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PAGE 5 | Alternative Income for an Unpredictable World: Understanding Private Debt Funds

SIDEBAR ARTICLE

Lending to the Lenders

Just as private debt funds require a high degree of specialization for success, the same can be said for those who provide financing to these firms. Western Alliance Bank, which lends to a range of types of borrowers, has worked closely with private debt fund firms. The bank currently has around $2 billion in committed capital to private debt funds. 

Private debt funds often take out a loan as a credit line that gets taken up and down as cash needs ebb and flow. For example, if fresh equity comes in, the private debt fund will pay down the line of credit. And if an opportunity to make end-user loans becomes available, the private debt fund will borrow to make the loan on a timely basis. 

Industry lenders such as Western Alliance suggest that the criteria for clients are the same ones that should be used by investors in private debt funds. “It’s crucial to clearly understand the controls in place against bad loans, fraud, etc.” says Seth Davis, a senior director at Western Alliance Bank. “It’s best to focus on private debt fund management teams with long track records,” he says. 

Davis takes the scrutiny needed by investors one step further. “It’s important to understand the markets being served by a private debt fund, as various segments of real estate have divergent fortunes in a changing economy,” he says.

Davis has been watching private debt fund managers through various economic cycles and has seen first hand how changes in interest rates impact the segment. In recent years, falling rates have led to a compression in margins for private debt funds. As a result, the returns they are able to offer investors have come down to the upper single-digits. That’s still very impressive in an era when many other fixed income investments sport miniscule yields. 

Why do margins compress as interest rates fall? “Wholesale lenders (such as Western Alliance) don’t lower their lending rates as fast as private debt funds must lower their own lending rates to provide competitive terms,” says Davis. In contrast, an eventual rise in interest rates will enable private debt funds to expand their spreads as wholesale borrowing costs would rise more slowly than real estate borrowers' lending terms.

Quantitative & Granular Due Diligence

Loan-to-cost and loan-to-value of underlying loans

One of Warren Buffett’s favorite concepts is “margin of safety”. In a lending or credit investment fund, the starting points for analyzing the margin of safety are loan-to-cost (LTC) and loan-to-value (LTV). 

Let’s illustrate with an example from real estate. Suppose an investor can buy a building for $1 million and after spending $400,000 on improvements, the building will be worth $1,800,000. For simplicity, we will ignore sales commissions and holding costs in this example. If a lender provides a loan of $750,000 on the purchase, the LTC would be $750,000/$1 million or 75%. Suppose that the lender also provided $300,000 or 75% of the renovation costs. The total loan amount would be $750,000+$300,000 or $1,050,000. The total value upon completion is $1.8 million. The ultimate LTV would be $1.05 million/$1.80 million, or 58.3%. In real estate lending, this is sometimes called the LTV on “after-repair value” (or LTV on ARV).

From the lender’s perspective, the margin of safety on day one is 25% or $250,000. Once the project is completed, the margin of safety is higher, namely, about 42% or $750,000 ($1.80 - $1.05 million). All other things being equal, a lower LTC or lower LTV indicates a safer investment. When considering a fund, the investor should ask, “is the fund getting paid adequately for the risk of the underlying investments?”

Volatility of underlying assets

Continuing with the real estate loan example, suppose that two loans are both made at an equal LTC and LTV. Let’s use the 75% LTC and 58% LTV based on ARV from the previous section. This margin of safety seems attractive, but if the value of the underlying real estate changes too much and too quickly, the margin could be eroded or even eliminated. By way of example, consider home values in Phoenix during the GFC. As shown in the chart below, they fell more than 50% in the span of several years. In contrast, home values in West Los Angeles fell by a much smaller percentage.

As a result, the lender faced more risk lending in Phoenix when compared to lending in West Los Angeles, where the supply of homes available for development is much more constrained. Investors wanting to assess volatility in their own area can reference the city and regional indices tracked by the Federal Reserve Bank.9 Also, Zillow estimates home values by neighborhood and Zip code. For example, Zillow provides a home value trend that is specific to the Westwood area of Los Angeles near UCLA, among many others.10

Several factors can influence the volatility of market values including the following:

  • Property type (consider hotel or retail property values during COVID-19 which are down dramatically, versus home values which have not dropped significantly);

  • City (for example, Phoenix vs. Los Angeles during the GFC);

  • Urban core vs. periphery (West Los Angeles vs. Inland Empire commuter cities such as Fontana, during the GFC);

  • Price point, for single family homes (ultra luxury homes in Los Angeles, which in some cases have fallen in value substantially during COVID-19, versus more entry-level or mainstream homes in the same market, which have not fallen in value).

Borrower profile

Independent of all the other factors discussed so far is the borrower. The best borrowers expect to borrow at lower rates, all other things being equal. Factors that make a borrower attractive to the lender include the following:

Creditworthiness

What is the borrower’s liquidity and credit score?

Relevant experience 

Does the borrower have a track record of creating value with the type of real estate investment being financed? Can the borrower execute successfully on his or her business plan?

9 For further details, go to: https://fred.stlouisfed.org/categories/32261

10 For further details, go to: https://www.zillow.com/westwood-los-angeles-ca/home-values/


Relationship vs. transactional 

Is the borrower a repeat borrower who has shown a desire to maintain a long-term mutually beneficial relationship with the lender? A repeat borrower who values relationships is much less likely to default than one who views each transaction individually, as a chance to negotiate the most advantageous outcome on that one transaction.

In conducting due diligence on a fund manager, it pays to understand the underlying borrowers. What percentage of the fund’s loans are to repeat borrowers? How experienced are the borrowers at doing the type of project being financed? And what is their financial strength?

SIDEBAR ARTICLE

Perspectives From a Leading Auditor of Private Debt Funds

Maier Rosenberg is a senior managing director at CohnReznick, an accounting firm that audits and works with a wide range of private debt funds. Maier notes that the greatest risk for investors in private debt funds resides with the quality of the fund manager and their decision-making. “They make so many critical decisions that can have a tangible impact on fund results.” As an example, he cites the decision to stick with the industry norm of 65% loan-to-value thresholds. “Some will lend at 75% or even 80% LTV ratios, which boost the risks in a portfolio,” he says. 

Rosenberg also stresses the importance of a fund manager’s knowledge of each deal, asking questions such as: “How strong is the borrower and the collateral in place?”; and he also asks if managers have a clear sense of how they will be able to re-market a distressed property in the event of a loan default. That’s why it is important for fund managers to stay focused on areas of lending and types of real estate that are within their core expertise. “I’ve seen managers do a poor job of assessing borrowers and their properties. They had to take back a property and it took quite a while to get their funds back,” he says. “At that point, they are no longer operating in an area they know well.” Citing one example, Rosenberg says if a fund is focused on construction loans, the manager should have a clear sense of how the construction industry operates, as well as asking whether “they know how to complete a project and sell it if they need to”. 

Investors in private debt funds need to understand accounting practices as they are not uniform across the industry. There are two approaches that a private debt fund can take for financial reporting purposes: 1) fair value and 2) as an operator. The majority of real estate debt funds that CohnReznick audits use fair value accounting as they fall under the Investment Company Guide (ICG) rules.  As such, loan loss reserves are not permitted under the ICG; rather all loans must be marked to their fair value. Therefore, if there is a concern about not recovering the principal (and accrued interest) of a loan, the loan should be revalued to its fair value. This adjustment is treated as an unrealized loss. This market adjustment can adjust back to par value if the loan ultimately performs, at which time it is recognized as an unrealized gain. If a loan is ultimately sold or settled for less than its par value, the loss would be recognized as a realized loss at the time of disposition. Loan loss reserves are permissible if the fund is presented as an operating entity.

 
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