Recovery notes are debt securities where the underlying asset is a defaulted or potentially not fully recoverable debt. They are a structured finance solution designed to turn what would otherwise be a total loss for creditors into a potential source of value. By repackaging non-performing loans and bonds, they create a new, tradable asset class. These securities can also be viewed from the litigation funding perspective as instruments of raising funds for recovery litigation, not necessarily stemming from a bad debt.
How They Work
At their core, recovery notes are a form of securitization. A special purpose vehicle (SPV) is created to hold the defaulted debt. This SPV then issues the notes to investors. The proceeds from any successful recovery efforts — such as legal action or out-of-court settlements — are used to pay back the noteholders.
There are two primary ways recovery notes are structured:
1. The Non-Monetary Exchange Model
In this model, the original creditors of the defaulted debt transfer their bad loans to the SPV. In exchange, the SPV issues the recovery notes back to these same creditors. No money is paid for the notes; it’s a direct swap of illiquid, defaulted debt for a new, potentially more liquid security. An outside contractor is hired to pursue the recovery. This contractor is either paid from an external source or, more commonly, receives a percentage of any funds successfully recovered, aligning their interests with the noteholders. This structure is simpler because there’s no need to assign a precise monetary value to the defaulted debt for fundraising purposes.
The original creditor (or other litigant) that received the notes in exchange for the assignment of the claim to the SPV may monetize them by offering the notes to specialized investors. The market for such instruments is, by definition, very niche, and those interested would probably be specialized funds and private investment companies of wealthy family offices. This instrument is definitely not for public offers.
2. The Capital-Raising Model
This structure is more complex. The defaulted debt is transferred to the SPV at a specific, speculative value. The SPV then issues recovery notes for cash, which is used to fund the recovery effort. This model is trickier because it requires valuing the defaulted debt to the satisfaction of potential investors. Valuing a bad debt is difficult, as its worth depends on numerous factors like the debtor’s financial state, legal challenges, and the value of any collateral. The risk of mis-valuation makes these issues more challenging to arrange.
Utility
Recovery notes offer several benefits. For the original creditors, they provide a way to get non-performing loans off their balance sheets, freeing up capital and resources. For investors, they offer a high-risk, high-reward opportunity to profit from the distressed debt market without directly managing the recovery process. The success of the investment depends on the effectiveness of the recovery efforts. Overall, these instruments help improve the efficiency of the credit market by providing a mechanism to manage and monetize bad debt.
Tiner Wernow (form. John Tiner & Partners) designs and creates securities and other financial instruments to enable our clients to raise capital, sell managed trading strategies and securitize any type of assets. We provide a full-cycle service from developing the structuring concept to its full implementation (ISIN, issuance, global clearing, exchange listings, placement routes). We help to wrap any type of asset or investing idea into easily tradeable, globally cleared securities. Our global services platform is 208Markets (https://208markets.com). We provide issuance, brokerage, SPV maintenance services in multiple jurisdictions. The educational materials appearing on the internet under the “Tiner Educational Hub” headline are to increase the awareness of the professional audience as to the securitization tools available to more efficiently attain your business objectives.
