Having a robust, diversified and scalable capital structure is paramount for all financial firms. This includes large commercial and investment banks as well as private lenders. This means private lenders would have multiple sources of funding. The type of capital varies but generally it could include an equity component (common and preferred) and several forms of debt (short term working capital, short term and long-term debt).

The reasoning behind building a more robust capital structure are many but include:

• Reduce risk inherent in having just a sole source should there be an interruption to that source.
• Ability to better match your assets and liabilities. You ensure that the life of your assets and liabilities match so you are not left with debt that is maturing but financing longer term assets and vice versa.
• Lenders may have many good opportunities to book business but their sole source is not adequate to fund this business (cash outflows exceed inflows).
• Match cost of capital against return on assets. Sometimes it may be necessary to book a deal at a lower interest rate than you are paying for capital, creating negative spread. This is especially true when competitive pressures increase, which is occurring more frequently now.

In practice, private lenders have historically funded their business through just one form of capital: A fund for registered private placements used to solicit investments from individual private accredited investors. For the most part, these investors are sourced and managed via registered retail broker dealers.

Some firms can bear the costs and risks associated with this strategy and have been able to establish a robust mechanism to invest in and execute in this arena. Many other firms have been limited in their ability to scale and execute on this strategy.

One of the key limitations of this strategy for all firms, regardless of success, is that it still exposes the lender to all the risks inherent in a single source capital strategy.

Due to recent market shifts, however, private lenders are attracting a lot more attention from institutional investors than has historically been the case. This creates an opportunity for lenders to access an additional funding source. A structure can be created that provides committed capital to the lender—somewhat like a private placement but without the costs, time and risk required. It solves most, if not all, of the single source strategy risks.

There are numerous institutional credit funds that are desirous to expand into the commercial real estate small balance lending space. These funds have historically invested in larger deals (approx. $15 million and above) and are now looking to partner and create long-term relationships with established private lenders.

These funds have excess capital to invest in assets generating current income and are accustomed to evaluating unique credit circumstances which mirrors what private lenders see every day. These funds manage patient capital (five to seven years) from pension funds, insurance companies and private wealth management offices.

Partnering with one of these firms enables a private lender to expeditiously and inexpensively establish a committed capital fund.

Benefits to institutional capital as opposed to private placements:

Some of the benefits

• Costs: There are minimal costs associated with setting up these relationships. Costs that occur are legal review of contracts and time resources. All costs associated with creating and filing a private placement are eliminated. Ongoing costs of compliance, including annual audits and reporting are likewise eliminated.
• Time: There is no set time table but these relationships can be created quickly. From initial contact to funding can be accomplished in as little as 45 days. This contrasts favorably with the time required to solicit and close individual investors.
• Regulatory risks: This is a private contractual relationship. The SEC nor any other regulatory body governs these relationships. All legal risks associated with accepting and managing private investor funds are eliminated.
• Number of investors: It is not uncommon for private lenders to have dozens if not hundreds of individual investors. The time associated with maintaining proper communication with these many individuals can be overwhelming.

Capital Format

There are multiple ways to structure a relationship. This will depend greatly on the lenders needs and resources.

• Commitment: It is important at the outset of the relationship that the lender communicates to their investor their capital needs and their capabilities to manage a new relationship. This will drive the structure and help in selecting the right investor. Investors are generally not interested in putting the resources in place to develop a relationship for just a “one-off” deal. They will focus on partners that can provide a steady flow of deals. This allows the lender to secure a certain size of commitment. The size will vary but a good starting point for investors focused on this asset class will be close to $20 million.
• Legal structure: The legal form of capital investment will be driven by lenders needs and capacity. The investor will commit capital to the lender under an agreed upon structure.These generally fall into these categories:

1. Servicing retained sales: Lender will sell a loan to the investor, but retain the servicing and management of the loan. The loan sold can already be funded and on the lender’s books or it can be a new loan that the investor will fund on behalf of the lender. The lender is compensated for the servicing and loan management and can retain a participation in the loan or can sell the entire loan. The lender can redeploy the capital in funding new loans.
2. Servicing released sale. This is similar to (a) but the investor will underwrite, fund and service the loan themselves. This works well when the lender doesn’t have the capital on hand to fund the loan themselves, and/or they do not want to take on the credit or capital risk on a certain deal.
3. Warehouse line of credit: This is a revolving credit line that allows the lender to accumulate a loan on their balance sheet for a given time, generally three to six months. This allows the lender to book a loan and hold on to it until they wish to place it into a longer-term funding source. This is applicable to larger lenders who have the balance sheet to support this strategy. The investor will not fund the entire loan and will require the lender to fund anywhere from 10 percent to 25 percent of the loan themselves.

Loan parameters:

Generally, credit funds are participating in the following loan characteristic

• Collateral: Real property: commercial, mixed use, apartment/multifamily, light industrial, self-storage, retail, hospitality
• Loan Purpose: Purchase, refinance, bridge, investment, property rehabilitation, rent stabilization, distress situations. Any instance where property is being “re-”

Some investors will finance vertical construction although this is not a common practice

• Term: Six months to two years
• Loan sizes: $750,000-$20,000,000
• LTV: < 70 percent

Legal Considerations:

Legal requirements will include execution of the following contracts:

1. Purchase and sale contract that outlines the duties and responsibilities of parties
2. If capital is in the form of warehouse credit line, then a warehouse lending agreement will be required
3. If agreement includes the lender retaining loan servicing, a loan servicing agreement will be required

Other legal issues of importance:

1. These transactions will generally be non-resource to the lender for purposes of credit risk. That risk will transfer to the buyer at closing.
2. Private lenders can retain a participation interest in the loan which will be considered a “first loss” position meaning that the interest will be subordinate to investors. Lenders will be compensated for retaining this position. Should be low-mid double digits

There currently exists a very strong desire amongst real estate focused credit funds to allocate capital to private lenders who generate small balance commercial loans. This is a very credible and effortless way to explore alternative funding sources beyond private placements.

If you believe your business could benefit from additional channels of funding this could be the solution you are seeking. The market is primed and a partnership created that now can afford your business a way to complement existing funding sources and reduce the risk and challenges of a single funding source.