Banks in the headlights

In the general media discourse, debt has been the talk of the town for the past year. Most of what is being said, however, isn't very positive. Whether it's the mortgage crisis, the dicey debt packages that were spread throughout the financial markets or the lack of credit, the news isn't filled with very positive messages about debt.

However private equity firms, always game for a bit of opportunistic investing, have been eyeing the possible silver lining in all this mess: the prospect of buying some of the debt now floating around unwanted and at skewed valuations. And it's not hard to see why. Now that the market for loans to back buy-outs has dried up, private equity real estate firms are looking for alternatives. Since the crisis came to a head last August, firms have been abuzz with talk about buying some of this distressed debt at discount prices. And the banks themselves have seemed to be holding out hope that nontraditional debt players would be able to step in and fill the vacuum, solving the debt liquidity crisis by putting a value on the products.

Yet despite these initial high hopes, this massive flood of private equity firms investing from debt funds has failed to materialize thus far. While some major players have launched a handful of new funds, the actual amount deployed doesn't even compare to the level of talk that's been generated on the subject. As many market practitioners have observed, there's a lot more talk about debt in private equity real estate circles than there has been actual money raised. So what's the hold up?

The opportunity
Certainly, there are a number of funds being raised. Last month, Los Angeles-based Colony Capital closed on a $900 million (€612 million) distressed credit fund for property debt. According to people familiar with the matter, the fund was raised from existing longtime Colony investors in just one month. Just a week earlier, the US real estate division of Bahrain-founded investment firm Investcorp launched its $1 billion debt fund, Investcorp Real Estate Credit Fund. In July, Lone Star Funds closed on a distressed fund that will partly target distressed real estate debt. And in May, Apollo Real Estate Advisors acquired a specialist debt company in London and is in the process of raising a European debt fund of up to up to $1 billion. That fund would join the $500 million vehicle that JER is believed to be raising for Europe, following JER's $220 million US debt fund launched last December. Blackstone's $3 billion European real estate fund is also expected to go after debt in a big way.

“A lot of what's going on is counterintuitive in a sense, because the underlying assets are generally still performing.”

Essentially, the real estate debt available isn't “distressed” in the traditional sense of the word at the moment. After all, this isn't debt that's not being paid back or is being defaulted on. Rather it's the holders of the debt that are distressed. When the credit crunch hit, the banks were left holding so much debt that they couldn't syndicate it. What has resulted is a disconnect between the value of the underlying asset and the value of the debt.

“A lot of what's going on is counterintuitive in a sense, because the underlying assets are generally still performing,” says Jay Zagoren, who advises private equity real estate players in the US offices of law firm Dechert. “But the people who are holding [the debt] are being forced by the accounting rules to take an artificial hit.”

“In the real estate debt markets right now, there's not a whole lot of traditional distressed debt out there,” agrees Charles Roberts, a lawyer in the London office of Cadwalader, Wickersham & Taft. “So if that's what all these funds are for, there'd be a lot of money chasing after not a lot of assets. I don't think people raising capital now are looking to sit around and wait for distress. I think they're going to look to buy existing portfolios from distressed sellers, which have overburdened balance sheets and are having liquidity problems at the moment, so they're willing to sell their assets at a discount.”

JER's US debt fund is one such fund pursuing this strategy. And Mark Weiss, president of the firm's debt REIT, JER Investors Trust, points out that the holders of the debt are distressed because spreads have widened so drastically as the market overreacted to what was going on in the US residential market. “You can look at BBB-CMBS as a framework,” he says. “In March of last year, spreads were at 80 over the 10-year swap rate. By September 30 of last year, they had climbed to 450. By December 31, they had widened to 900, and by March 31 of this year it had widened to 1,800. And it doesn't feel like the market's going to correct any time soon.”

As Weiss points out, valuations have changed. For the banks, they're running out of options. Something they've put on their books at X is now trading at Y, and though it isn't correct, there's not much they can do about it. At the beginning of the year, many people were looking to non-traditional buyers of debt, such as private equity real estate firms, to step in and solve this problem. Just a few months ago, at the IMN Real Estate Opportunity and Private Fund Investing Forum in New York, sessions on opportunities in the debt market were jam-packed with delegates, all buzzing with ideas about how private equity real estate could not only generate quick outsize returns from buying these debt products from the banks, but could also solve the debt liquidity problem by correcting the valuations over the long term.

“When the liquidity crisis first started, I was of the view that if in fact this all worked, if [non-traditional debt buyers] were able to buy these assets off the balance sheets of the bank at a certain price, we could solve the debt crisis because we would have injected some degree of liquidity into it,” says Zagoren. “There was a chance to establish what the market price should be. If there were a number of players all trying to bid for it, it would make the valuations on banks balance sheets more realistic. Unfortunately that hasn't happened, my prediction has not been born out.”

The challenge
So if this was such a sure-fire recipe for success, why hasn't it played out yet like some had hoped? Despite all of the talk, there hasn't been an equivalent level of actual capital raised. Like all the best laid plans of mice and men, something didn't pan out. The banks, despite what was predicted, have not been willing to sell yet.

“What's happened is that the pricing for the sale of the assets off balance sheet hasn't reached a level at which the funds are interested in buying, because [the funds] wouldn't be able to meet their return requirements,” says Roberts. “The banks aren't interested in selling at low levels yet because these are performing assets. Everybody's kind of waiting and asking ‘when will the banks start having to sell these assets?’ And no one's quite convinced that the banks will ever have to sell these assets in any significant amount.”

Bradford Wildauer, a partner at Apollo Real Estate Advisors, who manages Apollo-GMAC Real Estate Mezzanine, agrees that the banks so far are mostly unwilling to sell at discount rates, but he says that he sees this situation quickly changing.

“Part of the problem is that the cost of capital today is higher than the yield sellers want to sell properties at, and sellers are trying to hold off as long as possible hoping the world corrects itself,” he says. “But we're already seeing transactions beginning to be repriced, though it's still early. We're seeing more and more opportunities, we're seeing increasing signs of desperation, and I think you'll start to see sellers capitulate at the end of the year or early next year.”

The big question now is one of timing. When will those sellers be ready to sell at discounts that would enable equity-like returns on these investments? “That's the biggest difference between now and the situation in the early 1990s,” Wildauer says. “We don't have the same level of overbuilding. You just have overcapitalization of assets. So the underlying assets could still be performing, just not to a level that supports the debt and the equity that was put into the deal. There is going to be distress, but it's going to be stretched out, it's not going to happen all at once. It could play out over two to three years, so that capital is going to need to be patient.”

But the fact that transaction volume on these deals has been fairly low so far hasn't gone unnoticed by LPs. Despite the ease with which Colony's fund was apparently raised, many in the industry have noted that LPs seem not to be displaying much of an appetite for these sort of vehicles. As the chart on p. 34 shows, real estate mezzanine fundraising, for instance, doesn't seem to be on track to come near the 2007 total according to proprietary data from PERE magazine.

“For a while we were kidding in our group that I was doing a term sheet a week for [debt vehicles],” says Zagoren. “Now it's quieted down. I think they're finding that for fundraising, unless you're one of the really large players, it's very difficult. Investors have been very cautious about it, and a lot of the large institutional investors have allocation issues.”

For the moment, it may be just that the early bird funds that were the first to get in the game were able to quickly and quietly skim off the small top layer of banks that were willing to sell at a discount, and the loans that could have gone for those discounts have already been sold. “The earliest ones who were successful had access to the debt, they knew ahead of time what they were going to get,” Zagoren says.

It could also be that investors are wary of investing in a product which, to say the least, has been getting some bad press recently. “The feedback I hear from LP investors in the funds we have and the people who are out trying to fundraise is that they're seeing a lot of PPMs from equity guys trying to raise debt funds. But when I ask them how many they're pulling the trigger on, the feedback I get is ‘very few or none at all,’” says Wildauer. “And these are some of the larger pension fund private equity type investors.”

The successes
In looking to see which firms have been successful in actually getting these funds off the ground, two trends emerge. First, firms with previous experience in both debt and real estate have tended to fare better, and second, funds dedicated to European debt seem to be getting a lot of attention.

Though the size of the debt opportunity in the US is unquestionably larger than in Europe, there have been a number of large US firms who have set up or are looking to set up European debt funds. Apollo's new $1 billion European debt fund will likely be joined by a $500 million European debt fund from JER and a debt allocation in Blackstone's upcoming Europe fund. The fact that there is so much interest in these debt funds suggests that investors believe there is significant opportunity in Europe to get equity-like returns from investing in debt.

At a recent European real estate roundtable discussion hosted by PERE magazine, David Ryland, a London-based property funds lawyer at SJ Berwin, said he has seen a marked increase in European debt funds coming to market in Europe. “The debt funds are largely based on the premise that there has been a market over-reaction in the under-pricing of corporate debt and that these values may get impacted further if notes get re-rated or market issues force institutions to sell,” he said.

“The earliest ones who were successful had access to the debt, they knew ahead of time what they were going to get.”

In terms of timing, funds now being raised for Europe may be in a better position than their US counterparts because of where Europe is in a debt cycle. “Some people will tell you that European debt is backed up right now at a two year cycle low of risk refinance problems, and that 2010 is viewed as being the big year,” says Charles Roberts. “So it's not just about taking investments in positions that are having problems immediately, as far as defaults and issues, but rather figuring out where they can get involved in loans that will be having those problems.”

Roberts' colleague at Cadwalader, Conor Downey, says that another reason why these funds might be disproportionately targeting Europe is that they enjoy a greater competitive advantage there. “A [traditional] European debt investor is typically used to liquidation on default,” he says. “That concept was modified tremendously with US debt investors in the past dozen years or so, where they now expect to have a loan to own concept, where you'd actually have to own a property in order to enhance your return. That's a foreign concept to the European debt structure.” He adds, “In Europe, a private equity fund is going to be much better placed than a standard debt investor to put extra funds in and engage in lengthy transactions.”

Of course the experience of traditional debt investors isn't irrelevant to LP interest. In fact, prior experience with both debt and real estate seems to be a big determining factor in which funds see cash raised. Players already active in the area, such as TriLyn, Investcorp and Bank of Scotland, which last year together raised $110 million for TriLyn-Investcorp Mezzanine Partners I, are now planning to raise larger follow- on funds. Limited partners know that debt can be a complicated and unpredictable business, and so they're likely to look to these experienced players when investing their money. JER's Weiss says the ideal situation for funds right now is to have both real estate and debt experience.

“There is going to be distress, but it's going to be stretched out, it's not going to happen all at once. It could play out over two to three years.”

“I think we're uniquely positioned right now,” Weiss says. “We have a public vehicle that's focused on debt so we have the debt expertise. At the same time, we're now seeing an opportunity to play where we wouldn't have before. So there are opportunities for folks like us – who have had debt funds before but also have real estate experience – to step in and fill in that gap, and at an incredibly attractive rate relative to 15 months ago.”

The possibilities
But with private equity real estate firms entering the debt investing space, a natural question has arisen: could these firms start using their debt funds to invest in their own portfolio companies discounted debt? The answer is yes, but with great caution. Michael Harrell, head of the private equity funds group at Debevoise & Plimpton, says that although he's seen a number of GPs make such investments, they can be a complicated affair.

“It raises very complicated tax questions and conflict of interest questions that require a lot of hard thought,” he says. “If the fund that owns the equity buys the debt then there isn't any conflict. But if a different vehicle than owns the equity buys the debt, there could be a problem.”

Different firms have approached this scenario in different ways, depending on their relationships with their investors. Wildauer says that Apollo Real Estate wouldn't consider such a move. “Our view is we never lend to ourselves, not even to a project of one of our affiliated funds,” he says. “Life's too short to try to even consider that conflict. If the opportunities are there in the marketplace, why do you need to step into one with a conflict?”

JER, on the other hand, has found ways to do it. “It's a challenge because of the conflicts, but there are ways to do it,” says Weiss. “If you have a piece of debt which private equity firm X is the borrower on, they might be able to go and team up with somebody and say, ’Let's buy that $50 million mezzanine piece, we'll take 25 and you take 25, but in a meltdown scenario we'll assign all the rights to you, our JV partner in that piece of debt,‘ so I'm not in a position of foreclosing on my fund.”

“Our public company JER Investors Trust has done that exact scenario where one of our private equity funds is the borrower,” he adds. “We'd look into opportunities like that because we obviously have a good insight into that asset, better than any other asset we could buy in the marketplace.”

All in all, this is new territory being ventured into, both for the private equity real estate firms and for the holders of the debt. In many ways, the rules are being made up as the situation progresses, and no one can be quite sure what's going to happen next.

“Eventually the market is going to correct and the pricing will adjust to more accurately reflect the value of the underlying assets,” says Harrell. “But I don't know how long that opportunity will last, or how much is out there.” Time will tell if the amount of talk about debt funds will be matched by successful fundraising, and whether the banks will ever be willing to sell at the prices private equity real estate is looking for.