

Asset backed securitization is possible for corporate loans, but only for stage I loans due to current Turkish law. NPL securitizations for stage II, let alone stage III are not legally permitted. Plus, the domestic institutional investor base is currently rather limited. Therefore, currently such securitizations can only be made outside of Turkey. However, this often brings relatively higher transaction costs and higher haircuts, making securitizations seen as the “last resort” for many Turkish banks.

Debt for equity swap can play a major role in addressing the problems of impaired bank loans, but it is not a solution per se. Debt for equity swap is just a preliminary step for banks to provide liquidity and to clean the financials. This applies especially to corporate borrowers, who have the potential future prospects, if they are appropriately restructured and managed in future. However, commercial banks are not well-placed to understand or to have influence and responsibility over entities that are unrelated to banking. Owning businesses or performing business turnarounds can distract banks from their core functions, and raise conflicts of interest issues. Hence, banks’ equity holding should be limited in time, practically depending on the industry where the firm is operating and its capability to achieve recovery.

In Turkish practice, one of the potential candidates to have the role of an investment platform for viable assets could be the PEIFs, where private equity houses could play the role of the asset manager. Certain features of the PEIFs provide substantial benefits to investors, thus increasing the disposability of such NPLs for banks. Yet Turkish asset management in alternative investment space is at its crawling stage. Currently, there is only a handful equipped with necessary know-how, organization and infrastructure in the business of private equity asset management. Thus, the alternative asset management space could soon be offering a good investment potential for new players offering traditional value creating asset management services, including restructuring.

4. Conclusions

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Appendix

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The Framework Agreement which has been introduced with the new Restructuring Regulation is defining the processes and mechanisms to be followed by the lenders and the borrowers who are part of this agreement.

• Who can benefit from the regulation?For a borrower, approval of the majority of itslenders is needed to enter into a restructuringagreement under the regulation.

• If the borrower applies for the restructuringfor the debts at the banks who signed theFramework Agreement, approval of lendersforming 2/3rd of borrowers’ outstanding debtsis needed under Framework Agreement.

• If the borrower applies for a full restructuring,the lenders who signed the FrameworkAgreement and constituting 75% of theoutstanding debt should give their approval.

• Framework Agreement: It was signed bythe banks forming 90% of the total loans in themarket. It determines the general principles for therestructuring process stated in the regulation.

• Standstill Mechanism: A borrower whoserestructuring application is approved, will not makeany repayments to its lenders until the transactionis closed

• Independent Business Review: Eligibilityof the borrowers to participate in restructuringsmust be assessed by a party that will bedetermined by the consortium, either a bank or anindependent company. The borrower’s financialstatus and its ability to repay upon restructuring ofits debts must be assessed within this report

• Utilization of New Loans: During therestructuring process a borrower can utilize newloans only with approval of its lenders constituting90% of the loans that are being restructured. Inaddition, the new loan will be provided by theselenders on a pro-rata basis

• Hair-Cut: Hair-cut is allowed in a restructuringtransaction with 100% approval of the lenders.

• Debt for Equity: The lenders are allowed totake over shares of a borrower. (similar to usufructright)

• Period: A restructuring transaction under theregulation should be completed at most in 150days. (90 days given under Framework Agreement,but the lenders have the right to extend the periodby 2 months)

• Foreign Financial Institutions’position: These institutions are able to enterinto the process upon request and without anyapprovals of other lenders.

Although most of the banks have signed the Framework Agreement, there has been no restructuring transaction completed under this agreement yet. Some of the lenders are awaiting for the law to come into force which is expected to be published in 2019 On the other hand, following recent amendments in the regulation the Framework Agreement is expected to be amended accordingly. In addition, making reasonable long-term projections is difficult with the current market volatility. Hence, the local banks mostly prefer to provide short term relief to borrowers with amendments/extensions and plans to evaluate these transactions again at the end of the amendment/extension period.

In line with the tightening in their liquidity, lenders have additional requirements listed below from borrowers for the restructuring transactions,

• Deleveraging by asset sale

• Additional hard collateral

• Shareholders’ guarantee

• Improve corporate governance

• Carve-out noncore assets

• Appointing independent board advisors

• Independent business review

During a restructuring process, it is crucial that both the lenders and the borrowers to have a collaborative approach in order to reach the optimum solution for all parties. Borrowers should share information regularly and transparently, treating all lenders equally. On the other hand lenders should seek for long term and consensual solutions together with the borrowers.

Business Restructuring Environment for Companies

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