Loan on Loan Transactions: Special Considerations for Financing Purchases of Mortgage Debt and Mezzanine Debt in Loan to Own Transactions

Andrew Lance

Partner at Gibson, Dunn & Crutcher, LLP, Resident in the New York office

Samuel Goldberg, Gibson, Dunn & Crutcher, LLP, summer associate

Introduction: Loan on loan financing is a relatively recent institutional lending product designed to help combat the dearth of capital, in the wake of the credit crisis, available for acquiring small and large dollar value individual commercial loans and large portfolios of diverse distressed loans. The product consists of loans offered to finance the purchase of one or more other loans, whether mortgage or mezzanine debt. The product can be originated for a new borrower, alone or in partnership with others including the existing owner/borrower. The diagram below illustrates a typical pre-transaction debt structure, in which “OP” is an operating partner and “CP” is one or more capital partner.

Property

Mortgage Loan

Mezzanine Loan

Structurally subordinate, collateral is original borrower’s equity

Structurally senior, collateral is property

Diagram 1: Pre-Transaction Debt Structure: 1

1 The comments of Erin Rothfuss, a San Francisco based partner, and Matthew Kidd, a New York based associate,

of Gibson, Dunn & Crutcher, LLP, and our ACREL volunteer editor Michael Buckley of Fennemore Craig Jones Vargas’ Las Vegas office, are gratefully acknowledged.

Why Do Investors Seek Out This Financing? Reliance on mortgage loans rather than on real estate itself, as collateral for a new loan, is unfamiliar territory for many lenders, particularly in an environment in which the security of even senior mortgage loans has been tarnished. The resistance of many lenders to make such loans tends to require purchasers of existing mortgage loans to fully fund such purchases with cash, driving down pricing (and thus return of capital to distressed lending institutions which are sellers), and slowing the pace and breadth of repositioning such assets and the recovery of real estate assets generally. Loan on loan financing offers a number of significant advantages for both investors purchasing distressed debt and the lenders providing that financing. This financing can reduce the entry barrier for investors in loan acquisitions by providing capital to pursue the purchase of large loans or large portfolios of loans. Loan on loan financing increases the purchasing power of distressed debt investors by advancing the funds required to purchase a note that is in turn pledged as collateral to the lender. Investors who might otherwise be precluded from purchasing a note due to limited available capital or to the unique nature of the collateral (as a debt instrument rather than real estate) can close the gap between the purchase price of a note and the investor's capital. This financing mechanism thus may facilitate otherwise impossible deals, by improving proceeds to selling institutions while providing leverage to achieve target yields for buyers. Distressed debt financing by its very nature requires deal-specific solutions tailored to small, large, and fluctuating sizes of capital. Many distressed loans are non-performing, so the capital provider must be comfortable with non-income generating collateral. The investor often will have a relatively short period of time to raise the funds to acquire the distressed asset(s), and then will need to bridge the period between acquisition of the existing loan, through realization upon the underlying collateral (whether by foreclosure or deed in lieu) to, ultimately, achievement of the business plan milestones, when more conventional financing or additional equity capital may be available. The investor’s execution of remedies with respect to a distressed asset can involve significant legal expenses as well as carry costs for the underlying asset, and stepping into ownership of the asset may require immediate expenditures for repairs and deferred maintenance, utilities, security, tenant improvements and brokerage commissions. Financing of this type can significantly increase the yields realized by the investor- borrowers. Not only does financing of distressed debt acquisitions provide leverage that magnifies the internal rates of return on note purchases,2 but financing also allows investors to stagger capital outlays and avoid actual interest expense pending acquiring control of the underlying assets and execution of the repositioning plan. At the same time, the risk adjusted return from lending to a buyer of a distressed note is often higher than the return which otherwise would be realized if the lender were to directly acquire the loan.3 When stiff competition arises between potential

2 A10 Capital Provides $4.6 Million to Finance a Distressed Debt Purchase, Business Wire (Jun. 8, 2009),

http://www.thefreelibrary.com/A10+Capital+Provides+$4.6+Million+to+Finance+a+Distressed+Debt...-a0201433158.

3 Joe Ragazzo, supra note 2.

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purchasers of a note, firms that would otherwise bid directly to acquire the note may instead obtain lower loan to value ratios and thus a better risk to reward ratio by offering financing to the ultimate purchaser. Current macroeconomic circumstances help fuel the demand for loan on loan financing; over the next five years, approximately $1.7 trillion in commercial real estate debt is scheduled to mature.4 Because property owners face significant challenges in refinancing those loans, given a relative dearth of capital available in the market,5 financial institutions, seeking to close out their positions in these loans, are priming (and occasionally flooding) the market with distressed debt. Opportunistic distressed debt investors lament having to purchase the notes in all-cash transactions.6 In many of these transactions, the loan purchasers assume that they cannot finance their acquisitions until after the resolution of the loan.7 Loan on loan financing is an essential product to help close this market gap and facilitate financing prior to loan workouts. Loan on loan financing is still relatively scarce, in part because such financing most often is not initially secured by a direct first mortgage or a direct property interest. Few traditional lenders offer such financing on single-loan sales.8 Moreover, many traditional lenders, including savings and loan associations and banks, have limited capacity for issuing any loans on real estate, including indirectly through loan on loan financing, as they attempt to reduce their overall real estate exposure.9 Given the challenges particular to loan on loan financing, these traditional lenders are even more reluctant to issue loans secured by other real estate loans.10 Loan on loan financing for large loan purchases is even rarer.11 Thus, those lenders who do provide loan on loan financing face high demand for their loans and enjoy relatively strong bargaining power when negotiating loan terms. The above factors combine to create a market environment in which lenders who are risk averse still can profit by offering prudent loan on loan financing. Some institutions offering loan on loan financing do so with hopes of partnering with the underwater borrower or a third party investor to acquire the property directly by completing, after the borrower or investor acquires the loan(s) with such financing, a foreclosure on the loans or by negotiating a deed in lieu with the borrower. Conceptually the lender functions as an equity partner, seeking rights and returns analogous to an equity investment. In certain instances, however, an actual joint venture is not a suitable investment vehicle for a lending institution, so the loan documents incorporate elements of a synthetic equity investment. In many other instances, the lending institution has more mainstream motivations: to make a loan secured by an asset class which is under-appreciated by its competitors, or where it can command above-average yields.

4 Joe Ragazzo, Lenders, Investors Seeking to Leverage Distressed Note Purchases, DebtWire, (Apr. 27, 2012),

http://www.madisonrealtycapital.com/_files/2012_4_27_leveragedistressedpurchases.doc.pdf. 5 Id. 6 Id. 7 William T. Cavanaugh, Dallas Bar Association Real Property Section, Acquisitions and Dispositions of Non-

Performing and Sub-Performing Mortgage Loans 1, 6 (2010). 8 Id. 9 Id. 10 Id. 11 Note Purchase Loans, A10 CAPITAL, (Jun. 12, 2012, 2:20 PM), http://www.a10capital.com/lending/distressed-

debt-financing.html.

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Loan on loan borrowers usually are existing borrowers or third party investors. Such borrowers seek financing to pursue loan to own strategies. Loan to own strategies have largely focused on acquiring one or more existing mezzanine loans as the point of entry; mezzanine loans usually are smaller in amount, trade at a greater discount, and give rise to greater investor anxiety about risk, than mortgage loans, due to the first-loss position of mortgage loans in capital stacks and the relatively higher interest rates on mezzanine loans.12 Such borrowers can be an attractive customer base even for lending institutions looking for under-served product niches which can provide returns that represent above-market risk-reward ratios. In this circumstance, a lender that would otherwise be prepared to purchase mezzanine debt or mortgage debt directly decides instead to finance 50% or more of the purchase by its borrower client of an existing loan. The client may be able to obtain from the lender a substantial portion of the purchase price for the loan to be acquired, by borrowing that portion as debt, at half the cost of its own capital, and still end up the sole owner of the property that is the underlying collateral for the acquired loan if the underlying borrower defaults. For the lender, the security for the loan derives structurally from two tiers of loan to value ratios – first, the loan-to-value of its loan to its borrower, and second, the loan-to-value ratio embedded in the collateral (the acquired loan). Why isn’t REPO Financing Performing the Loan on Loan Financing Function? The function performed by loan on loan financing historically was addressed by repurchase agreements (REPOs). A REPO transaction consists of one party (effectively the borrower) selling securities (in this case, one or more distressed mortgage loans or mezzanine loans) to a REPO buyer (effectively the lender/depositor) subject to an agreement to repurchase those securities on a later date at a set price.13 The repurchase price generally includes the original purchase price plus accrued interest. REPOs serve as collateralized deposits that grant depositors the right to claim the underlying collateral when the borrower defaults.14 However, REPOs carry significant downsides and risks. REPOs often are relatively short-term. Further, REPOs were discredited due to accounting manipulations by borrowers in events publicized during the credit crisis. Issues also often arise with respect to mark to market accounting for REPOs. Where the terms of the REPO require the participating institutions to determine the fair market value of REPOs in order to determine whether the value of the borrowing base remains intact, there can be significant difficulties in determining values and possible losses based on trading positions which often are volatile. Mark to market valuation can create problems even where the underlying collateral for a REPO is secure. In contrast, the loan to loan structure can be fluid enough to accommodate the migration of the asset from collateral for a distressed mortgage and/or mezzanine loan, through indirect collateral for a loan secured by the distressed loan, to foreclosure or deed in lieu, and then repositioning to

12 Edward C. Hagerott, Considerations When Purchasing Loans in Today’s Market, THE REAL ESTATE FIN. J., 8, 9

(2009). 13 Tobias Adrian et al., Federal Reserve Bank of New York, Staff Rep. No. 529, 2 (2011), available at

http://www.newyorkfed.org/research/staff_reports/sr529.pdf. 14 Mark Carney et al., Bank of Canada, Financial System Review 1, 31 (2011).

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