Shadow Lending’s Rise Opens New Access to Capital

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Shadow Lending’s Rise Opens New Access to Capital

Once relegated to the dusty niches of capitalism, shadow lending has become a viable and sought-after source of capital that’s prized by borrowers and investors alike.

Investors chasing higher yield have embraced shadow lending. The opportunity to earn equity-like returns from the safety of a debt position is a big part of the attraction, while the ability to enter deals at a lower basis provides a valuable cushion should a downturn occur.

Meanwhile, borrowers who may not qualify for traditional bank lending, can’t raise funds with equity or desire more flexible terms that meet their unique needs are increasingly seeking capital from shadow funds.

Stonehill Strategic Capital entered the shadow lending space about a decade ago when the firm began buying up paper for hotels at significant discounts to par when banks were liquidating loans after the recession. Stonehill quickly built a reputation as a friendlier and more constructive note purchaser that would proactively work with borrowers to restructure their loan.

“We sent a note to the borrower notifying them ‘We’re now the lender, come to our office or let’s get on the phone and figure out a way to restructure this loan,’” said Mat Crosswy, President of Stonehill Capital.

“We were able to buy notes at a discount and restructure them for the borrowers.  By reworking the loan, we could create a “win-win” as long as the borrower was able to honor its new obligation. Effectively, we could provide a borrower with some relief from the face of their mortgage or terms, and allow them to continue to own the asset. Meanwhile, we could drive our investor’s returns through the economics of the discounted note purchase.

Funding what’s next

Shadow lenders are unregulated credit intermediaries. Although they function like banks, they are not regulated like banks and they are not insured by the Federal Deposit Insurance Corporation.

During the financial crisis of 2007-08, traditional banks slashed lending and toughened their standards.

Shadow lenders rushed to fill the gap and it has become more common in real estate, where pre-development costs and construction loans can be hard to obtain. Destabilized properties needing recapitalization are also good candidates.

Borrowers often use the capital to:

  • Fund acquisitions
  • Cover pre-development and development costs
  • Implement turnaround or repositioning strategies
  • Make capital improvements or renovations

Busting myths

The shadow sector is often misunderstood.

“Many people mistakenly believe shadow lenders have a bottomless appetite for risk and that it doesn’t touch the balance sheets of traditional banks”, said Daniel Siegel, Managing Director of High Yield Debt at The Ardent Companies. In reality, shadow lenders often sell a tranche of loans to a traditional bank such as Wells Fargo.

“A lot of these bridge funds, say the larger ones for big private equity shops, they’re still selling a bottom 50% tranche off to a bank. There’s still bank exposure, it’s just one layer removed,” Siegel said.

Another misconception is that shadow lenders want to take possession of a collateralized asset.

“That’s a perception that you’re a predatory lender, you’re loan-to-own, you’re exercising your rights in the documents to get to the real estate,” said Stonehill’s Crosswy.

Taking over an asset is usually a last resort, he said.

“Let’s do what’s right and work through or restructure this investment,” Crosswy said. “We view our documents as a means to protect us if we can’t, from the beginning, sit down with our borrowers and act in a manner that we would act if we didn’t have the loan documents.”

Proactive management

Shadow lenders with the strongest reputations share these traits: in-house expertise on certain asset classes, strong data gathering and analysis capabilities, and proactive management throughout the life cycle.

The Ardent Companies’ senior leadership team has experience across lending, construction management and operations, so they can independently analyze a borrower’s situation before deciding whether to fund it. They also set milestones, timelines and performance targets to create earlier opportunities for intervention if a borrower is struggling.

“The biggest mistake a lot of people make is not proactively managing the portfolio,” Siegel said. “Because for the most part, these are transitional business plans.”

Stonehill’s internal expertise in developing, acquiring and managing hotels as a “huge value add,” Crosswy says.

“If the deal does go bad, we’ve navigated buying distressed debt, buying paper, taking back these assets, stabilizing them, and then liquidating our position. We have the expertise,” said Crosswy.

Riskier or not?

The term “shadow banking” was coined by economist Paul McCulley in 2007 at a Federal Reserve Bank symposium in Jackson Hole, Wyoming.

Across the G20 economies, it’s valued at around $75 trillion and $100 trillion, according to the International Monetary Fund. Heads of central banks and economists have long been concerned about the systemic risks, especially in a down market.

In some respects, shadow lenders help mitigate risk, says Stonehill’s Crosswy. In 2008, banks would often lend at 75-80% loan-to-value (LTV), and today with shadow lending it can be closer to 50-55% with more sources of repayment, he said.

“Banks are lowering their position in the capital stack, and they have these larger funds as their borrowers and guarantors if these deals go south,” Crosswy said. “The credit enhancements are almost better than doing a direct loan, and I think the banks view it that way too.”

The bottom line

“As it matures, the shadow lending sector is starting to do more self-regulating by adopting standardized loan documents, better loan servicing procedures, and stronger policies that protect the rights of borrowers — all of which is necessary if loans are securitized,” said Siegel.

Self-regulation also gives investors greater confidence, which may attract more shadow capital.

Aprio’s Real Estate and Construction advisory team work closely with, debt funds, private equity funds, REITs, commercial and residential property owners and operators, real estate developers, homebuilders, land developers and more. We specialize in commercial real estate, industrial, affordable housing, multifamily and construction.

To learn more about how Aprio’s Real Estate and Construction group can help your business achieve what’s next, contact Justin Elanjian.

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