Risk and Reward – Does more debt solve your problems or do you need a JV Partner? HoldenCAPITAL

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This is a question faced by many developers as they find themselves inevitably stepping up to larger projects and the consequential demand on their equity resources. The answers are complex and can vary depending on many variables but let’s take a look at what each option offers

Firstly, lets be clear on the differences between debt and equity. Debt comes in many forms but essentially, it comprises funds that are lent at a proscribed interest rate which in a project scenario are usually but not always, capitalized as a cost of the project. Debt is typically but again not always, secured by a registered charge over the security property together with sponsor guarantees and in the final wash up, the lender’s repayment of capital, interest and fees take priority over those of the sponsor when apportioning the proceeds of sale. Clearly it is important to negotiate the best possible terms when committing to a debt position but at the end of the day, the golden rule tends to apply, he who has the gold, makes the rules.

Equity on the other hand is usually defined as the capital contribution provided by the sponsor of the project and any related parties. Equity can take the form of cash, services provided and any improvement in value derived from the revaluation of an asset as a consequence of a rezoning or similar.

Sponsor structures can take many different forms but for the purposes of this article we will treat partnerships the same as single traders (as do lenders), while Joint Ventures provide a structured arrangement enabling parties with differing skills and or capabilities to come together to undertake a project and share in the resulting profits. 

The manner in which debt and equity can be sourced and applied is almost limitless but lets take a look at the typical options available to a developer and consider the benefits.

The Debt Options:

Firstly, you need to be aware that the state of the market will often determine what is actually available. Simplistically, in a rising market, access to both debt and equity is typically more readily available and pricing is competitive. Traditional debt providers such as the banks and major funds chasing market share, will consider higher Loan to Cost/Value ratios, more competitive terms such as lower presale requirements and keenly priced interest margins and fees.

Alternatives such as mezzanine funding also become more prevalent in rising markets with participants providing funds to top up the capital stack in a project. Typically filling the gap between senior debt at say 75-80 percent up to 90-95 percent of the total project cost, the cost of Mezzanine can range from 20-25 percent p.a. but as the market gets hotter and depending on the level of risk, pricing can fall to as little as 14 percent.

While these funds may seem attractive, they are often accompanied by very tight and restrictive terms, which can result in the sponsor losing control of the project to the advantage of the mezzanine lender. Sponsors need to be aware that a Mezzanine partner is really just another lender albeit with more to lose that the senior debt provider and when the going gets tough, you potentially have two masters to satisfy rather than just one and neither is likely to have the same agenda as you.

A key point to remember is that in a rising market Mezzanine Lenders are attracted to a share of the upside and negotiate accordingly. In a falling market they will seek to cap their exposure and prioritise their returns at your expense. Conversely, you as the developer are looking to maximise the blue sky in the project or protect your downside as the case maybe.

“Stretch senior” debt is another option that is usually seen in stronger markets with some specialist lenders prepared to exceed the usual Major bank construction loan LCR’s of between 70-80 percent by lending up to 90 percent+ of LCR in return for a margin that reflects the associated risk, which might be some 3-4% above that charged by the banks, depending on their assessment of the project and sponsor risks.

In a falling or credit constrained market as we are currently experiencing, the traditional lenders tighten their terms and we see LCR’s firm to between 65-75% and the application of stricter presale requirements, typically with a minimum of 100% debt cover as a condition precedent. 

Joint Ventures:

The attraction of Joint Ventures is that they provide a multitude of structures that can be tailored to the developers needs and typically provide access to capital and expanded skill sets in return for a share of both the profit and the risk.

Like debt, Joint Venture funds are easier to secure in a rising market but even more importantly than with debt, the secret here is to find the right partner. While negotiating the right terms and a soundly drafted JV Agreement are critical (we will deal with this in a future article), the most important consideration is finding a partner who not only has complementary skills and capabilities to work with their own but also has the same goals and values in terms of their decision-making processes. This is a more challenging exercise that selecting the right debt or mezzanine partner but has the potential to be far more rewarding. 

The classic JV structure where the parties are equal in their contributions and profit entitlements are rare with most comprising of a party with the ideas/opportunities and the other with the capital and resources to make it happen or a similar permutation. As a result, in a rising market Joint Venture partners with capital are attracted by an increased share of the upside and negotiate accordingly, while in a falling market they will seek to cap their exposure and prioritise their returns at the expense of their partner or the lender. Conversely, the initiating developer is also self motivated and looking to give away as little as possible in their project which usually results in an increased downside in the event that they do not perform their obligations and for newcomers this inevitably ends in tears as they over estimate their own capabilities.

So, the question as regards more debt as opposed to equity is not simply one of cost. More importantly it is one of understanding your capabilities to deliver and being able to deal with the consequences if unforeseen forces result in a less than optimum outcome.

In the case of “more debt”, the developer needs to be aware that losing control to the lenders has a proportionally higher risk in terms of the financial consequences both in terms of the project and their personal fortunes. On the other hand the Joint Venture can reduce the downside risks from a capital exposure perspective but comes at the cost of having to give away a substantial portion of the projected profit.

So, there is no right or wrong answer here, the key question an under capitalized developer needs to ask themselves is what option best fits my situation, what is the downside if events outside my control mean that the project fails and can I live with the consequences of my decision?

This article was written by Dan Holden of HoldenCAPITAL, who are a bespoke construction finance firm, they arrange construction finance and invest in projects through their equity fund, Queen Street INVEST. To discuss your project finance requirement please call (07) 3171 4200 or visit HoldenCAPITAL here.