Mr. Kimball

Development & Construction

Pitfalls of Private Versus Institutional Financing

By Larry K. Kimball, Director of Hotel Development, C. W. Clark, Inc.

This past tumultuous two year period has seen large and small banks come and go, regulations rise, consumer demand fall, hotels close, and the general public’s acceptance of uncertainty about the future. While we are all reluctantly drinking the “new normal” kool-aid manufactured by Wall Street and politicians, commercial real estate developers need to consider the implications on financing. Are the traditional US institutional lenders lending? Not really. Will institutional banks, pensions, and life companies return and who are all of these new private capital groups? This article is a roadmap for successfully navigating the 2011 financing maze.

What is now affecting the traditional institutional lenders?

Basel Global Cure All

Like the case where the medicine harms the patient, the recent introduction of a global liquidity standard for the largest banks is expected by many to restrict credit and increase borrowing costs . As a contrary indicator that helps prove this growing consensus, Treasury Secretary Geithner said the opposite will be true- US banks can meet higher capital rules through future profits without crimping lending. If that is true, why did Deutsch Bank, historically an aggressive hotel construction lender, announce in September 2010 plans to raise $13.3 billion in new capital through a stock offering? Why would Angela Knight of the British Banker’s Association state "All the changes are good from a stability perspective but add billions to the fixed operating cost of a bank. The result is that the cost of credit - the price that borrowers pay for money - will rise. The cheap money era is over. " As you can see, the new liquidity standard that essentially requires a doubling of risk capital over the next few years is an international standard and not a US-only issue.

US Dodd-Frank Reform

Financial regulatory reform in the form of this 2,300 page law adds uncertainty while providing new safeguards. A recent AEI publication summarizes the potential impact of the law very well:

The competitiveness, innovativeness, and risk taking that have always characterized U.S. financial firms will, under this new structure, inevitably be subordinated to supervisory judgments about what these firms can safely be allowed to do. But the worst element of this system is that the extraordinary power given to regulators--and particularly the Federal Reserve--is likely to change the nature of the U.S. financial system. Where financial firms once focused on beating their competitors, they will now focus on currying favor with their regulator, which will have the power to control their every move. What may ultimately emerge is a partnership between the largest financial firms and the Federal Reserve--a partnership in which the Fed protects them from failure and excessive competition and they in turn curb their competitive instincts to carry out the government's policies and directions. In addition, with the creation of the Consumer Financial Protection Bureau, the act abandons a fundamental principle of the U.S. Constitution, in which Congress retains the power to control the agencies of the executive branch. These wholesale changes in traditional relationships are hard to explain except as the triumph of a fundamentally different view--a corporatist political model more characteristic of Europe--of the government's role in the U.S. economy .

The previously described global and US regulatory environment created a brave new world for institutional lenders. In turn, new “private” capital sources that are exempt from Basel and US regulations are emerging to fill a financing gap left by financial institutions.

What is private capital?

For the purpose of this article, private capital is simply capital form sources other than a financial institution. For a more in depth discussion of a form of private capital including liquidity from securitizations and other off-bank balance sheet financing, please refer to this footnote .

Below we explore some of the pitfalls of dealing with these capital sources and suggest some strategies.

Pitfall #1 - Lack of Transparency

You definitely lack a banking relationship with this new group so you don’t really know them. The introduction came from a trusted referral or third-party intermediary with an interest in earning a fee from a consummated transaction. Naturally you want to conduct due diligence on your new source of financing. You are looking for answers to quaint questions like who are the principals, where do they get their money, what clients and projects can be referenced, and are they trustworthy?

It’s called “private capital” and there is a simple reason you may not have heard of the players. We are not only talking about the Blackstone’s of the world. We are talking about difficult to label sources of capital that make private equity and venture capital groups that fund start-up companies easy to understand.

The point with this pitfall is that getting information will probably be more difficult than what you would encounter with an institutional lender. Understanding the information you obtain is another matter.

Pitfall #2 - Emerging Experts

You may hear that private capital is complicated to understand. Naturally a cottage industry of “experts” is emerging and it will only get worse. Remember Bernie Madoff’s most successful lure was to build a prospective investor’s expectation of exclusivity like they were being accepted into a private club. You are simply looking for financing and not to be intimated or to be judged as being intellectually inferior. Just remember Groucho Marx’s line, “I don’t want to belong to any club that would accept me as a member.” Beware the cottage industry.

Pitfall #3 - Different Deal Structures

We all know the traditional institutional debt financing deal points that are negotiated in loan documents. The personal guaranty part was as important as the interest rate but the overall moving parts did not really change from one financial institution to another. You did not care about the source of the bank’s money did you? Just so they would fund the loan draws during construction and you’ll pay it back. You assumed the lesson you learned in Economics 101 still applied. A deposit is made in a financial institution, that money is lent to creditworthy borrowers, and the transactions stay within the bank and on their books. Those were the days.

These are real private financing stories:

• The developer of a large new hotel project in a west coast gateway city needed about $400 million of debt and equity financing for their project. Even though the deal size limited the number of investor candidates, their investment banker, strong brand, realistic feasibility study, and the developer’s deep experience painted a story of above market returns for investors. First, several “investment bankers” aka intermediaries wanted six figure retainers before any discussions ensued. Second, there was no shortage of offshore capital sources available if one simply “trusted” the participants. Credit rating approved private placements of Series 144 bond offerings through new foreign subsidiaries was a common approach.
• Investment programs that generate guaranteed monthly payments to the developer are emerging. With this, a capital provider makes a deposit in a financial institution who then issues a letter of credit or other form of collateral to an investment party. The investment party leverages the letter of credit multiple times in investments that do not involve credit default swaps or other derivatives and are not of an unusual or “exotic" kind but which nevertheless have the potential of exceeding normal investment returns. The investment party has a contract with the Owner whereby the Owner would receive a guaranteed fixed amount of investment proceeds per month to be used for development and construction of the hotel. It is not debt or equity and it is not inexpensive but there is no mortgage on the hotel at completion.
• Escrow - Since you’re not dealing with a financial institution, an escrow company may manage the funding and disbursements from the construction loan account.

Good luck in the new world of financing. We will all need it.

Larry K. Kimball has over thirty years of hotel experience in development, finance, operations, and asset management at the corporate and operating unit levels. Mr. Kimball is currently Director of Hotel Development for C. W. Clark, Inc., a San Diego-based commercial real estate developer. In this capacity, he is responsible for the entitlement, design, financing, and asset management of several large public-private hotel and mixed-use projects totaling ~1,200 keys with combined development costs of $600+ million. Mr. Kimball can be contacted at 858-875-5146 or larryk@CWCLARKINC.com Extended Bio...

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