A discounted payoff (DPO) is the repayment of a loan for less than the outstanding principal balance. DPO’s are typically reserved for distressed assets that have declined significantly in value. Writing-off any portion of the principal is an expensive proposition for the lender; before accepting any such loss, the lender must be confident not only that any prospective replacement/refinance loan will offer lower proceeds than the existing debt, but also that a) the borrower is unable or unwilling to infuse additional equity, and b) that the prospect of foreclosing and selling the asset will not recover the principal balance either.
Lenders are incentivized to accept a DPO by the expense and effort of foreclosure, and by the threat of a borrower putting the asset into bankruptcy. Furthermore, any such process entails the risk of legal liability for the lender. Lender’s typically prefer to stay off the chain of title if possible in order to minimize exposure. The lender’s incentives may also be influenced by factors beyond the dynamics of the specific asset and borrower relationship, such as balance sheet management and regulatory requirements. Thus, the ability to close a DPO on short notice may be advantageous to the borrower.
DPO’s can be financed with new debt and/or equity. The payoff amount agreed with the old lender is typically treated as an arms-length sale transaction for purpose of establishing value; it assumedly indicates the maximum value the old lender expects to recover from the asset through a foreclosure process. As such, the any new debt available to facilitate the DPO will likely constrain their proceeds to a percentage of the DPO amount, and look for a fresh equity infusion. Joint venture equity investors will participate in DPOs, but look for a defensible explanation for the distressed condition of the asset, a strong go-forward business plan, and support for the sponsor’s capabilities to perform.