Commercial Real Estate: Back Leverage
Whether you are a private capital sponsor, investment banker or real estate owner, it pays to understand the growing role of back leverage in the credit fund space. In this article we shall provide a broad overview of its history, some popular deal structures and what happens in a stressed scenario.
Historical background
Prior to the global financial crisis, banks sold their newly originated property loans to public securitisations and mezzanine debt funds. Then the crisis changed everything.
Risk retention rules were introduced making securitisation less attractive to banks, while tighter prudential regulation forced banks to hold substantially more capital on a risk-weighted basis.
As a consequence, public securitisation of European commercial real estate debt has dwindled. CMBS on the continent is no longer an option save for the strongest sponsors and safest asset classes, such as logistics. And although it once threatened to re-emerge, European CRE CLO is not a realistic option.
In addition, banks have retreated from highly leveraged product and some sectors and geographies altogether.
Filling the void
To fill these resulting voids, mezzanine debt funds have re-invented themselves as whole loan originators over the past decade. These private debt funds offer real estate borrowers a “one-stop shop” with suitably high leverage and efficient execution.
And in order to meet their double-digit investment mandates, the funds have found a way to leverage their whole loans. Although provided by banks, “back leverage” operates behind the scenes, so that the real estate borrower only has to contract with the fund.
However, despite this lack of privity, real estate owners facing private credit should seek to understand the potential impact the use of back leverage may have during the execution phase and over the life of its borrowing.
Structures
Structures can range from straight-forward to super complex. This variability is driven by the bank’s regulatory capital treatment on its senior exposure and differs from provider to provider. Loan-on-loans are at one end of this spectrum with a combination of repacks, repos and listed securitisation at the other end. For some readers, it may be helpful to describe these terms in some detail.
In a repack, a single purpose vehicle (“SPV”) issues a note and uses proceeds to buy or fund the loan. In this way the loan is said to be repackaged into a note. This process converts illiquid loans into tradeable securities bringing greater liquidity perception and creating more conventional repo collateral. Where the note is used as collateral in a repo arrangement, we call this a “repack to repo” structure.
In a repo, an SPV acts as seller of collateral to a bank at a discounted price. The discount is called the repo “haircut” and reflects the leverage being provided. At the end of the agreed term, the SPV must buy back the collateral at the same price plus an amount which reflects the cost of what is in effect a borrowing.
In addition to providing the private credit fund with leverage, the repo is helpful as it provides a tried-and-tested margin call construct housed in a standardised suite of documentation.
Where a loan is used as collateral, we call this a loan repo. Conversely, where a note is used as collateral, we call this a note repo. Note repos are more commonly used. As the bank only provides part of the funding required, the SPV must seek additional funding via equity or subordinated debt.
In a securitisation, an SPV issues a senior A-note and a junior B-note to fund a loan. This tranching of risk results in regulatory classification as a securitisation which is beneficial for the A-note holding bank from a prudential capital perspective. Meanwhile the B-note not only serves as credit enhancement for the A-note, it also offers a profit extraction tool for the private credit sponsor.
Structural combinations
We have seen combinations of all three used on the same deal, although noting that so-called “repack-to-repo” and “loan-on-loan” trades are the two most prevalent in our experience. Whatever structure is ultimately decided upon, comprehensive security is generally provided throughout, together with careful regulatory, tax and bankruptcy analysis especially given that loan and note transfers may be required.
Rewarding complexity
Private credit funds have wisely sought to grow in structural confidence given the rewards available. After all, back leverage can reach as high as 80% of the underlying loan amount with related pricing allowing for 10-12% returns for credit funds.
Managing the downside
Margin calls
Margin calls are a feature across most transactions as they allow banks a dynamic and therefore capital-friendly tool to weather a downside scenario. They are generally speaking triggered when underlying real estate values decline beyond a certain threshold. It is critical to appreciate the importance of the precise language used in order to ensure appropriate liquidity provisioning for downside scenarios.
Look-through financial covenants
It is possible to avoid margin call provisioning through the use of look-through financial covenants. However, as this is likely to soften the bank’s ability to manage its downside, Day 1 available leverage and pricing will be adversely impacted.
Relationship focus
It is also interesting to note that where once back leverage was seen as unwise for smaller funds, there is now a growing appreciation that banks can take a relationship-based approach in the event that the underlying loan struggles. Indeed, during the pandemic, transparent back leverage borrowers with a concrete business plan who kept the facility current tended to avoid the sharp end of margin call provisioning.
Learn more
We invite you to contact us to learn more about this product so that you may determine its suitability for your credit strategies or on any given loan exposure. Similarly, if you are a real estate owner seeking to access credit from the private markets and are curious about the net impact to your refinancing or acquisition, please get in touch.
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