Is now the time to buy a debt fund?

The rising popularity of real estate debt generates M&A opportunities, but the lack of independent debt fund businesses limits the scope for consolidation.

When Savills Investment Management bought a minority stake in real estate debt fund manager DRC Capital in July, chairman Nick Cooper described how the deal will broaden the firm’s investment proposition.

“With the benefit of regular income and the borrower’s equity cushion, debt is often seen as an attractive alternative to direct equity investment,” said Cooper. “With Savills IM primarily adopting an income-style investing approach, we believe that the investment fundamentals of debt investing make it attractive to offer both strategies throughout the whole cycle.”

Six years after London-based DRC was founded by a trio of former property bankers, the real estate investment management business of property services firm Savills owns an initial 25 percent stake, with the option to acquire the remaining 75 percent in 2021.

Although the value of the deal was undisclosed, its structure suggests DRC’s partners expect the company to grow in value by the time its part-owner has the opportunity to buy it outright.

“Vendors in these minority deals are prepared to maintain the majority of the ownership for a period because they believe in the value of the business going forward. This shows their commitment to the growth story and the opportunities in the real estate finance sector,” explains Christopher Sullivan, partner at Clifford Chance, the legal advisor to DRC in the transaction.

In October 2016, DRC co-founder Dale Lattanzio pointed to the firm’s growth plans when Real Estate Capital asked whether the firm had been approached by potential suitors. Lattanzio declined to comment on specific approaches, but said: “On our own, we can at least double the business, and that’s been our operating premise.”

The property debt fund manager, considered a significant player in the flourishing alternative real estate lending space in Europe, has arranged more than £2.6 billion (€2.9 billion) of debt investments and has assets under management of £2 billion across a range of senior debt, high-yield and wholeloan products.

As Savills and DRC team up, their “complementary resources and strengths” will help to grow the platform over the next three years, Lattanzio told Real Estate Capital following the transaction.

DRC’s peers in the non-bank property lending space seem to agree. The deal is a “smart” move, as a rival property debt fund manager, who prefers to remain anonymous, puts it. “It’s probably a win-win for both parties involved.”

“While DRC will benefit from a cash injection, Savills gets into the business of lending with access to fee-generating assets under management without the headwind of hiring a team and building a portfolio from scratch,” the manager adds.

ASCERTAINING VALUE

Savills IM’s vote of confidence in DRC and entry into the real estate lending business comes at a time when debt is seen to offer a defensive method of investing in European property late in the real estate cycle.

“Investors undoubtedly want to put more money into property debt. This is becoming an established asset class,” argues Anthony Shayle, head of real estate debt EMEA at UBS Asset Management.

Indeed, fundraising activity has been in full swing, with total Europe-focused real estate debt raised in H1 2018 totalling $3.3 billion, up from $1.74 billion over the same period last year, according to Real Estate Capital data. In 2017, total fundraising reached $9.53 billion, almost double that of 2016.

Although many agree real estate debt is a market in growth mode, valuing alternative debt fund businesses is a challenge, with so little M&A activity having taken place in what remains a relatively nascent industry. Many debt fund managers are expected to increase their assets under management, a
crucial metric by which to value debt funds along with fees to investors.

Valuations of debt funds, like with property equity funds, also depend on the property cycle, argues Neil Odom-Haslett, head of commercial real estate debt at Aberdeen Standard Investments.

“When you look at the equity market, values will have a weighting towards earnings potential depending on where [investors expect] they are going to be in the next 12 months. However, for debt funds the valuations will be more weighted to actual performance – with promote structures for future growth,” Odom-Haslett explains.

Shayle points out that fund valuations often depend on the type of lending debt funds engage in. “If a debt fund focuses on senior debt where the return is effectively the front-end fee and the interest rate, it is possible to be valued using amortised costs which may be less sensitive to interest rate changes. This is typically equivalent to a core-style investment.

“Debt funds where the performance of the loan is linked to the performance of the underlying assets, will more likely use a mark-to-market or fair value model which can experience more sensitivity to interest rate changes, especially in the forward-looking environment of potentially rising interest rates. These loans, that may well be higher loan-to-value than 65 percent, are more likely to be perceived as equivalent to value-add investment,” Shayle explains.

Interest rates play a key role in fund valuation, in that an increase could result in a fall in capital values of a portfolio. “The profit of property debt, especially when valued on a fair value basis, is volatile, because it’s linked to interest rates,” Shayle adds.

LIMITED SCOPE

Soon after the Savills IM/DRC deal, Cain International announced the acquisition of a majority stake in Fortwell Capital, providing a capital injection of £400 million into the UK-based boutique bridging and development finance specialist. These recent deals add to a handful of examples of independent
debt providers being acquired by larger organisations. In 2015, Renshaw Bay sold its real estate finance business to Swiss asset manager GAM, soon after Italian investment bank Mediobanca bought a 51 percent stake in Cairn Capital.

It is unlikely there will be a flurry of M&A deals in the real estate debt space in the short term, as there are fewer independent firms out there, Shayle explains. “In order to start achieving consolidation, you need more independent debt funds being launched. But there are quite big hurdles to launching a new debt fund – you need an infrastructure […] and a sponsor for the startup costs.”

Recent launches of property debt businesses have been more likely to come from large asset managers such as Schroders, Amundi and BNP Paribas Asset Management, branching out into the real estate debt fund space.

For Clifford Chance’s Sullivan, this might create an opportunity for spin-offs and the set-up of independent firms. “Investors are starting to understand the attractiveness of real estate debt funds business, it’s an early stage but deals like DRC have helped to put real estate debt funds on the map for investors.”

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