What’s Worse? Capital Call? Rescue Preferred Equity? Or Foreclosure

[Scott Trench]

We are seeing more and more syndications and funds getting into trouble.

And while years will have to pass before we can really understand the nuances of what leads to losses in each deal, and how to parse out what is due to gross negligence, what is due to incompetence, what is due to fraud, and what is due to bad luck, there are decisions that GP and LP investors have to make right now, to get the “least bad” outcome in a given investment.

Some GPs are trying to raise capital via capital calls. Others are handing the keys back to senior lenders. And others still are raising preferred equity to inject liquidity into the deal.

My question for the experienced capital raisers on this forum is this:

-What’s least bad?

I feel like if a deal is millions of dollars underwater at present valuations, it’s better for everyone to just hand the keys back. Why wait for a day that might not come for a decade? I could be investing the dollars going into a capital call into something else.

Similarly, a preferred equity raise can be the worst case scenario for investors, but it is being billed by some syndicators as a great tool and “safe”.

When I see a fund injecting a preferred or "protected" equity raise into a deal to meet DSCR requirements from the senior lender and pretending like this is somehow any different from a foreclosure and total equity wipeout, I'm confused. This is a disaster, and may be worse than foreclosure for both new and existing investors. It's an alternative, and not necessarily a good one, to capital call or foreclosure.

I think that as a community we need to hold all syndicators accountable to outcomes for investors, yes, but also we need to be practical about what the right thing to do is.

A few syndications have handed the keys back, for nearly total wipeouts. They are getting beat up in the forums here.

However, I wonder if their investors, though angry now, will in time greatly prefer this approach to the extend and pretend approach of those raising rescue preferred equity, or those calling more capital on deals that have little to no equity in them, even after the call. 

Should we be giving a little more grace to the folks who have handed it in and admitted defeat, simply because they will not compound losses on those deals?

And, should we be a little more tough on the folks who are in the same position but raising EVEN MORE capital to double down on failing investments?

[Brian Burke]

@Scott Trench there is no single correct answer here because the best course of action depends on the totality of the circumstances.  Not to mention that what is thought to be the best course of action could later turn out to be wrong.

I’ll use some hypothetical examples to illustrate:

1. Phoenix apartment deal purchased in 2021 with 90% LTC 3-1-1 bridge debt. Since, prices have fallen 25% so the property is now worth nearly 20% less than the loan amount. There are 1-year extensions available but the property doesn't meet the extension covenants due to underwater DSCR and debt yield. Lender will grant the first extension with a 20% principal pay down. The syndicate ran out of cash reserves and doesn't have enough to purchase the required replacement rate cap.

Foreclosure/DIL/short sale may be the best option.  With 90% LTC initial debt it’s likely the LPs have about 20-25% of the capital stack. To do the loan pay down for the extension or to get new permanent debt investors would likely be subject to a 100% capital call.  Better to invest that cash into a new deal because even if the value recovers the investor would recover the same in a new investment as in the existing.  Pref equity makes no sense because if the LPs are essentially wiped out already that would put pref equity too high in the capital stack.  Pref equity isn’t priced for that risk—that’s for common equity.

2. Tampa apartment deal purchased in 2020 with 10-year fixed or floating debt (doesn't matter for this example) at 65% LTV. During COVID, evictions stacked up costing tons of legal fees and bad debt. Last year, rent growth fell off, occupancies dropped, insurance skyrocketed 4X, and interest rates rose (if floating). For whatever mix of these factors, the property burned through its cash reserves and has slightly negative cash flow.

In this case, a capital call might be the best option.  The syndicate needs to rebuild cash reserves and bulk up for the slightly negative cash flow enough to get through to the other side of the market cycle.  Because the initial purchase had 65% LTV debt the LPs might have 40-50% of the capital stack, so this might be only a 10% capital call.  Even if the investment ultimately only breaks even after 5 more years, putting in $10K to save $100K is a good return on the $10K.

Pref equity could be an option for example 2 if the investors did not wish to pony up.  But pref is really best as an option of last resort because the current pay makes the problems worse, and pushing back the LPs to a subordinate position isn’t ideal.

There are a multitude of variations on these examples that shift the decision. My guess is there will be dozens, hundreds, or thousands of case studies to examine a few years down the road to use 20/20 hindsight to evaluate outcomes.

On your second question about extending grace vs being tough: that also depends. For too long many GPs and LPs had too cavalier of an attitude for the risks, and too many GPs made poor risk mitigation decisions and the LPs didn’t know any better.  Just last week I saw a deal from a syndicator that was full of misrepresentations and financial manipulation.  This operator will likely implode one day and should suffer every consequence coming their way.  But we are also likely to see experienced, competent groups that get struck by market factors largely beyond their control.