Enterprise Finance II: It’s Hard, But Do It Anyway

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Last month’s column identified enterprise finance – the practice of lending to the sponsor entity as a conduit to its whole portfolio, rather than to each project as a non-recourse stand-alone special purpose vehicle (SPV) – as having many benefits, and pointed as a positive example to British experience with larger, vertically-integrated, geographically-concentrated housing associations.

If enterprise finance is so appealing, why isn’t it the norm in affordable housing? 

Actually, in the U.S., we have two multifamily examples; one among the best, one among the worst. The best is the modern publicly-traded REIT, whose financial structure offers speed, massive capitalization, free tradability, and diversification. The worst is the public housing system – authorities are shackled with inability to liberate individual properties for refinancing, negative cash flow, efficiency disincentives, and subsidy dependency.

The principal downsides and obstacles of enterprise finance include:

  • Portfolio cross-collateralization. With enterprise finance, all the entity’s assets are pledged to the master revolving loan. One default sinks the ship.
  • Variable-rate or balloon financing. Entity-level loans tend to be revolvers; the sponsor can  increase the loan amount provided that the portfolio meets loan-to-value or debt-service-coverage covenants. Such a loan is usually variable-rate, with periodic resets, exposing the entity to the capital markets’ vicissitudes.
  • Cash flow headroom risk. In British housing associations, headroom – the excess cash flow above debt service – rises and falls with changing property net operating income and interest rates. Sponsors can be whipsawed by rates rising when NOI cannot.
  • Over-levering in good times. In good times, the portfolio rises in value. With enterprise finance, that equity buildup can be swiftly tapped – one easy earnout-style refinancing of your line of credit. Like an open bag of potato chips, the temptation to over-consume is well-nigh irresistible.
  • Single-purpose vehicle (SPV) restrictions. Virtually every current affordable housing financing or regulatory program requires an SPV with sequestered funds. And while individual property tracing of commingled funds is trivial, you can’t both have enterprise finance and SPV capital restrictions.

Put all of the above together and it becomes evident that enterprise finance is pro-big, anti-small. Lenders and regulators will un-tie the strings only for a sponsor that is large, professional, proven, and well-capitalized, with very material equity at risk. REITs, the exemplars of enterprise finance, use low leverage and have frequent access to the capital markets.  And in the U.K., the affordable housing regulatory body, the Housing Corporation, aggressively brokers arranged mergers and acquisitions, with the larger and stronger absorbing the smaller and weaker. 

Enterprise finance thus emerges, if it does, out of consolidation (a phenomenon I’ve described in a recent State of the Market: Consolidation and Merge-o-phobia), and it is driven by money – namely, the capital providers’ interest in moving portfolios of properties out of the hands of floundering under-capitalized sponsors and into wiser, more durable hands.

We’ve already seen this in the banking business in the U.S. TARP, designed as a project-finance intervention to buy asset pools, was implemented as an enterprise-finance intervention, with large preferred-stock capital injections into banks picked to be survivors. These banks, in turn, were induced or coerced into acquiring other institutions (e.g., Merrill Lynch, Bear Stearns, Wachovia).

Enterprise finance will emerge in the U.S. if and when capital providers and regulators, worried about troubled portfolios, survey the landscape and decide that their best hope is to transfer asset pools to capable larger sponsors. Should this happen, the sponsors will be in a position to build an enterprise-financed portfolio, one disentanglement at a time, exhibiting such features as:

  • The buy-out of limited partners after Year 15 for pennies on the original dollar.
  • If necessary, the restructuring, rescheduling, or payoff at a deep discount of any hard debt to produce positive cash flow at the property level.
  • Subordinate or restructure existing soft finance from municipalities and states.
  • The rewrite or cancellation of regulatory agreement dividend limitations.
  • The elimination of budget-based rents.
  • Reclaimed cash flow for the developer.

Enterprise finance will not be used for American affordable housing until both sponsors and capital providers realize that it makes no sense to invest 100x capital in an individual property that is controlled by a sponsor who has 1x capital at risk and even less operating upside. Then it will happen one property and one portfolio at a time.

In an upcoming Guru column, I may have to write about the zombies walking among us – the post-Year-15 partnerships.

Got a question you’re burning to have answered?  Email it to [email protected].

David A. Smith is CEO of Recap Real Estate Advisors, an oldly-renamed Boston-based firm that optimizes the value of clients’ financial assets in multifamily residential properties, particularly affordable housing.  He also writes Recap’s free monthly essay State of the Market, available by emailing [email protected].