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PAGE 9 | Alternative Income for an Unpredictable World: Understanding Private Debt Funds

Glossary

Advance rate

The advance rate relates to debt funds that use structural leverage to enhance returns. When banks provide a warehouse line of credit to debt funds, one of the key terms of the warehouse line is the advance rate which refers to how much the fund can borrow on any given loan, and on a portfolio of loans, relative to the value or principal amount of those loans. With a 65% advance rate and $100 million of loans pledged, a debt fund could borrow $65 million. The advance rate is similar to the loan-to-cost (LTC), except that the advance rate pertains to the borrowing between a commercial bank and a debt fund on a portfolio of loans, whereas the LTC refers to the borrowing between a real estate owner and a debt fund on a single property. Among bond traders, the advance rate is sometimes referred to as the “attachment point.”

After-repair value or ARV. 

This term is used mainly in one area of real estate lending, namely, renovation loans. Furthermore, with larger commercial real estate loans or apartment loans, the alternate term “stabilized value” is more commonly used, whereas ARV is often used for single family home renovation projects. Suppose a property is purchased for $1 million. After a $400,000 renovation and addition, the estimated value upon completion will be $1.8 million. In this case the ARV is $1.8 million.

Borrowing base

A borrowing base is a group of loans that are pledged to a bank as collateral for a portfolio-level loan such as a warehouse line of credit. Fund managers are limited in the amount they can borrow based on the value of loans in the borrowing base and the advance rate prescribed in the warehouse line loan documents.

Closed-end fund

In a closed-end fund, a group of investors is locked in at some point in time, and no new investors are added after that. Typically in a closed-end fund, when the fund reaches the end of its intended life cycle, all investors are redeemed out together at the same time, or “pari passu”. See also “open-end fund”.

Debt fund

A debt fund is a pooled investment vehicle that owns a portfolio of debt investments rather than equity investments. For example, a real estate debt fund would own loans secured by real estate, whereas most real estate funds own whole properties or equity interests in properties. Debt funds may invest in private loans or in debt securities that are traded publicly. Some debt investment vehicles may be structured as separate accounts, joint ventures, or a “fund of one” investor. The main distinguishing feature of a fund is that there are typically many investors in a fund rather than a single investor.

Evergreen fund

See “open-end fund.”

Fair value

Under generally accepted accounting principles (GAAP), a fund manager is required to hold each investment in a fund on its balance sheet at fair value. This means marking an investment up or down as needed if the value of the investment has changed from the original value. For open-ended funds, fair value is important as relates to redemptions. If one or more loans are impaired, investors may see a reduction in their capital account and may lose principal. See also “impairment”.

Gearing

See “Turns of leverage.”

Impairment

A loan is impaired if the value of that loan becomes lower than the principal amount of the loan. Suppose a lender makes a loan of $3 million and due to a decline in the value of the collateral, the lender expects to recover only $2.5 million. In this case the loan would be impaired by $500,000. The impairment can also be expressed as a percentage, namely, $500,000/$3 million or 16.7%.

Junior loan

A junior loan is referred to as junior because it is subordinated to another loan. Specifically, it is subordinated to the senior loan. The senior lender is paid off first from any proceeds from the sale or refinance of the underlying collateral. Only after the senior lender is paid off in full, with any interest due, does the junior lender receive repayment of principal and any interest due.

Loan loss reserves or LLRs

Like a bank, a non-bank lender may build up loan loss reserves over time. The mechanism to do so is to withhold a small portion of income each month. For example, a fund generating an 8% return might pay out 7.75% in a given year, which would build up LLRs by 0.25%. If the fund subsequently suffered a loss on one of its loan investments, it could use the LLRs, before impacting fund returns or capital accounts. The appropriate level of LLRs for a given fund may be the  subject of discussion and debate between fund managers and the fund's auditors. Different auditors may have slightly different interpretations of what is appropriate policy as relates to LLRs, under generally accepted accounting principles.

Loan-to-cost or LTC

LTC is a ratio used by lenders to identify an important risk characteristic of a given loan and is expressed as a percentage. The numerator is the loan amount and the denominator is the cost of a project. A loan of $3 million on a project whose total cost is $4 million would have an LTC of $3 million/$4 million or 75%.

Loan-to-value or LTV

LTV is similar to LTC with one important difference. Instead of using the cost of a project as a denominator, LTV uses the value. A loan of $3 million on a project whose value is $5 million would have an LTV of $3 million/$5 million or 60%. The lower the LTV, the greater the margin of safety of a given loan.

LTV on ARV

This term is used by professionals who deal with renovation loans. It is short for “loan-to-value on after-repair value”. Suppose a home is purchased for $1 million and the renovation budget is $400,000 for a total project cost of $1.4 million. Upon completion it is expected to be worth $1.8 million. Furthermore, suppose a lender agrees to lend a total of $1 million out of the total project cost of $1.4 million. The LTV on ARV is $1 million/$1.8 million or 55.6%.

Margin of safety

Margin of safety is a central concept in the field of investment management and was made famous by Warren Buffett who mentions this concept frequently. As relates to loan investments, the margin of safety is the difference between the loan amount and the value of the underlying collateral. For a loan of $3 million on a project worth $5 million, the margin of safety is $5 million minus $3 million, or $2 million. The margin of safety may also be expressed as a percentage, namely $2 million/$5 million or 40%. The value of the underlying collateral would need to go down by 40% before the loan investment would become impaired.

Mezzanine loan

Also see “junior loan.” In real estate, a mezzanine investment may or may not be structured as a recorded mortgage or junior loan. Mezzanine investments are so called because in the order of priority of payoff in case of a sale or refinance of the underlying property, the mezzanine investor is in between the owners/equity investors, who are last to be paid, and the senior lender, who is first to be paid.

Non-bank lender

See “private lender”.

Open-end fund

In an open-end fund, investors can and do come into the fund or leave the fund at various times. There may be no defined end to the fund’s life, but instead the fund manager can operate the fund so long as he or she has investors with a critical mass of investment capital, and opportunities to make investments that the fund manager deems attractive. In an open-end fund, investors have “redemption rights” which determine their ability to get their capital account returned to them in cash. Some real estate debt funds use the open-end structure while others use a closed-end structure. Each structure has advantages and disadvantages for the investor and for the fund manager.

Origination (of a loan)

Loan origination refers to the process of making a new loan to a borrower. Some key steps in loan origination include issuing a term sheet; meeting the borrower; inspecting and underwriting the collateral; drafting, negotiating and executing loan documents; and finally funding and recording the loan. Many credit funds do not originate loans themselves because all the steps in loan origination require specialized expertise and significant resources and staffing. 

Private lender

A private lender is a non-bank lender who originates loans, which loans may be secured by real estate, equipment or other assets, or may be unsecured. Private lenders have a balance sheet which typically consists of investor capital and may also include bank financing (see “structural leverage”). Some private lenders are affiliated with one or more particular debt funds. The private lender and the fund may be one and the same entity, or the private lender may have a small balance sheet and may regularly sell loans to one or more debt funds to recycle capital to make more loans.

Real Estate Investment Trust or REIT

A vehicle for holding real estate equity or debt investments that enjoys certain tax benefits for investors. 

A REIT may be publicly-traded or private.

Redemption rights

In an open-end fund, investors have the ability to request that their capital be returned to them. The redemption rights built into the fund partnership agreement or operating agreement determine how such redemptions work, typically stipulating a minimum investment period; the amount of notice required for redemption requests; target redemption timelines; and the rights of the fund manager to slow down or halt redemptions under certain circumstances.

Repo line of credit

Similar to a warehouse line of credit, a repo line of credit allows debt funds to borrow money against the loans they hold in their portfolio. Repo lines differ from warehouse lines in that when a loan is pledged in a repo line, the repo lender, which is frequently a Wall Street investment bank, actually takes control of the underlying collateral, making it faster and easier for them to assert their rights in case of non-performance by the fund. Repo lines frequently allow an advance rate higher than what warehouse line providers will offer, and they often charge even lower rates, however the Wall Street lenders who offer repo lines create more uncertainty for the fund manager when the financial markets are volatile, as compared to the commercial banks that provide warehouse lines of credit.

Senior loan

A senior loan is one in which the lender has the most secure position. In real estate a senior loan is also known as a “first lien.” The loan is senior or in first position, in that in case of a sale or refinance of the underlying property securing the loan, the senior lender receives principal and interest due before any other lender receives any principal or interest repayment.

Structural leverage

Structural leverage is used by some lenders to increase returns to investors. Typically a bank provides financing at a relatively low rate, so that the returns from a lending program end up higher than they would otherwise be. The amount of structural leverage can be expressed either in “turns of leverage” or as a percentage. The authors prefer to refer to turns of leverage to avoid confusion with LTC and LTV ratios. Suppose a fund manager raises $100 million from investors, and is able to also borrow $100 million from a bank, in order to make $200 million of loans. The result can be described as “one turn of structural leverage” because for every $1 of bank borrowing there is $1 of investor equity.

Turns of leverage

Also known as “gearing”, turns of structural leverage refers to the amount of bank borrowing in a lending vehicle, compared to the amount of investor capital. If a borrower uses $2 of bank financing for every $1 of investor capital, this equates to “two turns of leverage”. The higher the turns of leverage, the greater the returns that investors typically earn, but high structural leverage also increases volatility of returns. By way of example, consider a 10-speed bike in the highest gear. The rider can go fast in this gear on a flat road, but if he or she encounters a steep hill, the rider needs to shift to a lower gear quickly, or risk finding it too hard to pedal and falling off the bike.

Underwriting (of a borrower and/or a loan)

Underwriting refers to a particular type of research and analysis performed by lenders when they are considering originating a new loan. In real estate lending, elements of the underwriting process include evaluating the borrower’s expertise, background and credit-worthiness; and understanding the borrower’s collateral and business plan for that property, in detail. This analysis includes assessing the as-is value of the property; the budget for any planned improvements or construction; and the expected future value of the property upon completion of the proposed improvements. This future value is sometimes called the “after repair value” or ARV.

Warehouse line of credit

In the context of this white paper, a warehouse line of credit is a loan from a bank made to a debt fund. The fund holds a portfolio of loans and can pledge these loans into a borrowing base, which provides collateral for the warehouse line of credit. Because the bank is in the safest position of any of the parties, it usually charges a relatively low interest rate on the warehouse line of credit, which in turn enhances returns for the investors in the fund. The warehouse line of credit is in effect a senior loan secured by the whole portfolio of loans, making the fund and its investors subordinate, for which they receive a premium return.

Recommended for Further Reading

“Why CalPERS, the country’s largest pension fund, is getting into banking,” by Ben Christopher. Orange County Register, July 9, 2020. 

https://www.ocregister.com/2020/07/09/why-calpers-the-countrys-largest-pension-fund-is-getting-into-banking/.

“Survey of Capital Market Assumptions: 2020 Edition,” Horizon Actuarial Services, LLC, July 16, 2020. 

https://www.horizonactuarial.com/blog/category/publications.

“2020 Preqin Global Private Debt Report”, Preqin, February 4, 2020. 

https://www.preqin.com/insights/global-reports/2020-preqin-global-private-debt-report.

“PERE Investor Perspectives 2020”, PERE Reports, 

https://www.perenews.com/investor-perspectives-2020/.

“Growing Demand for Built-to-Rent Single Family Homes,” by Gregg Logan and Todd LaRue. RCLCO Real Estate Advisors,  August 13, 2020. 

https://www.rclco.com/publication/growing-demand-for-built-to-rent-single-family-homes/.

 

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WHITEPAPER | How Debt Funds Use Warehouse and Other Credit Lines

Learn how private debt funds use lines of credit to maximize their efficiency, enhance returns, and provide liquidity to borrowers. You’ll also learn how private debt funds are capitalized and discover a new way for non-bank lenders to capitalize their portfolios. Available online and as a PDF download.

 
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