How can commercial real estate debt platforms achieve returns in the face of economic and interest rate uncertainty? An important part of the picture is how they use back leverage at a time when the cost of debt is rising.
Back leverage – including loan-on-loan financing – is used by debt fund managers to enhance internal rates of return by using debt at a cost lower than that of the equity commitments to the fund. In return, back leverage providers benefit from providing facilities with asset-backed protections and better regulatory capital treatment than if they lent directly to an unrated fund.
However, debt fund managers that use back leverage are now subject to the higher cost of finance due to interest rate rises in the past year. For those managers, an obvious mitigant to the elevated costs of finances is the potential for higher returns achievable on the underlying property loans they provide.
We are also seeing lenders and users of back leverage structure loans to mitigate the risks that higher rates and economic uncertainty pose. For example, we have seen back leverage structured with different margins applying to loans backed by real estate across different subsectors and geographies, thereby adjusting for a diversity in risk profiles.
Fluctuating valuations mean margin call mechanisms can be unpalatable, especially to smaller and medium sized debt fund managers with limited access to alternative funding lines, or the option to voluntarily deleverage.
Therefore, we are seeing cases of margin call mechanics replaced by a more consensual approach whereby banks offer margin call holidays in return for reductions in the advance rate they will provide to the manager. It is also typical for advance rates to ratchet up as more assets are added to the line.
Other structuring options include protections being offered to lenders in return for better terms or increased advance rates. For example, debt fund managers have been seen to use orphan SPVs as back leverage borrowers, as they are bankruptcy-remote and not part of any corporate group, thereby mitigating any ‘double credit risk’ that the back leverage provider would otherwise be taking against both the fund and the underlying credit.
We have also observed back-to-back financial covenants in the back leverage documents, sized on underlying loan covenants as well as cure provisions and grace periods for whole loan breaches before a back-to-back event of default is triggered, which are akin to the protections afforded to mezzanine lenders in a more traditional senior/mezzanine real estate financing.
Debt fund managers may also negotiate whole loan enforcement flexibility, including provisions that allow the manager to swap the underlying loan for borrower equity, while leaving the back leverage intact.
Managers with a multi-currency strategy may also establish fully cross-collateralised structures, with a surplus in one set of cashflows reallocated, and exchanged on a cross-currency basis, to fund shortfalls in another.
We are also seeing true sub-participation – where a manager sells parts of the underlying loan to other finance providers instead of a loan-on-loan – being considered by fund managers as an alternative to loan-on-loan finance as a means of de-risking in an uncertain economic environment.
To the extent permitted by a debt fund’s organisational documents, fund-level recourse, or limited fund guarantees, can also bolster the bank’s collateral package. This, again, should translate into improved terms for the user of the back leverage. Moreover, careful drafting of back leverage facilities can eliminate the risk of benchmark – for example SONIA – mismatches between the interest receivable on the underlying loan and the interest payable on the back leverage.
While structured solutions, including the repackaging of loans into notes that are used as collateral in a repo, CRE collateralised loan obligations and private securitisations, may come with higher upfront costs and greater complexity than traditional loan-on-loan transactions, such structures can provide attractive pricing for the borrower because back leverage providers can treat the financing as, for example, a senior tranche of a securitisation, which is beneficial to them from a risk-weighted assets perspective.
In short, back leverage lenders tend to fall into two camps – those with a credit mindset, which undertake detailed due diligence on a smaller number of assets, demand discretionary approvals and control over material decisions at the underlying loan level – and those with a fund finance mindset, relying on detailed diversification and eligibility criteria in the context of a larger pool of assets and the fund manager’s track record, plus some step-in rights.
In the absence of a commercial real estate CLO market in Europe, where the latter ‘fund finance’ approach would be more prevalent for the larger players, the former, credit-based approach to back leverage dealmaking is likely to continue for now.
Medium-sized debt funds with portfolios that are not big enough to warrant a full-blown CRE CLO but are too big for smaller loan-on-loan financings may find it more difficult to obtain the back leverage they need. Against that backdrop, offering back leverage providers additional controls may be a necessary bargaining chip for funds aiming to achieve attractive returns in a time of economic uncertainty.
Richard Hanson is a London-based partner at law firm Morgan Lewis. He advises alternative investment funds and asset managers on structured finance, securitisation and bespoke finance solutions
Julius Maximilian Rogenhofer is a London-based associate at Morgan Lewis. He advises banks, investment funds and asset managers on a range of structured finance transactions