The financing quilt: the Musgrave Ritual, Part 2
[Continued from yesterday’s Part 1.]
Assisting my friend Musgrave with his financial structuring problem, I was demonstrating the impossibility of any one financier providing all the capital required. Except, I observed, in pre-capital-markets countries, where savings circles, credit unions, mutual building societies, and similar capital aggregators are designed to save up all the capital at once. Unsurprisingly, these early forms are inefficient and inhibit capital formation — there is a role for a bank. As nations progress, there emerges in their financial ecosystem a specialized financial marketplace.
In a capital-market scenario, one must divide the large rectangular space into segments, and fit the pieces together. “What is the first step? Your ancestor states it clearly.”
‘Where do we start?’
‘With permanent bonds.’
I sketched it.
Permanent finance presupposes the property is developed, occupied, and making positive cash flow.
“You will observe that I drew the loan as funding only a portion capped by a loan-to-value (LTV) ratio. You will need some long-term investment. Are you able to contribute hard equity?”
‘Yes, I can assemble an equity syndicate from among my toff friends. That is the orange capital above the green? I see. But you show the financing extending unchanged thereafter. In fact, once the scheme is complete it should appreciate in value, so I would wish to refinance that loan, repay my partners, and keep the remaining value for myself.”
“That part is straightforward. If the property appreciates, the owner may prepay the loan (subject to prepayment lockout provisions), place a new loan on the property, and use the resulting excess proceeds as equity takeout to repay investor capital. Like so.”
For borrowers, a key benefit of long-term debt is refinancing, at the borrower’s option, to take out equity.
“The remaining equity, shown in a stylish violet, represents not capital that you have contributed, but residual value built up and not yet financed out.”
Musgrave stirred impatiently (perhaps as the reader might). “Holmes, this is all well and good, and doubtless there are thousands who would find it fascinating, but there is no trick in financing property that already exists and is valuable. You are working in the wrong direction, for I need money now, not in the future.”
“Come, come, you know my methods! Starting from where I do unravels the whole yarn. One never secures capital haphazardly, with neither plan nor structure. Rather, one works backwards, securing not the money itself but a promise to lend in the future if certain conditions are met: in financial parlance, a forward commitment.”
The loan committee evaluates your proposal with a show of fingers … er, hands.
This, of course, costs money (commitment fees) and involves some risk, because capital sources will normally specify the rate not as a number but as a spread above an index (such as like-term Treasuries).
Still, a forward commitment for permanent debt is a useful thing, because it becomes the basis for pursuing the next piece, as suggested by the Ritual:
‘What gain we next?’
‘Those who lend short.’
I divided the space into initial closing, construction completion (beginning of rent-up or home sellout), and stabilization (for a rental). Now, I observed, there are financing sources willing to take rent-up risk, so they will provide an interim loan. I drew the box.
The interim lender takes only one risk — rent-up.
“You will observe, Musgrave, that I have drawn the interim loan as lower-leverage than the permanent? That is because the interim lender looks to the permanent as its takeout source. The interim finance incorporates several key principles worthy of an inset box.”
Key principles of financial structuring
“Assembling the financing quilt”
1. Start with the safest capital, move gradually to the riskiest.
2. Typically, each piece of capital takes one and only one major risk. Each source has a different mixture of collateral and guarantee requirements.
3. Debt commitments are normally secured before equity commitments.
4. Any earlier (non-amortizing) commitment is predicated on a takeout forward commitment.
5. Each earlier loan is lower leverage than its successors.
6. Each earlier loan is higher cost (spread over the safe rate) to reflect the risk premium.
7. Each boundary between capital sources involves negotiating changes in guarantees, commitments, and equity obligations.
8. The price of control is risk acceptance.
9. Maximum leverage equals lowest average cost but highest risk volatility.
If one has secured the interim loan, there are then a multiplicity of construction lenders, who take only the construction risk.
Permanent finance presupposes the property is developed, occupied, and making positive cash flow.
“Your ancestor clearly appreciated the sequential nature of financial assembly,” I said, “as he memorialized it in this couplet.”
‘How span our gap?’
‘Credit by long and by short, equity by slow and by fast, mezzanine by rent and by buy, sponsor by sweat and by pledge, and so closing.’
Asked Musgrave, “How are rates established?”
“In the financial marketplace, of course. Capital sources want the highest rate for lowest risk. Sponsors want low rates and high risk tolerance. As sponsors and capital sources compete for each other’s business, a price emerges. As the Ritual says:”
‘What does it cost?’
‘All that it’s worth.’
“So far you have drawn only debt, Holmes,” Musgrave objected, “and made no mention of equity. Whither comes it?”
“As the Ritual says, Musgrave.”
‘Sponsor by sweat and by pledge’
“Some equity you raise from your friends, business associates, or private speculators. Some you contribute through your efforts (sweat). Some you guarantee personally (pledge). And some you contribute out of your own pocket.”
Musgrave shivered. “That seems scarcely sporting, old chap. I mean, a fellow’s word should be his bond. Shouldn’t it?”
“Why should I, a superior being, have to put my own money in?”
“I have previously observed that only hard equity outlay is sufficient to sustain the developer’s interest in the high-risk interval. Risk acceptance is the price of control.”
“That seems expensive.”
“Compared to what?” I chided. “Right now you have dreams and schemes and no property. Your ancestor knew what he should do.”
‘Why should we pay it?’
‘For the sake of the deal.’
The result, therefore, is a complete financing quilt:
The equity requirements are highest early in the transaction.
“Your ancestor understood that.” I weighed the ambergris object, inside which a miniature scroll appeared suspended like a prehistoric insect. “This, I believe, is a tombstone of the original partnership certificate of the Dutch East India Company, the world’s first major investment syndicate, and along with its English parallel and competitor the originator of investment banking.”
Musgrave examined it in wonder. Then he returned to my diagram. “I observe that in the first two phases, there is something between debt and equity.”
“Yes, these are more sophisticated, short-term high-yield forms of capital. Indeed, in this realm debt and equity become so many labels, for one can mix attributes of each:”
“Much as light will be seen sometimes to have properties of both particle and wave. The intermediate forms have many names — mezzanine finance, subordinated debt, participating debt, preferred equity — but they are all high-yield, high-complexity.”
“Holmes, why all this slicing and dicing? What does it gain me?”
“First, the money you need, which is not available from any single source. Second, because each source provides capital on its terms, taking risks that capital source understands, the overall weighted average cost of capital (WACC) is cheaper. And a lower weighted average cost of capital translates into a more valuable property for you. More equity, Musgrave. More coins in your pocket.”
Relative to spread, because risk declines over time, so does the Weighted Average Cost of Capital (WACC) — so the value of income producing property rises.
“Often these financing quilts, and in particular the specialized mezzanine or preferred equity pieces, are custom-designed by investment bankers” — I saw his start of surprise — “who are to bankers as Professor Moriarty is to a cutpurse.”
“Indeed, had the professor turned his thoughts to the City, he could have been a great investment banker.”
“Then by all means, let us visit one,” said Musgrave. “The deal’s afoot!”
And that, Watson, is the story. I betook myself and Musgrave off to my brother Mycroft — oh, have I never mentioned Mycroft? He is the most sophisticated of them, but he never bestirs himself from the upper floors of the Diogenes Bank. I shall have cause to speak of him when we describe the financial markets, with which I had experience in the Adventure of the Money Store.
