One of the first non-bank property lenders in Europe, DRC Capital has expanded its repertoire to include senior lending to under-banked sections of the market. Daniel Cunningham met the partners.
When the banks pulled back from European real estate lending after the Global Financial Crisis, DRC Capital was one of the first alternative sources of money to move in.
Back in 2008, the three founding partners of the London-based debt fund manager set out to plug a gap. Banks’ willingness to lend fell short of borrowers’ financing needs, creating the opportunity for high-yielding property lending for those prepared to take the risk. The trio raised capital from insurers and pension funds to channel into the market.
At the time, non-bank property lenders were viewed by some as opportunists who would not be around to refinance the loans they provided. However, DRC has become something of a fixture on the lending landscape. As the real estate markets around it have changed, so too has the firm.
“Those of us who raised capital between 2008 and 2010 were making mezzanine loans to deleverage the banks, but we’ve moved on quite a bit since then,” explains Dale Lattanzio, one of the founding partners and the ‘D’ in DRC. “The market has opened up and we’ve changed our strategy to incorporate the new liquidity which has come into the sector, not only from banks, but also from institutional investors.”
DRC is best known for the ‘high-yield’ lending with which it made its name. That strategy today comprises mezzanine loans, whole loans and bridge finance. “The other part of our business, which we’ve been developing over the last two years and is probably lesser known is senior lending,” explains Lattanzio.
Through a mixture of segregated mandates and a co-mingled fund, the company has been building up a senior lending business, which like the high-yield strategy focusses on parts of the market which the banks are not serving. The senior platform is expected to comprise €500 million of raised and invested capital within six months’ time, and further growth is planned.
It means that Lattanzio and fellow founders Rob Clayton and Cyrus Korat (the ‘R’ and the ‘C’ of the company name) now oversee a lending business which aims to generate “high quality returns” across the capital stack.
The trio came together in 2008 at the alternative asset management firm Duet Group. Lattanzio and Korat had both worked at Merrill Lynch and Clayton’s background included finance roles at investors Topland and CIT. The maiden fund, raised under the auspices of Duet, was the high-yield European Real Estate Debt (ERED) I. Launched in early 2009, it reached final close in Q3 2011 at more than £300 million, with a listed £76 million feeder fund invested in it.
DRC was set up as an independent business, fully-owned by the partners, in early 2012. The second ERED fund was launched soon after, reaching final close on £487 million in 2014. High-yield debt is currently being written through that and a third ERED fund.
The senior programme features three European Real Estate Senior Debt (ERESD) funds, the first two comprising one or two investor commitments. As previously reported, the cornerstone investor is believed to be Finnish institution Pohjola. ERESD III is a comingled vehicle, which currently stands at around €200 million with a further €50-100 million expected to be raised in the coming six months.
DRC’s activities are managed by a team of 20 from what Lattanzio jokingly calls DRC’s “World Headquarters” on Duke Street in London’s upmarket St James’s.
The most significant recent addition to the team is Trevor Homes, formerly of Gatehouse Bank and ICG-Longbow, who joined in October to head the senior lending drive. He was joined by former Gatehouse colleague and CBRE Capital Advisors alumnus Graham Fasham. With the hires, DRC aims to bring more cohesion to its senior strategy.
“We think there’s a tremendous opportunity in the senior market because we see that the banks are providing increasing liquidity, but to a smaller sub-set of the market,” explains Lattanzio. “We’re banking some of the clients which used to have access to that liquidity but no longer do.”
The sweet spot for senior loans is within the €20-50 million size band, below the level that is currently interesting the banks. Leverage is provided up to around 60 percent. Sponsors are typically investors seeking opportunistic and value-add investments; the type of borrowers which many banks are side-stepping but which have been DRC’s customer base since it set up shop.
Increased uncertainty in the market in the aftermath of the UK’s vote to leave the EU in June has brought an increasing number of that type of borrower to the table, explains Clayton: “It’s not as if different types of people have come through the door in the last six months. More people have come to us, but they are similar to the types of borrower we’ve always worked with.”
Korat adds that senior lending dovetails well with the firm’s higher-leverage lending: “We talk to the same borrowers about both products because most of them operate across multiple types of property and we want to provide them with the breadth of products they need, while matching what our investors are trying to achieve.”
Capital for the senior funds has been raised from European and North American institutions, usually investing through their fixed-income allocations rather than their real estate buckets.
“The senior space is like a fixed-income replacement where investors are looking to try and generate some real yield compared to where fixed income is at any given moment, but they are obviously looking to take less risk,” explains Korat. “In the high-yield space, investors are seeking double-digit returns and they are comfortable with that level of risk.”
“The nature of allocation is beginning to change,” adds Lattanzio, “and that is really down to the establishment of private debt as an asset class.”
The need for higher-leverage finance remains, the trio believe, and DRC is currently raising for its ERED III fund. The target volume is £500 million, with a £700 million hard cap, expected to be wrapped up early next year.
Mezzanine lending typically goes to around 75 percent and DRC is able to create mezzanine strips by writing whole loans and placing the senior element with either a bank, insurance lender or another debt fund. As liquidity in the market has increased, so have the firm’s options when approaching a financing.
DRC’s track record in high-leverage debt has made fundraising easier, explains Clayton: “People get the debt space more than they did when it was nascent. It’s here, it’s real and that’s a good thing. We have been successful at fundraising and we have been successful at deploying and that’s hugely helpful.”
The first ERED fund targeted a gross IRR of 15 percent and Korat says that the high-yield strand of the business still targets similar returns. “We’ve been remarkably consistent across our three funds and although we have generated returns in slightly different ways, the result has been pretty much the same. We’re looking for mid-teens returns and by and large we’ve been achieving them.”
Does this mean DRC is taking additional risk?
Korat explains that, in the early days, there were fewer high-yield deals in the market, but also fewer lenders, so DRC could lend on quality properties and be rewarded for it. The risk element then came from the lack of senior liquidity, equity and pricing transparency. Today’s market might be more competitive, but the firm is able to take a more confident view on the prospects for the underlying property due to the increased volume of investment and lending across the sector.
“People say to us ‘you must be taking more risk if you’re generating a similar return to 2009’,” adds Lattanzio, “but I explain to them that while we might be taking a little more property risk, that is off-set by the fact we have a lot more certainty as to where the real estate fundamentals are.”
Market visibility has become somewhat clouded since the UK’s June referendum, but Korat argues that rigorous analysis of the downside to any deal is always crucial to debt providers. “We’re supposed to be a bit pessimistic,” he says. “We have to worry about what can go wrong. We might be slightly more careful in some of our assumptions now than we were before, but we are still fundamentally cautious.”
Starring role at Pinewood
By geography, DRC’s core markets are the UK, Germany and France. Deals have also been done in the Benelux and, to a lesser extent, Scandinavia. Southern Europe has been less of a focus, although a deal each has been closed in Spain and Italy this year.
Although DRC is looking at several continental European opportunities at the moment, Clayton denies that the focus has shifted away from the UK. The pipeline “ebbs and flows” between the UK and continental Europe, as well as between refinancing and acquisitions, he explains: “Right now it’s fair to say that we’re seeing more refinancing deals in the UK and more acquisition on the continent, but that will change.”
Since the EU referendum, DRC has closed two UK deals; the financing of a large supermarket in the outer London borough of Croydon, and – arguably its most glamorous deal to date – a loan to partially fund the recent takeover of film studio owner Pinewood Group.
DRC’s £60 million mezzanine debt facility supported Aermont Capital’s takeover of the owner of the iconic studios near London where blockbusters such as the James Bond franchise are filmed. The debt was originated through the ERED II and III high-yield funds and sits alongside around £100 million of incumbent bank debt. Lattanzio attributes winning the Pinewood deal to the firm’s ability to arrange the loan within a short timeframe “with as few moving parts as possible”.
Such deals can only raise DRC’s profile in the market, and it is hard to imagine that the independent company has not been subject to takeover interest from bigger organisations. Its debt fund peers have gradually been bought by larger investors; Renshaw Bay agreed to sell its real estate finance business to Swiss asset manager GAM last August, soon after Italian investment bank Mediobanca bought a 51 percent stake in Cairn Capital. In 2014, alternative asset manager Omni Partners bought 40 percent of Brookland Partners.
The DRC partners decline to comment on whether they have also been approached by any bigger buyers, but pressed on growth plans, Lattanzio says: “On our own we can at least double the business, and that’s been our operating premise.”
“We’ve grown the business because we are confident that non-bank debt is going to play an important and permanent role in the marketplace,” he continues. “The need for debt is not just in high-yield, it’s in other parts of the capital structure, so I wouldn’t be surprised if we weren’t launching another strategy which is different to the two we already have.”
That could be development finance, or it could be a sector-specific strategy, Lattanzio says. “It will be driven by the fact that the banks that used to provide everything are no longer doing so.”
“It’s still not a hugely intermediated market,” adds Clayton, “it’s still pretty much borrower to lender. People value relationships in that context. Borrowers that have done deals with alternative investors have liked what they have seen and so they are doing repeat business. It’s old-fashioned, but it’s happening.”
As for the argument from some bankers that debt funds like DRC have not proven themselves through a whole cycle, Clayton admits to finding it an “amusing” position. “Where were they when the last cycle finished?” he asks.
“If you start from the premise that the banks cannot satisfy all the requirements for commercial property in Europe, the question is where will the capital come from?” says Lattanzio. “It’s unlikely to come from the capital markets because we haven’t seen CMBS take root with bond investors, so we are left with the institutions, and funds play a role intermediating savers’ capital into the market. I think it is permanent and it’s really just started, but it’s not going in reverse.”