THE ART OF THE WORKOUT

Editor’s Note: FrontView Group wishes all of its partners, clients, colleagues and friends a very healthy, happy and prosperous New Year. The 2009 calendar year marked the launch of our firm and proved to be a busy year for us but we are happy to see it pass and look forward to 2010. As our team closed out 2009, we experienced a significant increase in velocity in both deal flow and advisory assignments and we expect this trend to not only continue, but to significantly increase, as we head into 2010 and are anxious to capitalize on new investment opportunities and assist our advisory clients with their workout and restructuring needs.

A borrower’s workout of choice is a favorable loan modification -- a restructuring of the loan so as to alleviate the borrower’s default and mitigate its loss. The lender may be asked to agree, among other things, to (a) forgive principal (whether by accepting a discounted payoff or otherwise); (b) advance additional loan funds; (c) extend the loan term; (d) reduce the interest rate; (e) defer current interest and/or principal payments for a stated period (whether as to all or a bifurcated portion of the loan amount); (f) allow the borrower to bring in one or more new equity partners, (g) agree to make the lender’s recovery of past-due interest contingent on the occurrence of specified subsequent events (such as a condominium sellout occurring at certain price points), and/or (h) waive any other existing defaults.

When trouble strikes a project, the borrower will often come to the lender with a request for the lender to forbear in exercising its rights and remedies, and/or take a haircut, in order to lessen the pressure on the project and mitigate losses. The lender is unlikely to make the requested concession unless it is convinced that same will contribute to a successful resolution of the underlying problem impeding the asset's performance.

A lender should not agree to any loan modification which just delays the inevitable. For example, deferring (or even waiving) interest or amortization may serve only to get the borrower into deeper trouble. Time is a lenders enemy; “letting it ride” is not the answer. In order to evaluate a request for more time or for temporary debt service relief, a lender must evaluate the project's going-forward economics, based on assumptions that reflect current market conditions and in light of the borrower's current business plan.

The value afforded to a borrower through a lender's willingness to restructure and extend should be matched with a “pay-to-play” component on the borrower's part. In practice, this means three things: First, that in the event that a workout does prove successful, the borrower should by no means reap all of the rewards of that success. Instead, those rewards must be shared with the lender who helped make them possible (examples are described below). Second, the lender should not make the requested concession if it is unlikely to result in a successful turnaround. And third, if a restructuring effort does fail despite the lender's best efforts to be cautious in giving the borrower more rope, the borrower's principals and not the lender should be the ones who hang.

The first consideration may lead the lender to seek any one or more of the following forms of upside participation, as the “price” of the lender’s forgiveness, forbearance or other forms of cooperation:

• A shared appreciation mortgage (whereby the borrower must pay the lender a portion of its sale or refinancing profits if the property appreciates).


• An equity kicker or partial equity interest in the asset.


• Convertible debt (a right to convert part or all of the debt into an equity interest in the asset). (If exercisable upon a subsequent default, this is typically considered a voidable clog in many jurisdictions.)

Any of these “upside” strategies, unless properly structured, may create the risk of the borrower later raising various defenses to the enforcement of the workout agreement. These defenses, which will be discussed in further detail in a subsequent article, may include assertions of (x) a constructive partnership between lender and borrower, and/or (y) a “clogging” by the lender of the borrower’s “equity of redemption”.

And what about the other side of the coin? What happens if the lender makes concessions in furtherance of an attempted workout arrangement that ultimately just doesn’t work out?

Any lender worth its salt will insist on protecting its position against the possibility of such a failure. And that same lender will also take the view that if a restructuring does fail despite all efforts, the borrower’s principals should bear all or as much downside exposure as possible. Either viewpoint may lead the lender to effectively trade whatever forbearance or forgiveness it is willing to offer for any one or more of the following protections and concessions:

• The delivery of new letters of credit, or other forms of new collateral. (This approach raises bankruptcy concerns, especially if the new collateral is other than in the form of a letter of credit. It also may raise possible defenses of marshalling, single action and election of remedies limits, issues of allocation for transfer tax and title insurance purposes and issues of doing business in new jurisdictions for taxation and qualification purposes.)


• New recourse, in the form of new guarantors; new guaranties; or guarantee modifications (to include new bad boy events, or to expand a payment guaranty to cover all principal and interest payments where it formerly just sent all net operating income to the lender, for instance).


• New cash management arrangements, such as hard lockbox activation using tenant direction letters that activate the assignment of rents; a new excess cash flow sweep; new budget controls; new performance criteria; new reporting requirements; and/or new escrows.


• New mandatory prepayment events (as from monthly net income, outparcel sales, etc.).


• Installation of a new, unaffiliated property manager; manager fee reductions; subordination of fees to debt service; and/or new kick-out triggers (based on measurements of DSCR, vacancy rates or other appropriate metrics).


• New cross-collateralization; new cross-defaults; new hair-trigger defaults; delivery of a deed or foreclosure judgment in escrow; and other Draconian measures.


• Extension or restructuring fees; payment of expenses; default interest rate bumps; catch-up payment requirements; etc.


• New bankruptcy protections, including solvency representations and clawback provisions.


• Releases from lender liability and other claims.


• Appointment of an asset manager (essentially, a mortgagee-in-possession without having to get a receiver) – this avoids a mortgage tax and lets the lender restore the borrower to control and/or keep some equity if things improve; the risk to the lender is lender liability (especially environmental) and equitable subordination.

The list can continue growing as long as your imagination remains active. The “art of the workout” is in selecting just the right quid-pro-quo -- the tradeoff that maximizes the parties’ overall value. After all, it was a wise man who gave us this maxim of real estate: “first rob the bank; then you can always argue how to split the loot back at the hideout”. In other words, in real estate the players are in this thing together, and for the long haul -- and so the deal (or deal restructuring) that grows the pie the most is usually the right deal to make. Allocating the pie pieces to the players is important primarily insofar as it creates the right incentives to grow the pie, not so much as an end in itself.

About FrontView Group

FrontView Group, operating through its subsidiaries FrontView Capital Management LLC and FrontView Advisors LLC, is a real estate principal investment and advisory firm. The firm offers its capital partners and clients the experience, industry contacts and multidisciplinary skill sets necessary to source, underwrite, restructure and manage prospective and existing investments in today’s highly dislocated and volatile commercial real estate markets.

David J. Steinberg
Managing Principal
FrontView Group
300 Park Avenue
New York, New York 10022
(212) 572-6294
ds@frontviewgroup.com

Bret R. Salzer
Managing Principal
FrontView Group
300 Park Avenue
New York, New York 10022
(212) 572-6294
bs@frontviewgroup.com

Christopher M. Bellapianta
Principal
FrontView Group
300 Park Avenue
New York, New York 10022
(212) 572-6294
cb@frontviewgroup.com

Copyright © 2010. FrontView Advisors LLC. All rights reserved. FrontView Advisors LLC is not a law firm and Distressed Real Estate Update should in no way be relied upon or construed as legal, financial or other advice and should not be relied upon to address specific factual situations without the advice of legal counsel and/or other professional advisors.