By Chris O’Leary
A real estate developer needs short-term cash to complete a project, but after last year’s credit crunch—and a dramatic decline in property values—financing is no longer available from traditional lenders. What to do?
Pay more. “If you’re a residential hotel that has already put $10 million into a project when credit dried up, and you only need another $500,000 to turn the project into an asset-generating facility, you’d pay a high rate of return just to get a bridge loan to get you there,” says Guy Haselmann, a principal at Gregoire Capital in Milburn, N.J. “You’d pay 20% easily.”
But to whom? Many commercial banks remain on the sidelines as they work out billions of dollars in impaired assets. Commercial lenders, such as GE Capital and the troubled CIT, are also less willing to lend.
Enter asset-based lending funds. ABL funds that either survived the harsh fall and winter of 2008 or had the good fortune to launch after the worst of the financial crisis are thriving. “There is no better lending opportunity,” says Paul Iacovacci, co-founder of $370 million Brevet Capital, whose asset-based lending fund has gained 12.48% for the year through September.
ABL funds have historically reported steady but moderate gains, with a return stream whose consistency makes them look like coupon clippers. Today, these funds are achieving rates of four to six percentage points higher than two years ago, with asset-backed loans now being priced at 1600 basis points over LIBOR compared with 1100 over in 2006 and 2007, one ABL fund manager says.
The new state of play comes after a winnowing period over the past 12 months, when, in addition to commercial lenders, many ABL vehicles (including Quantek Opportunity Fund, Madison Realty Capital and Ambit Bridge Loan Fund) were restructured or wound down. Some shutdowns were partly a result of redemptions by panicky investors, but they can also be attributed to collapsing loan values. Not surprisingly, the hardest-hit asset classes were commercial and residential real estate, but a variety of loans, including those against autos, education and general business operations, also declined in value. And at least one ABL vehicle, fund of funds Eden Rock, fell victim to alleged fraud.
Today, among hedge funds, the competition to make loans against collateral falls neatly into two categories—veteran survivors, such as Brevet, which does not follow a typical ABL strategy, and relative newcomers like Perella Weinberg Partners, which introduced an asset-based value fund last year as the credit crisis unfurled.
“The opportunity is better now because value has been marked down so drastically,” Gregoire Capital’s Haselmann says. Funds that aren’t stuck with a loan portfolio filled with dicey product from 2006 and 2007 (and which don’t run the risk of having conflicts of interest because they must unwind current funds) are particularly in good shape, he added. “If you had a loan portfolio prior to the fourth quarter 2008 you could be in big trouble, but if you got into the market after, when TARP and so on had loosened up the credit markets, it’s a different story.”
Perella Weinberg Partners Asset Based Value Fund was formed in April 2008 and thus managed to avoid picking up loans that caused so much heartburn for more established competitors. “Certainly having no legacy assets was a plus for us,” says portfolio manager David Schiff. “Our business model does not rely on leverage, which limited the fund’s volatility as leverage disappeared. It was clear to us when we launched the fund that unemployment was going up. Therefore, we invested with a fairly defensive stance, creating a short duration portfolio that produced predictable and stable cash flows.”
Perella also chooses its assets carefully, staying clear of residential mortgages and most commercial mortgages to focus on asset classes it views as being relatively homogenous and easier to value, such as franchise loans to McDonald’s and Taco Bell. “Based on our team’s view of where we are in the macro cycle, we identify a select number of asset classes to focus on at any one time, targeting areas where we believe the greatest relative risk-adjusted reward can be achieved. We look opportunistically across public and private opportunities and at all parts of the capital structure—we can buy the asset itself, invest in distressed bank debt, or, if appropriate, originate our own loans.”
Schiff also keeps an eye on the exit. “We consider the self-generated cash flow from our underlying assets as our primary means of exiting our investments, limiting our dependence on liquidity in the marketplace. From our perspective, it’s still unclear when full liquidity will return.” Perella does all of its servicing (and liquidation, if necessary) in-house. So far, so good. Through September, the Perella fund had gained nearly 43%.
Many ABL funds active between 2006 and 2008 got slammed when the economy came to a standstill. “What the seasoned portfolios grossly underestimated was the magnitude of the crisis. They underestimated what that value really was, which was much lower than they thought,” says Haselmann. In some cases, loan-to-value ratios declined by as much as two-thirds (say from 120 to 40). Often, an ABL fund’s collateral is a non-transferable asset (film distribution rights, for example) or a hotel project that can’t be easily liquidated.
“In the traditional ABL business, many underlying borrowers were dependent on someone else to refinance them. With the dramatic changes that occurred in late 2008, the dependence on refinancing has become problematic. Borrowers with bridge loans or maturing term loans needed a more permanent source of financing at a time when there was limited availability from lenders.” Perella’s Schiff explains.
Real estate loans were unusually troublesome. Even ABL funds with conservative investment strategies felt the pinch. Take Stillwater Capital Partners, a $1 billion ABL shop. Its core vehicle, Stillwater Asset-Backed Fund, is composed of loans against real estate (40%), law firms (30%), life insurance (25%) and energy receivables (5%). About one-third of the fund’s loans, or lines of credit, were made to repeat clients with proven track records. But real estate still proved toxic: For the year through August, the fund had lost 4% because it had to write down real estate loans early in the year.
Unsurprisingly a number of ABL funds had to gate investor redemptions starting in the third quarter of 2008, and some players are now winding down. Quantek Opportunity Fund “is being liquidated as fast as practicable,” says Mark Lowe at Nomos Capital, a third-party marketing firm that once represented Quantek. Other funds bowing out include Madison Realty Capital and Ambit Bridge Loan Fund, both of which had focused on commercial real estate bridge loans, and the London-based fund-of-funds Eden Rock Structured Finance, which had invested as much as 75% of its assets in ABL strategies. (It should be noted that Eden Rock was not just hit by collapsing real estate prices. The firm was also the victim of fraud, as some of its funds had invested with Petters Group Worldwide, which was accused by federal officials in 2008 of running a $100 million Ponzi scheme. Eden Rock will reportedly liquidate its assets over the next two years.)
The surviving ABL funds have a few common characteristics. For one, they zero in on unusual asset classes. For example, Brevet Special Opportunities Fund focuses on short duration, non-real estate, non-commodity lending. “We do more principal financing,” Iacovacci says, including litigation and municipal receivables. He adds: “We focus on assets that are not correlated to the economy. So if the economy goes down, the likelihood of our assets being directly affected is minimal.”
Brevet’s Special Opportunities Fund was launched in February 2007 and did its first deal in May of that year.
Forum Asset Management avoided getting burned by staying out of real estate and avoiding the U.S. Today, $77 million Forum Asset Based Investment Fund lends against a variety of assets, including education and medical equipment. During the worst of the market crisis last year, Forum focused on energy financing projects in Mexico and South America, typically for quasi-governmental borrowers like Petroleos Mexicanos in such ventures as short-term contracts with energy service companies. Forum hedges its positions against local currencies as well as with specific government entities. “Even with oil prices going from $140 to $70 a barrel, the oil sector still needs to continue to pump money into exploration and maintenance,” says Jose Pedreira, the fund’s chief investment officer.
For many ABL funds, every loan is negotiated differently, so they “end up with a diverse portfolio of idiosyncratic loans,” Haselmann says. Firms with the expertise to seize assets and service delinquent loans can further increase returns. He adds: “For [funds that] can go through the workout, if it gets to that point, the rate of return may increase because it’s overcollateralized.”
Given the lack of mainstream lender competition, ABL funds can also negotiate better terms, such as first-lien positions and step-up coupons in case of borrower delinquency. Ideally, “you end up getting double-digit returns,” says Haselmann. The Pepperdine Private Capital Markets Study, which surveyed 627 private lending and investment professionals during the first half of 2009, found that asset-based lenders expect an 11% return on investment (by contrast, bank lenders expect a 6.5% ROI).
Each fund takes a slightly different tack to get to that goal. For Forum, dealing with government-tied businesses means “our payment risk is minimized considerably,” Pedreira explains. “You’re left with performance risk, which we’re comfortable with.”
For example, Forum last year financed oil drillers whose equipment was appraised at a level reflecting the $120 to $140 a barrel oil prices of early 2008 as well as the scarcity of drilling equipment. When the oil market collapsed late last year, the drill was suddenly no longer worth its initial assessment, and its loan-to-value ratio fell to 80 from 100. Says Pedreira: “In some situations, we asked for additional collateral, real estate if needed, or more contracts. We will definitely go after additional collateral. It’s the equivalent of a margin call.”
ABL funds also say they’re benefiting from a more diversified investor base. Investors from the 2006-2007 period were often opportunistic and at times unfamiliar with the strategy. But Pedreira, for one, has noticed what he termed a new wave: “People who understand the concept of private equity—pension funds, endowments, trusts, foundations—they’re filling the void, and they’re benefiting from the current market dislocation.” As are the funds strategic enough, or lucky enough, to be in the ABL sector today.
