Asset Based Lending: the Charging Bull in the Distressed Debt Market

Distressed Debt is starting to make a lot of noise in the alternative investment arena, and with everyone jumping on the boat it might be ready to tip. I have seen numerous announcements of new distressed debt funds and I think we will keep seeing more down the line. Here are questions you should be asking: who are going to be the winners and losers, and does anyone really know how distressed the debt really is?

The buzz in the investment air went from buying real estate to buying distressed debt. What I would like to concentrate on here is distressed debt in the form of real estate mortgages. Being a fund manager of a specialized fund that operates as an asset based lender in the business of alternative financing, we are getting hit almost daily with people looking for money for foreclosure acquisitions. Everyone is talking about buying foreclosures, and the media is again helping to purport the good news/bad news story by publishing articles about investors making big money through foreclosures. The most favored structure for investors is to negotiate short sales with banks before the foreclosure, and lately it seems the banks are more open to this option than before.

A short sale, for those of you not familiar with the term, is a sale of a mortgage note for less than its face value. Banks do this because they want to get the bad debt off of their books. This works well in a good market because it gives the new note holder instant equity in an appreciating asset with the hope of a large gain on the eventual sale after an eventual foreclosure. Granted, in this current market, short sale pricing is a little more discounted than usual, but for good reason since the housing market is a bit in shambles. Once an investor actually does negotiate a short sale and take possession of the note, the long foreclosure process begins.

First off, real estate is not a liquid asset and the foreclosure process makes it even more illiquid. If you are looking for a quick turnaround, look somewhere else. The foreclosure process is not only long and tedious, but if you are unfortunate enough to buy a note for a residential property that is owner occupied, the law is not on your side. As a rule, commercial property is a less regulated structure that is more of a business agreement than the regulated monster that is residential lending. In residential lending, the law gives the borrower every possible leniency and time is on their side. A residential owner can stretch out a foreclosure for anywhere between 6 to 18 months, and depending on the state and how much they fight it, it could go even longer than that. Imagine having to service the debt that was used to buy the foreclosure during this long unpredictable wait; every month the payment to carry that debt eats into the profit. However, that is only the start of the pain because you also need to add up all the costs like legal, insurance, maintenance, and the potential damage that will have to be repaired when the borrower leaves (needless to say, evicting someone from their own house brings out the worst in people). Wrap it all up and distressed debt starts looking less like a slam dunk and more like a dunking tank.

The big question is how certain are the funds betting on this strategy. Furthermore, I am curious about whether or not there is a long term strategy for these funds? If there is a long term strategy, what is it? Because the amount of new loans being made is decreasing, and once we start churning through all of the bad debt and foreclosures, how much business will there be to support a multi-billion dollar fund?

This is not to say that there aren't a lot of very skilled fund managers out there with the experience and know-how to make this kind of strategy pay off, but if I had to take a guess, I would say that the Asset Based Lenders (ABL) are going to be the big winners here.

Now I am possibly biased. In full disclosure, the fund I co-manage is an asset based lender collateralizing on commercial real estate, but here are the facts to back up why the ABL's are the play here. It takes cash to negotiate a short sale, and it is next to impossible to get a bank to give you an unsecured line to go out and buy short sales. Even trying to get a loan on a commercial property that you already own is becoming a magic trick, so these buyers only have one choice and that is alternative financing. These alternative financing sources can charge what they want for the simple reason of supply and demand. When I say they can charge what they want, I am talking about rates in the neighborhood of 11%-20% on average, and those are good returns in any market. Not only can they charge what they want, but they can also afford to be cautious. Most alternative financing sources (many being ABL funds) only lend on commercial real estate, and during the heyday, banks were lending somewhere between 75% to 100% loan-to-value(LTV) while ABL's were generally lending around 65% (LTV). On average that is 15%-20% more collateral in a deal, and collateral translates into security. In addition, most good ABL's are originating and underwriting their own loans which helps keep these valuations accurate. An experienced ABL should know how to sift through the numbers and nuances of a deal to understand what the end looks like before the start.

ABL's are currently doing very well and the significant returns are still ahead of them. One must consider that ABL's are probably going to lend around 65% LTV on a note that has already been negotiated down between 25%-30%. In fact, the new norm for ABL's seems to be below a 60% LTV. That means that a note that was discounted 30% is then discounted by the ABL's another 40%, and clearly the security starts looking more secure. If the borrower defaults and the ABL forecloses on the property, there is an awful lot of equity remaining to provide a potential gain in the end. It's easy to see in the short-term that ABL's are generating great returns through high interest, and in the long-term they have the potential to secure healthy gains through possible foreclosure on their own deals.

Let's be clear, there is a vast amount of opportunity in distressed debt. However, the most lasting and secure opportunity is in the hands of whoever is at the end of the end game, and that long end game player is the Asset Based Lender.

Copyright: Dominic Mazzone, Regent Global Funds 2008

This article was written by Dominic Mazzone, Managing Partner and Fund Manager of Regent Global Funds.

This article and other like it can be viewed at http://www.investingsymposium.com which is part of the Regent Global Funds Network.

Regent Global Funds is a alternative investment fund that offers its participating investors and asset backed investment through asset based lending and can be found at www.rgfunds.com

The Fund Managers of Regent Global Funds have an expertise in commercial real estate lending and have created a successful alternative investment vehicle that is diversified through this structure.

They separate themselves from other fund mangers by personally investing their own money side-by-side with their investors in the fund, creating an absolute structure of accountability. Dominic Mazzone has written about the need for this type of accountability in an article titled Fund Managers Need to be Accessible and Personally Invested.