Friday Letter The wrong type of capital

Why the sale of a stake in a £1.4bn loan book by Royal Bank of Scotland ended up as one for a debt fund, not an opportunistic real estate vehicle.  

When news of a £3.2 billion property loan sale by Royal Bank of Scotland surfaced a year ago, it was unsurprising private equity real estate firms salivated.

Project Monaco, as it was codenamed then, comprised an eclectic mix of non-performing loans, sub-performing loans, loans at very high loan-to-values (some as high as 150 percent), and loans in ‘op-co, prop-co’ structures in which part-nationalised RBS is the lender. The underlying collateral was equally dizzying and included car show rooms, pubs and care homes, as well as traditional real estate asset classes.

It seemed perfect fodder for an opportunistic player with higher return expectations working on the basis that some borrowers could go bust, giving the lender the chance to do something with the assets – but only as long as a steep enough discount were applied to the sale. A discount in the region of 50 percent was being talked of by certain parties.

The thing is, the deal changed a lot over the course of a year. The portfolio of Project Monaco shrunk as some of the worst loans were taken out and the better, more senior ones became the focus, and it got renamed Project Isobel instead. Finally, after a year of discussions, last week The Blackstone Group was picked to buy a 25 percent stake in a £1.4 billion package of loans at a much smaller discount than 50 percent, and to manage the whole portfolio.

The key factor in this deal is that Blackstone is not making the investment for its opportunity funds that typically try to achieve IRRs of 20 percent-plus. Instead, it is doing the deal for its mezzanine debt business, Blackstone Real Estate Debt Strategies (BREDS), with a much lower return profile of 10 – 12 percent.

Of the four bidders on Project Isobel, only two (Blackstone and Starwood) were bidding with a similar low cost of capital. Lone Star and Westbrook/KKR were apparently not, though Lone Star was thought to have bid competitively by factoring in management fees, which could have hyper-charged its return. However, that model didn’t fly.

Instead, Blackstone’s debt fund with much lower return ambitions has bought the 25 percent stake and will manage the loans to a business plan overseen by RBS. In time, the bank's remaining 75 percent stake can be sold down. It is a clever structure. Rather than take all its losses now, the bank has brought in an asset manager who can control the loss making over time. The structure is akin to a fund with one investor where the sponsor puts up 25 percent of the capital with partial discretion over assets. RBS has the right to sell its 75 percent stake to whoever it wants.

One could surmise that a benefit for under bidders in continuing to look closely at the deal, despite becoming less appropriate for an opportunity fund, is to build rapport with RBS, knowing the bank has a UK loan book of £80 billion that will have to be reduced over time.

Nevertheless, RBS and perhaps Lloyds Banking Group could well structure future property loans sales like this one. If they do, it has now become harder to imagine many private equity real estate firms without debt fund divisions having a seat at the table.