Optimal Efficiency – Fund Finance

Co-authored by Richard Hanson, Morgan
Lewis

Private debt funds are gaining CRE market share
via back leverage structures. Corinne Smith
explores how these facilities can optimise risk, tax and regulatory
treatment.

Private debt funds are gaining market share in the commercial
real estate sector by originating loans that are financed by banks
via bespoke back leverage structures, including private
securitisations. These facilities have increased in complexity this
year, as sponsors and lenders sought to optimise the risk, tax and
regulatory treatment of the arrangements.

Back leverage is financing advanced to private debt funds for
the funding, leveraging, acquisition or origination of one or more
loan positions.

Funds typically use leverage provided by commercial banks to
enhance returns on their real estate debt investments at a lower
cost than that of direct equity investments into the fund. In
return, back leverage providers obtain indirect exposure to
illiquid assets, as well as additional asset-backed structural and
contractual safeguards.

“Back leverage became popular as interest rates reached
historical lows. In an era of cheap debt, it makes sense for debt
fund sponsors to expand using back leverage,” observes
Richard Hanson, partner at Morgan Lewis.

A variety of structures can be utilised to achieve back
leverage, including loan-on-loan facilities, repo agreements and
private securitisation – whereby loans are transferred to an
SPV, which issues a senior note to the bank lender and the junior
note is retained by the fund sponsor. Among the advantages of
employing a structured solution is achieving favourable regulatory
and tax treatment, which allows banks to hold less capital
against the position.

“The structural driver is finding a balance between the
right regulatory treatment for the bank lender and the right tax
and accounting treatment for the fund sponsor, with the overall
objective for the fund sponsor being to create cheaper funding and
diversify funding sources. We’re seeing more structures being
combined to achieve those aims,” Hanson explains.

Nick Shiren, partner at Cadwalader, notes that loan-on-loan
financings are typically used to finance smaller sized transitional
assets. Drawing on repo technology, a traditional facility treats
each asset as being referable to a separate loan, but it is also
possible to structure the facility more akin to a typical borrowing
base facility.

In the US, loan-on-loan facilities are documented under a master
repurchase agreement. From a business and financial standpoint,
these work in the same way as financing and entail the same reps
and warranties, covenants, event of default clauses and
remedies.

Aaron Benjamin, partner at Cadwalader, notes that a repo
structure benefits from a statutory exemption from automatic stay
that US courts would impose on most key contracts of a bankrupt
sponsor or borrower under the US bankruptcy code. This exemption
allows lenders to liquidate collateral, notwithstanding the
imposition of the automatic stay that would otherwise apply.

He adds that there are three other credit pillars that support
this structure: daily mark-tomarket rights; a partial recourse
guaranty by the sponsor, with some ‘bad act’ full
recourse and loss recourse carve-outs; and a repurchase obligation
by the sponsor of defaulted loans or breaches of loan-level
R&Ws. The ‘bad act’ carve-outs under the partial
recourse guaranty include collusion in bankruptcy, fraud,
breach of environmental R&Ws and intentional
misrepresentation.

The structures are commonly performing loan facilities, but they
aren’t exclusively. For facilities that allow non-performing
loans as collateral, a lender would require some control or
consent rights over the contemplated workout plan, among other
conditions.

Shiren views the product as part of the relationship lending
offering between an investment bank and debt fund sponsor.
“Loan-on-loan financings are one of the funding tools used by
sponsors, which may look to the CR E CLO or CMBS market as well, as
part of their funding strategy. Essentially, the bank buys into the
business strategy of the sponsor,” he explains.

He continues: “The debt fund originates assets and asks
the bank whether it can put them on the line; the lender can agree
or decline to fund the asset. If it agrees, the bank typically
takes a strong interest in the sponsor and its ability to adhere to
its business plan.”

The approval process for onboarding assets is usually
collaborative and there are different methods of mitigating risk,
including pricing, assuming a greater percentage of recourse and
margin calls. “For example, if the NOI or NCF declines such
that the repo buyer (lender) determines that the market value of
the property securing the mortgage loan has declined, then the
lender can issue a margin call to rebalance its advance rate
against the new market value of the property (and hence the loan).
Additionally, it’s possible to solve for unusual asset risk
by providing for increased recourse for specific assets,”
explains Benjamin.

He continues: “The structure is a flexible way for R EITs
and other funds to obtain leverage at asset-backed financing rates.
Part of the business plans for real estate funds has been to
use these facilities in order to obtain levered returns.”

In terms of tax treatment, vehicles are often domiciled in
Ireland, which is attractive for both banks and sponsors –
especially US sponsors – if their aim is to achieve
tax-neutrality. Shiren is aware of cross-border and multicurrency
facilities (in sterling and euro) being structured, encompassing
continental Europe, Ireland and the UK.

“This brings additional complexity and requires
understanding the lending and regulatory regimes across different
jurisdictions. For instance, it is necessary to undertake due
diligence on the different banking monopoly rules to ensure that an
SPV can actually lend in a given jurisdiction,” he says.

Whether a transaction will technically be a securitisation
within the regulatory framework is often discussed early on in
negotiations and is typically led by the bank, which wants to
achieve the associated regulatory capital benefits. Shiren confirms
that most banks would take the view that the As such, it is
necessary to address the associated risk retention and transparency
requirements. “Risk retention tends not to be an issue
because it’s usually possible to find an
‘originator’ within the sponsor group and, since the
advance rate of the facility is less than 95%, the sponsor will
have to provide some equity to the vehicle. This is structured as a
first loss piece and is usually sufficient to satisfy
retention requirements,” he notes.

However, Hanson warns that smaller funds need to be careful in
such a scenario. “Securitisation can be beneficial from a
pricing perspective, but they also need to be cognisant of their
obligations under the securitisation regulation,” he
notes.

Equally, smaller funds are more exposed to potential margin
calls in repo arrangements by the bank. Hanson says that standard
features that are always negotiated are mark-to-market terms and
decisions regarding control over enforcement and material
modifications.

“Banks have become more focused on due diligence and
control recently, in order to mitigate downside risk. While certain
parameters can be set, ultimately a bank has absolute discretion as
to whether to finance an asset,” he adds.

Back leverage transactions either provide matched funding or
have historically been termed out into the securitisation market.
Hanson expects such activity to return, once the public market
begins to stabilise following this year’s challenging
conditions. This may be facilitated by the emergence of a CR E CLO
market in Europe, although he points out that many hurdles need to
be overcome for this to occur.

“CRE CLOs can be expensive to structure and it can be
prohibitive for smaller debt funds to access warehouse lines to
ramp portfolios. On the other hand, CRE CLOs tend to offer more
competitive advance rates compared to repo and are attractive
to fund managers because they allow more discretion over the
assets,” Hanson remarks. 

Shiren says he is seeing continued interest in CR E CLOs in
Europe and believes it is only a “matter of time”
before a market emerges on this side of the Atlantic. He adds that
many loanon-loan mandates have CR E CLO take-outs contemplated in
the documentation.

Benjamin confirms: “We’re seeing certain sponsors
warehousing assets that satisfy CR E CLO rating requirements, for
example, and sometimes they securitise those assets and other times
they maintain their leverage through the repo
facilities.”

Looking ahead, Hanson anticipates that the real estate finance
market will be characterised by the need to address loan
refinancings, ICRs being breached and LTVs potentially being
breached – which will result in banks seeking to delever and
funds looking to take market share. “Back leverage is a
solution. Although back leverage providers are currently charging
higher interest rates, if it is undertaken in a structured way,
funds will still be able to enhance their returns,”
he concludes.

Originally published by Structured Credit Investor

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.