Mr. Clark

Finance & Investment

Could Financial Instruments be the New Collateral to Traditional Hotel Debt Financing?

By Bryan J. Clark, President & CEO, Lion CFC Inc

So what are the alternatives that allow for 100% project financing without the requirement of equity participation from investors or other capital contributors? The answer lies in the leverage that can be created by using 3rd party financial instruments (CD's and Medium Term Notes) as collateral for financing. Cash backed collateral including financial instruments such as Bank Guarantees, Standby letters of credit, Medium Term Notes (MTN's), Structured Certificates of Deposit (CD's), Zero Coupon Bonds, and various other financial instruments have been used for decades as leveraging tools and for the purposes of financing large projects worldwide. However, in recent years a growing number of savvy and sophisticated Hotel and Financial Executives across the globe have pioneered new finance techniques that employ these financial instruments in new and innovative ways for the purposes of funding large projects worldwide. The use of these financial instruments (as mentioned above) has allowed top hoteliers worldwide to lower their cost of financing while reducing the time and legwork required to secure the necessary and adequate project or company financing. Although these financial instruments can be utilized for a variety of reasons, the focus of this article is using these instruments as collateral to secure 100% financing for hotel projects almost anywhere in the world, with no recourse and no equity required.

Due to the nature of zero coupon financial instruments (they are purchased at a discount now and reach their "face value" at some point in the future) and the particulars of this funding structure, the financial instrument can serve as the sole collateral for the loan (no Borrower credit required) as well as provide for the repayment (pay off in full) of the principal balance of the loan at the end of the loan term. Within the structured finance industry, this is sometimes referred to as the financial instrument "collapse in" structure because at the end of the loan term, the financial instrument "collapses in" on the outstanding principal loan balance and pays it off in full. This is made possible by the fact that the maturity date of the financial instrument will almost always coincide with the loan term (a ten year loan term would require a ten year zero coupon bond, MTN or certificate of deposit). Therefore, the Borrower is only responsible for interest only debt service/payments while the loan balance is outstanding. Over the past 15 years, several resort developers years have borrowed between $100M and well over $2B for the development of various major resort projects (across the globe) and at the end of their loan terms (ten years), their projects were owned free and clear without any principal repayment by the Principals/Borrowers. To better understand this finance structure, one must first gain a firm understanding of the general mechanics.

First, a CD or MTN (hereafter simply referred to as the "financial instrument") with a "face value" of roughly 250% of the total loan amount needed for the project will have to be provided to secure this type of financing. The first question that is always asked by the Project Developer or Borrower at this point is "where do we get the financial instrument, and who pays for it?" The fact is that very few Project developers or companies seeking financing for a project will have enough capital to purchase a financial instrument of this size. Therefore, a 3rd party collateral provider/investor (referred to as the "investor") will need to be located. However, many firms that offer or facilitate this type of financing will often purchase the financial instrument (and act as the "investor") on behalf of the project and will be repaid at funding from a portion of the loan proceeds. As mentioned earlier, a financial instrument with a "face value" of roughly 250% of the total loan amount needed for the project will be needed. The reason for this is that the financial instrument will provide a loan amount large enough to do several things at closing including, fund 100% of the project's cost, repay the collateral provider/investor in full plus a rate of return, and cover any applicable interest reserves, broker fees, etc. Therefore at funding the Borrower receives a loan for 100% of their project's cost in the form of a credit line, the investor (who purchased the financial instrument) is often repaid in full and removed from the deal altogether, interest reserves are typically funded into the credit line, and all parties are paid their required fees and commissions. After everyone is paid, the project developer or Borrower is left with their requested loan amount that covers 100% of their project's cost and the financial instrument is left as the sole collateral for the loan. At the end of the loan term (typically ten years), the financial instrument reaches its "face value," (which equates to the outstanding principal loan balance), and the financial instrument pays off the outstanding loan balance leaving the Borrower with a Project that is owned "free and clear."

Now, how do the numbers breakdown and how is it possible for the investor (purchaser of the financial instrument) to be repaid at funding leaving the Borrower with enough loan proceeds to fund 100% of their project? The key element to understand here lies in the nature of zero coupon financial instruments. Let's use an example where a Borrower is looking to finance a project at a total cost of $100M (needing a loan amount of $100M+/-). A $100M loan would require a financial instrument that will be worth $250M ("face value of $250M) in ten years (assuming the loan term will also be ten years). The cost of the financial instrument will depend on the market price at that time for the specific instrument (CD or MTN) and the nature of the specific investor that is purchasing the financial instrument on behalf of the project. Since a major financial institution, trust management group, or hedge fund will typically be the investor purchasing the financial instrument for the project, the cost of the financial instrument will be significantly less than it would be for a normal "consumer/retail" buyer of the same instrument. A "consumer/retail" buyer of a ten year CD or MTN could expect to pay roughly 40%-60% of the "face value" (future or mature value) of the instrument whereas a major financial institution, trust management firm, or hedge fund can often purchase them for closer to 20%-35% of the "face value" since they usually purchase them in "blocks" and in larger quantities (several instruments at a time). Therefore, a ten year CD or MTN with a $250M "face value" that is needed for this specific example would cost the investor approximately $75M ($250M multiplied by .30) using a 30% purchase price for this example. The investor puts out the necessary $75M to purchase the financial instrument and the instrument is pledged as the sole collateral for the loan. Then the bank (usually a top-rated world bank) funds a loan in the form of a credit line, and in several tranches, (based on the underwriting of the project) of up to 100% of the "face value" ($250M) of the financial instrument. This means that a $250M loan is funded and disbursed as follows: $100M+/- is disbursed to the Borrower to cover 100% of the project's cost, roughly $100M is disbursed to the investor (purchaser of the financial instrument) to repay them for their $75M investment and purchase of the instrument plus a rate of return, and the remaining $50M would be disbursed and used to cover interest reserves (if necessary), bank fees, legal fees, broker fees, etc.

In concept, utilizing financial instruments as cash-backed collateral in the "100% Funding Structure" described here is fairly simple and easy to understand. However, the expertise of a qualified international law and due diligence firm, a top rated world bank, an A-rated collateral provider such as Merrill Lynch, an investor (major financial institution, trust management firm, hedge fund, etc.) to purchase the financial instrument, and an extensive background and experience in this field are all required to facilitate the due diligence, underwriting, and funding processes of this particular collateral enhanced funding structure. This is worth reiterating: the expertise of a qualified international law firm that specializes in collateral enhanced loan structures, due diligence and fraud prevention, a top rated world bank, an A-rated collateral provider, a collateral investor, and an extensive background and experience in this field are required to successfully facilitate the "100% Structured Project Finance" process described here without any unnecessary, costly mistakes, and most importantly, fraud. In addition, all professional parties retained to facilitate this funding structure and process must agree upfront to work with the other parties involved. Using cash-backed collateral to secure 100% Project Financing requires a high level of comfort, collaboration, and communication between all parties involved in the process. The entire process (due diligence, underwriting, funding) typically takes anywhere from three to ten months after completion and submission of a "high-level" business plan.

A simple explanation of the "100% Collateral Enhanced Project Financing" structure is as follows:

1. An International Due Diligence/law firm completes preliminary due diligence and underwriting of the given project based on the "high level" business plan provided by the Principals of the project.

2. A Top Rated World Bank commits to fund the specific project subject to receipt of a "certified" due diligence and underwriting package from the international law/due diligence firm AND receipt of the acceptable cash-backed collateral (financial instrument).

3. A Collateral Investor (major, financial institution, trust management firm, hedge fund, etc.) issues a commitment to purchase the required cash-backed collateral (financial instrument) on behalf of the project (also subject to receipt of a certified due diligence and underwriting package from the international law/due diligence firm)

4. The due diligence/law firm completes the necessary due diligence and underwriting for the project.

5. Assuming no fraud or misrepresentations are found during the due diligence and underwriting process, the due diligence/law firm gives the "green light" to the bank and collateral investor/provider.

6. The Loan proceeds are deposited in escrow by the bank. The Financial instrument is deposited in escrow by the collateral investor/provider.

7. A "simultaneous" closing occurs wherein the cash-backed collateral/financial instrument is pledged as the sole collateral for the project and the funding bank disburses loan proceeds to the borrower.

Bryan J. Clark is President and CEO of Lion Commercial Funding Consultants Inc. Lion CFC maintains relationships with real estate investment trusts, hedge funds, and a variety of private money pools. The firm is a leader in innovative alternative finance structures and solutions involving standby letters of credit, bank guarantees, medium term notes, bills of exchange, and "take or pay" contracts. Mr. Clark is a member of the Urban Land Institute and contributing writer to various monthly publications. Mr. Clark can be contacted at 858-602-8080 or info@lioncommercial.com Extended Bio...

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