FEATURE: Slow and steady saves the value

When Lehman Brothers filed for Chapter 11 bankruptcy protection in the overnight hours of 15 September 2008, sharks throughout the real estate and investment banking worlds could smell blood in the water. After all, the investment bank’s stock had lost nearly 95 percent of its value since the beginning of the year due largely to risky bets on a host of investments and financial instruments, including real estate, and was facing roughly $1.2 trillion in claims.

To satisfy those obligations, at least in part, Lehman’s estate needed to liquidate assets, many of which were highly attractive (at the right price). Potential buyers were hoping for a fire sale of epic proportions. But with the exception of a few quick division sales, the deep discounts on hard assets that the market had been anticipating never materialised.

The killer of these fire-sale dreams was largely Bryan Marsal, who has taken a methodical approach to working through Lehman’s various assets in a way that emphasises maximising value, sometimes through strategic investment.

The co-founder of global turnaround firm Alvarez & Marsal, who now oversees the restructuring of Lehman Brothers as the estate’s chief executive officer, detailed this value-maximisation strategy during his keynote address at Kirkland & Ellis’ fifth annual Real Estate Private Equity Symposium in New York at the end of September.

Guiding principles

Marsal’s approach to working through Lehman’s commercial real estate portfolio is partially rooted in expertise developed over his decades at the helm of Alvarez & Marsal. He therefore strongly resisted investors’ initial expectations to the Lehman bankruptcy situation, expectations which he jokingly referred to as “discount city”.

Marsal said would-be asset purchasers wanted to help lighten Lehman’s real estate portfolio, and they demanded not one, but three, overlapping discounts: a bankruptcy discount, which was the premium because Lehman needed money and they had it; a liquidity discount, which represented the premium on having liquidity at the time; and a market value discount, which represented the need for a cushion due to decreasing real estate values. “With all those discounts, I told them it sounded like I would have to pay them money,” he quipped.

After turning down numerous discounted sell opportunities, Marsal came up with three principles that would dictate how Lehman would approach the workout and management of its real estate portfolio. The first was to find best-in-class partners for joint ventures, particularly those with strong asset management skills. This was crucial because neither the remaining Lehman bankers nor the Alvarez & Marsal workout specialists had that necessary skill, Marsal explained.

The second principle was, if Lehman was considered an equity risk, it should get an equity return. “What that meant is, if you default on my loan, I own you,” Marsal said. This was a tough position to take because many of Lehman’s partners in these deals were banks and, if a bank owns an asset, it needs to take a write-down, he explained. For Lehman, however, it made sense given their junior position within the capital stack of many of its deals – a position that more than likely would get wiped out in the event of a default. “As a result, I was an awful partner with the rest of the bank group,” he added.

The last – and perhaps key – principle was that Lehman will only sell an asset if it meets its target value. Following this last principle, Lehman has recovered $2.2 billion to date through property sales, Marsal noted, adding that this figure represents at least double the recovery level than if it had tried to sell the same assets within the first six months after its bankruptcy filing. “This is about value creation versus just cash generation,” he said. 

Achieving target values, however, is not just a waiting game. “We needed to be willing to re-invest in the business,” Marsal said, adding that the estate has spent between $1.4 billion and $1.5 billion so far to enhance existing real estate assets.
That being said, any new investment in Lehman’s existing real estate assets needs to pass three strict criteria in order to be approved. First, every deal needs to prove that it is 99 percent rock solid. Then, it needs to show it can achieve a market rate of return. Lastly, the deal needs to demonstrate that it will enhance the legacy assets, as this is the entire reason for the exercise in the first place.

We can work it out

This year, Lehman has been busy re-working a number of large exposures. In July, it launched a pre-emptive strike in the Innkeepers bankruptcy, negotiating a pre-arranged restructuring of the $250 million senior mortgage it still holds. Although the move has ruffled the feathers of Innkeepers’ other creditors, Lehman is the only one able to negotiate a workout because the other $1 billion in loans were sold to various CMBS vehicles governed by strict REMIC rules.

In addition, the Lehman estate spent roughly $260 million in July to pay down a mortgage on six office buildings in Rosslyn, Virginia that it purchased for $1.3 billion through a joint venture with New York-based developer Monday Properties. It also bought back a $255 million bond with liens on 237 Park Avenue in New York from Prudential Financial Investment in an effort to shore up its holdings. That was done because Lehman already held $437 million in mezzanine debt on the building that was junior to the bond and, had Prudential decided to sell, a new bondholder could have moved to foreclose on the property, thereby wiping out Lehman’s position.

When all is said and done, Marsal and his team are likely to have recouped billions of dollars more than anyone expected when the liquidation of Lehman’s estate first began. While that may be great news to the ears of the firm’s creditors, Marsal is mindful of opportunities missed. “If they had given us 90 days [before filing for bankruptcy], we could have saved Lehman another $75 billion to $100 billion in value,” he said.

Archstone not for sale

Despite recent published reports to the contrary, Lehman’s stake in apartment REIT Archstone Smith Trust is not for sale. “We have no interest in selling it,” said Bryan Marsal, CEO of the Lehman estate, at Kirkland & Ellis’ fifth annual Real Estate Private Equity Symposium. As of May, Lehman held 47 percent of the controlling stock in Archstone, according to court papers, but it recently completed a major conversion of debt for equity.

At the time of its bankruptcy filing, Lehman’s holdings in Archstone included a permanent equity investment of $250 million, some $2.3 billion in bridge equity and various debt financing totalling $5.4 billion. In May, Lehman won court approval from its bankruptcy judge to join Barclays and Bank of America in converting $5.2 billion in Archstone loans to preferred equity, according to court documents that put its share of the conversion at $2.4 billion in secured debt. Last year, the three banks had committed an additional $485 million in financing to Archstone.

The scope of the problem

Lehman finds itself in its current predicament because management made a conscious decision to embark on an aggressive real estate growth strategy at a time when the mortgage market was progressing from problem to crisis. And once the depth of the crisis was clear, management was slow to act in reducing its exposure.

According to the bankruptcy examiner’s report released in March, the investment bank nearly doubled the balance sheet limits of its Global Real Estate Group (GREG) from $36.5 billion in the first quarter of 2007 to $60.5 billion in the first quarter of 2008, with the group regularly exceeding those limits. In addition, its real estate bridge equity positions in the US increased tenfold from $116 million to $1.33 billion between the second quarter of 2006 and the second quarter of 2007, then more than doubled again to in excess of $3 billion by the end of the second quarter of 2008.

Much of the balance sheet growth experienced by the GREG can be attributed to a series of large transactions completed between May 2007 and November 2007. They include:

• a $2 billion financing to Broadway Partners to acquire a sub-portfolio from the Beacon Capital Strategic Partners III fund
• a $1.3 billion financing to Broadway Real Estate Partners to acquire 237 Park Avenue in New York
• a $1.2 billion financing to Apollo Investment Corp for its acquisition and privatisation of Innkeepers USA Trust
• a $1.1 billion financing to Thomas Properties Group to acquire Equity Office Properties’ Austin portfolio
• a $1.7 billion financing for the acquisition of Northern Rock’s commercial real estate portfolio
• a $1.5 billion financing to industrial REIT ProLogis to acquire the Dermody industrial portfolio
• a €2.1 billion financing for the acquisition of the Coeur Defense office complex in Paris
• another $1 billion financing for the acquisition of Northern Rock’s commercial real estate portfolio
• a $1.5 billion financing to The Blackstone Group for its acquisition of Hilton Hotels
• a $5.4 billion financing for the acquisition of apartment REIT Archstone Smith Trust

Because Lehman encountered difficulties in selling or securitising portions of these deals, many of these transactions remain among the largest exposures on its balance sheet.

In addition to those financings, Lehman acquired a number of substantial bridge equity positions, both in the US and Europe. They include: $2.3 billion in Archstone; $574 million in the Dermody portfolio; €475 million in Coeur Defense; $221 million in the EOP Austin portfolio; and $195 million in the acquisition of the 200 Fifth Avenue building in New York.