EUROZONE: Poisonous mushrooms

There is a mushrooming industry in Europe of specialist advisors that set themselves up as being able to help banks with their complex and/or troublesome loans. Such advisors range from established fund managers like Aberdeen Property Investors to new groups like Reviva Capital, to name but two.

Everyone agrees that something needs to be done about these loans because banks really shouldn’t be holding onto them, therefore a specialist asset manager that can facilitate an outcome in the short or long term generally is welcome. The area to question, however, is the terms under which such an advisor is engaged and specifically whether an advisor should co-invest in the lender’s assets in the name of alignment of interest.

The issue is of more than passing interest to private equity real estate firms as the borrower in some of these cases or indeed as the potential acquirer from the vendor bank. After all, as the borrower or potential purchaser, they might well be dealing with the appointed asset manager on a regular basis, so it is worth knowing their incentive.

According to one participant, the most common practice currently is for the advisor to convince the bank that, instead of simply charging a fee for its services, it will be mutually beneficial to also take an equity stake. This is done to comfort the bank by letting it know the advisor is incentivised to do everything necessary to achieve the best outcome, including a sale at the highest value.

Certainly, in many circumstances, this is indeed alignment of interest. However, it is not always the best structure. In fact, it can actually present a conflict of interest.

For example, critics of the approach point out that the first problem is how to price the equity stake the advisor takes in the first place. The suspicion must be that the advisor is pitching – and paying the bank – as low a price as possible in order to magnify its returns upon sale of the asset. Some would say there is an initial conflict in setting this pricing.

Second, what is the cost of capital of each party? The bank itself might well have a longer term hold and sell horizon than the advisor that has put in money. This can be misalignment in itself. The advisor will be making decisions every day about the asset in question, but how can the bank (and the borrower) be sure that the decisions taken are for the benefit of the bank alone and not partly for the advisor’s sake?

For instance, consider the scenario of a building that needs a tenant. Along comes a tenant willing to pay a fair market rent. Does the advisor take that lease offer knowing that it would stabilise the asset for the benefit of the bank, or does he hold out for someone prepared to pay the higher rent because that will lead to the return threshold the advisor needs?

How much equity is the advisor putting in? The co-investment might be a considerable sum in terms of the resources of the advisor. But if it is miniscule in comparison to the bank’s exposure, is that real alignment?
When it comes time to sell, most banks want certainty in any potential partner. But again, will the advisor be more inclined to negotiate a steamier price “on behalf” of the bank rather than go for a lesser price with a solid buyer.
The other factor to consider is the advisors’ expertise. What is the core competency of the advisor? If it is as an investor or developer, then the bank should really question why the firm wants to get involved in the first place. If the answer is for the fee, then the bank doesn’t have a problem. But if it is for the co-investment, then the bank might have one.

Lastly, is that advisor properly equipped to impart the best advice? After all, the actual problem might be that something is wrong with the borrower’s overall business plan rather than just the property itself.

Put it this way: if you were the lender to a car rental company whose payments were defaulting or in breach, do you hand over the fleet of cars to a garage? If the garage says it will charge a fee, put in x percent of co-investment, fix up the cars however it wants and sell them at maximum value, your interests might not be best served. Wouldn’t you rather employ someone who also will investigate the way the car rental company was conducting business, as well as look under each car hood for a fee only?

There are some firms out there that do operate on a strictly fee-only basis, and they point out there are ways of creating alignment with advisors other than co-investment, such as success or recovery fees, stepped compensation and so on. Maybe banks should be concentrating on these advisors, otherwise they run the risk of swapping one poison soup for another.