Willingness to Pay, and Crescent Resources

Generally, borrowers pay until they can’t (a theory I discuss in more detail in “Does Recourse Matter on Income Property Loans?"). There are exceptions, of course; a recent example is Crescent Resources, LLC, which (along with more than a hundred subsidiaries involved in separate developments) filed bankruptcy last week. From Pensions & Investments:

Crescent Resources LLC, a joint venture between Morgan Stanley Real Estate Fund V U.S. and Duke Energy Corp., filed for Chapter 11 bankruptcy protection to reduce the debt level and improve the capital structure. Investors in Fund V include the $40 billion Pennsylvania Public School Employees' Retirement System, $119 billion California State Teachers' Retirement System and $6.2 billion San Bernardino County (Calif.) Employees' Retirement Association.

Although Morgan Stanley and Duke Energy (as well as their pension fund partners) are down, they’re certainly not out, and if they chose too they have the ability to write whatever checks were necessary to pay their debts as agreed.

The lesson is, although ability to pay is a necessary condition for a good CRE loan, it’s not a sufficient condition.

Morgan Stanley Real Estate Group: The Problem With Partners II

Morgan Stanley’s real estate partners are not happy.  Excerpts from Pensions & Investments:

Two investors — the $60.5 billion New Jersey State Investment Council and the $3.86 billion Contra Costa County Employees Retirement Association — backed out of their commitments to its latest closed-end fund, the approximately $5 billion Morgan Stanley Real Estate Fund VII. Contra Costa had committed $75 million; New Jersey, $150 million. (Fund VII is closed to further commitments but is technically open to tie up loose ends, according to sources close to Morgan Stanley.)

•Its $5 billion open-end core real estate fund, the Morgan Stanley Prime Property Fund, has a line of investors asking for a total of more than $500 million in redemptions as of year-end 2008. The fund returned -19.8% for the 12 months ended March 31, underperforming the NCREIF Property index but outperforming the NCREIF Open-End Diversified Core Equity index, according to fund information provided to investors.

This is not just a Morgan Stanley problem, of course; general partners in all types of private equity funds are worried about their limited partners performing on cash calls. From the Wall Street Journal:

How worried are private-equity-fund managers that their investors might not be able to meet capital calls? Very, if the results of a new survey by Private Equity Analyst are any indication.

The Sources of Capital survey asked fund managers, also known as general partners, to rank how important a variety of characteristics of investors, or limited Partners, are to them. Of respondents, 84.8% listed an ability to meet capital calls as extremely or very important, second only to their desire that investors be long-time participants in the asset class, at 88%.

The rapidity with which the inability to meet capital calls has emerged as a problem has been stunning. It wouldn’t even have occurred to us to ask this question a year ago. Now, as the response to the survey shows, there are fears that this is going to become a widespread phenomenon.

It’s almost inevitable that when one partner provides expertise and the other partners provide most of the money, there is going to be a falling out when performance declines (see my related post, The Problem with Partners).

The Problem With Partners

From Luke Johnson’s column in the Financial Times, “Time of Trial Brings Out Our Litigious Side”:

The truly vicious [lawsuits] are those where professional partners have a dispute…Falling out can arise through envy, through desperation, through honour, and a feeling that some are not pulling their weight. Writs are being served all over the place for non-payment of debts, warranty claims over failed acquisitions, unfair dismissal and who knows what. The air is thick with recriminations and resentment, as the Great Recession leaves lots of people broke, unemployed or looking stupid and out for revenge.

Partnerships in various forms (general partnerships, limited partnerships, limited liability companies, tenancy in common) are very common ownership structures in commercial real estate. Sometimes they represent equals pooling resources to acquire and operate properties larger than the individual partners could acquire on their own. More often, the partners bring different things to the table; for example, investors with money but without a lot of real estate expertise invest funds with a general partner that has expertise but not a lot of money.

This all works well until it doesn’t. When a property severely underperforms, few partnerships survive. If additional cash is required, the money investors often balk or expect the general partner to contribute an equal amount or step aside. Even if contributing additional cash to save the investment makes sense, too often partnership differences prevent an economically rational solution.

Lenders often depend on the financial strength of the investor partners, and don’t realize that more often than not the money partners will not support a deal when they’ve lost confidence in the general partner. The greater the number of partners, the greater the difficulty. The sad story of DBSI (see this link) is an extreme case which is being repeated on a smaller scale on a daily basis.

The safest ownership structure is a single experienced, financially strong operator. If you can’t have that, a partnership of equals is your best bet. Partners with unequal resources are their own source of trouble when the going gets tough.

Complexity is not a Virtue

The General Growth Properties bankruptcy filing actually involved 166 entities (here's a link to the petition). To help everyone understand the relationships between the entities, a helpful organization chart was provided:

(Click on image for a larger version in a new window)

Clear? Oh wait, there’s more:

And more:

And more:

And more:

In fact, there are 25 pages of organizational charts like these. No doubt there were clever reasons to create this web of entities, but it seems obvious now that some of the intellectual firepower that created this rat’s nest should have been directed at managing debt maturities.

There isn’t any available data to test this hypothesis, but one of my rules of thumb is the risk of default is positively correlated with the complexity of the borrower’s organization.

Let the Judge Sort Them Out: How Bankruptcy Remote are Single Purpose Entities?

CRE lender standard operating procedure is to make loans to entities whose sole purpose is to own the real estate collateral. The goal (as I’ve posted about here) is to ensure the loan is not entangled in a bankruptcy related to other obligations of the borrower. From an Arent Fox article:

Lenders customarily require that the real estate projects they finance be owned by SPEs. In this context, use of the SPE structure is designed to confine the lender's risk to the particular real estate asset being financed and to avoid the problems encountered when a borrower with multiple assets files a bankruptcy petition…

The SPE structure will, in fact, isolate the property from other assets and focus the bankruptcy risk on the specific property.

So, the fact that the General Growth Properties’ bankruptcy filing includes a list 12 pages long of what appear to be more than 100 single purpose entities is causing some consternation. From Law 360, “For Commercial Market, Mall Giant May be 1st Domino:”

The number of entities that were listed on GGP's bankruptcy petition has raised the eyebrows of some attorneys who question the justification of putting solvent entities with no debt into bankruptcy in the first place.

Burroughs [Katherine A. Burroughs, a partner at Dechert] said a preliminary issue in the proceeding will be whether the court should allow the parent company to cause the independent entities to take on additional debt solely to benefit the parent.

“If GGP is successful in having these entities stay in, this could have a significant chilling effect on structured finance going forward,” Burroughs said, explaining that many structured finance deals are premised on keeping solvent entities out of the bankruptcies of parent companies.

Foley [Doug Foley, chair of the bankruptcy practice at McGuireWoods LLP] said GGP could have included these entities in the filing as a means of protecting them if the debtors had some cross-collaterization issues with other lenders.

They could also have been included to provide collateral to support the DIP loan, he said.

Nolan [Thomas Nolan, chief operating officer of GGC] said that the primary consideration for including certain properties in GGP's filing was the capital structure of each individual property, including the amount and terms of each property's mortgage.

Some properties were not included because they already have extended maturity dates, and there was nothing that could be gained from the restructuring process, Nolan explained.

A simple explanation could be that, although each asset is owned by a separate SPE, they are security for credit facilities which include many assets and which need a maturity extension (some of the org charts accompanying the filing support this theory). Or, it could be the bankruptcy equivalent of the Special Forces slogan, “Kill them all and let God sort them out.”

Single versus Multi-Asset Borrowers

One of the most irritating workouts I’ve participated in happened in Los Angeles in 1992 while I was Assistant Director of Special Assets at Home Savings (then the country’s largest S&L). Irritating, because the problem was largely self-inflicted.

We had made 17 loans secured by apartment buildings to Shashikant Jogani. At the time, Shashi was one of the largest apartment owners in Southern California. From a later court filing:

In 1979, plaintiff Shashikant Jogani (who prefers to be called Shashi on appeal) began investing in residential apartment properties in and around Los Angeles County. By 1989, he owned properties having a fair market value of $375 million and a net equity of $100 million. Because of an economic recession that started in the late 1980’s and continued into the mid-1990’s, Shashi faced defaults and foreclosures on valuable properties.

We knew some of our deals with Shashi were struggling, but we thought most of the loans would weather the storm. However, Shashi and his advisors asked for a meeting and presented an ultimatum – modifications to all his deals, or he would file bankruptcy.

At that point in the recession we were well acquainted with bankruptcy proceedings; in fact, sometimes we required borrowers to file bankruptcy to confirm our workout plan so if there was a subsequent default we wouldn’t have to go through an adversarial bankruptcy filing then. So, the threat of a bankruptcy filing ordinarily was not something that concerned us. Shashi’s case was a different, because he held almost all of his properties as an individual. A bankruptcy filing would not just involve our 17 properties, it would involve more than 50 properties and more than a dozen lenders. It would be a procedural nightmare, and there was a good chance our properties which had equity would end up supporting other lenders’ problem properties. Shashi of course knew this, and used it as leverage to negotiate with all his lenders.

We ended up agreeing to split the properties into three groups. For the most severely troubled properties Shashi stipulated to the appointment of a receiver and did not oppose our foreclosures. The marginal properties got substantial modifications (a significant reduction in interest rate for an extended period). For the properties which were performing adequately we agreed to an interest only period and allowed the excess cash flow to support Shashi’s other deals. And, we required Shashi to form separate legal entities for the properties which received modifications and transfer ownership to those entities so if the modifications didn’t work out we would not be facing the same nightmare again. As it turned out that requirement was a good idea, because Shashi subsequently defaulted on the marginal group.

Most lenders require a single asset borrowing entity to avoid these kind of entanglements. However, this ownership structure can protect owners too. The Pierce County Housing Authority recently learned this lesson; lawsuits related to mold at one of its apartment complexes put the entire Authority into bankruptcy a few months ago. From the Tacoma News Tribune:

 

The Pierce County Housing Authority prefers to declare bankruptcy rather than fight multiple lawsuits over a mold-ridden apartment complex in Puyallup.

 

The agency’s six-member board of commissioners voted Monday to take the step. If approved, bankruptcy protection would prevent 81 current and former residents from collecting damages they say they suffered from mold at Eagle’s Watch, a 193-unit complex on South Hill.

 

Charlie Gray, deputy director of the Housing Authority, said Wednesday that bankruptcy is the only way the agency can continue to operate and provide affordable housing for about 8,000 clients throughout the county

 

…[The Housing Authority] owns 1,123 apartment units in 13 complexes throughout the county, along with 134 homes.

Had Eagle’s Watch been owned by a single asset entity, it’s likely damages would have only attached to that single asset.

Isolating ownership of multifamily projects makes sense for both owners and lenders.