Commercial Mortgage Insight

Co-Lending: A Well-Established Practice Draws More Attention

Co-lending is attracting more attention as a desirable investment option for life insurers and other portfolio lenders. However, lenders must be careful when developing co-lending relationships and documenting transactions.

BY JEFFREY WILLIAMS

Co-lending, also referred to as co-investing, is a well-established practice. For decades private placements, bank syndications, re-insurance contracts, and club deals among financial institutions have been a practical way to handle large financial transactions, diversify risk and exposure and accomplish other strategic goals.

A resurgence of commercial real estate mortgage co-investing among life insurance companies over the last five years has brought new attention to this investment format. Many financial institutions including life insurers completed mortgage co-investment transactions in 1998 and 1999, and 2000 is looking like more of the same.

First, it is best to define some terms. In general, most people use the term "co-lending" or "co-investment" to describe all investments in which two or more parties share a mortgage investment. Other terms frequently used include: club deal, syndication and participation.

One major distinction is whether all parties commit to, or enter into, the investment at the same time. It is common to regard a co-investment and, in most cases, a club deal as one in which all parties jointly commit and fund the investment, each having substantial decision-making authority in the making and administration of the investment.

A participation or a syndication typically refers to an investment that is originated, committed and closed by one institution and in which another institution(s) invests on or after the closing date with the originating lender retaining substantial authority for servicing the investment.

The benefits of co-investment

The decision to co-invest is typically driven by diversification strategies. Virtually all portfolio lenders have a maximum dollar limitation for a single asset, for a portfolio of assets and for an individual borrowing entity. Loan opportunities that exceed a dollar limitation can be accommodated through a co-investment.

Other diversification and exposure issues such as property type, location and borrower concentrations may also be managed through co-investment. A lender can accommodate the new business that creates diversification issues by finding a co-lender for the new loan or by finding a participant(s) for existing portfolio loans, thereby freeing up capacity to do the new loan.

Some lenders use co-investments to leverage their origination capacity. Portfolio lenders that have reduced their real estate staffs but still desire the yields provided by commercial mortgages can co-invest in new loans or purchase participations in existing loans originated, closed and serviced by others.

There are now Web-based services that provide a forum through which club deals can be transacted, yet another avenue to leverage or outsource the origination, closing and servicing functions.

In the 1990s, Wall Street investment banks dominated the large loan market, offering large loans in both public and private securitizations. At that time most life insurance companies were either out of the market or focused on smaller loans. As the markets improved in the later 1990s life insurers returned to the market and co-lending again became popular. The investment banks continued to exploit the efficiency of the capital markets for those borrowers who could conform to the structural requirements of loans destined for the CMBS market, or they originated large and more structured loans for private securitization.

Life insurance co-lenders, by contrast, tended to win the deals that required more unique structuring and with borrowers still unaccustomed to and uncomfortable with public securitization. Life insurers can also offer a borrower more traditional mortgage documentation, as well as lower closing and servicing costs.

After the capital markets meltdown in the late summer of 1998, few investment banks were willing to warehouse a large loan and take the spread risk between origination and securitization. Life insurance companies saw an opportunity to regain lost business, but most needed a co-lender(s) to commit to the large deals. The limited number of capital sources for large loans resulted in wider spreads for those able to do a co-lending transaction.

Co-lending has often allowed lenders to diversify into very high quality, trophy assets with the best and strongest borrowers - assets they might not have otherwise been able to accommodate individually.

Picking your partner

Clearly the best co-lending partners are organizations with similar investment philosophies, underwriting standards, loan parameters, and risk tolerances. In short, there must be a good alignment of interests.

In a participation, the party(s) investing in the originator's loan must perform their own due diligence on both the investment and the documentation, since the loan with the borrower has been closed. In a co-investment, where the parties jointly negotiate with the borrower (and each other), the importance of picking a good partner cannot be understated. Often the relationship between institutions is based upon a relationship between individuals in the respective organizations.

It also might be a similarity of corporate cultures that forms the basis for a good partnership. Borrowers are often hesitant about negotiating with a club of lenders who have not worked together previously. Negotiations are stressful enough without the added uncertainty and contingencies of working with two or more lenders who may have difficulty agreeing on loan terms and inter-creditor issues.

Among the issues on which there should be common ground are:

term and amortization of the loan,
degree of leverage and debt coverage,
underwriting methodology,
approval/commitment process,
rate circle/hedging strategy,
third party consultant requirements,
closing requirements,
servicing and voting rights,
regulatory requirements,
legal representation.

Most of the institutions active in co-lending prefer to have only one co-investor. Very large deals, of which there are an increasing number, often require three or more co-investors. Experience suggests that the more parties at the negotiating table, the more complicated and time-consuming the process.

Commercial banks, on the other hand, appear to be much more comfortable with multiple participants - probably a result of more extensive experience with the syndication format.

It is important that the co-lenders recognize that compromise is an important ingredient in reaching a successful conclusion. Critical issues should be identified early so the parties can reach a resolution. There is usually a solution which can satisfy all of the co-lenders.

The lead lender

One lender should be designated as the lead lender at the outset and given the responsibility for coordinating the negotiations, underwriting and closing. Being the lead lender requires good coordination, administrative and negotiation skills, as the additional inputs and perspectives of the co-lender(s) add complication to each step of the process.

It is important that the opinions and biases of the co-lender(s) are accommodated and the process be as seamless as possible to the borrower. A good experience enhances the chance for repeat business with the borrower and lending group.

Organizations vary on who assumes the lead role in the inter-creditor negotiations. Some use their attorneys, others the investment underwriter, while some with large co-lending operations have a person dedicated to fostering the co-investment business.

Whatever the arrangement, it should be clear to all who has the authority to negotiate for each co-lender. Mortgage bankers and brokers are keenly aware of the co-lending trend among life insurers and when a large loan opportunity arises they are often quick to initiate the process of forming a club of lenders.

This can be very helpful; however, it is still critical that one lender takes the lead. Lenders should also carefully consider those with whom they are being encouraged to co-lend. A club works best when its members share similar philosophies, risk appetites and views of the capital markets.

Banks have a long history of syndicating both term and construction loans. With increased activity among life insurers in floating rate debt, some life companies have begun investing in bank syndications.

These loans are almost exclusively floating rate loans and are either a closed loan into which other lenders invest, or the loan is subject to arranging the syndication. While banks have some different regulatory requirements and structural features, it should not be difficult for life insurers to understand and participate in bank deals.

On the other hand, commercial banks have historically not invested in insurance company originated loans, as they are typically long term, fixed rate loans originated to match the duration of longer-term liabilities of life companies. Bank pricing may also reflect other relationships with the borrower or the loan might be full or partial recourse, which is less common in life insurance company lending.

Look for increased co-lending between commercial banks and life insurers, particularly as life companies offer more short term financial products.

Latest trends

An increasing number of life insurance companies are characterizing themselves as financial services companies. For many, a component of this strategy includes spinning off their investment operations into a subsidiary that has stand-alone profit and loss (P&L) responsibility. Consequently, some of these organizations are looking for revenue producing activities and capital sources.

One strategy is to earn origination and servicing fees from arranging co-investments. The concept of paying a fee for originating and servicing a loan is readily found in the CMBS and banking worlds. In fact, the independent rating agencies also require fair and adequate fees.

Many believe an effective lead lender should earn a fee for coordinating the due diligence, arranging site inspections, ordering third-party reports, hiring legal counsel, negotiating with the borrower on behalf of the co-investors and closing the loan.

At the same time the participant's resources can be leveraged for use on other investment opportunities. In many cases the lead lender has sourced the deal directly and brings a valuable relationship to the co-investment. An increasing number of co-lending participants recognize the added value and are willing to compensate the originator appropriately. This type of arrangement is very common in commercial bank syndications.

Lead lenders are also looking to earn a servicing fee over the term of the loan. These fees vary with the size and complexity of the deal, and range from five to 15 basis points annually on the outstanding balance.

For this fee, the lead lender provides the full menu of master servicing functions including receipt and disbursement of the monthly mortgage payment, administration of real estate tax escrows, administration of capital improvement escrows, annual inspections and reports, receipt and analysis of the financial statements, administration of insurance and condemnation claims and any other actions delegated to the servicer under the terms of the inter-creditor agreement.

In bank syndications it is common for the agent, or lead bank, to receive an administrative fee paid by the borrower for the master servicing duties. The borrower adds the coupon and administrative fee to compare alternative quotes.

Life insurance companies have not adopted this convention; instead a servicing fee strip is taken off the coupon. In some agreements, if the loan defaults and is placed in special servicing the servicing fee is increased, compensating the servicer for the higher level of skill and greater intensity of effort required by the servicer handling default situations, workout, foreclosure and/or bankruptcy.

Finally, if the loan collateral is acquired by the lenders as a result of a default, an asset management fee might be charged by the lead for the additional responsibilities of providing asset management and supervising a more labor-intensive investment.

Capital markets similarity

As lenders have trimmed their staffs over the last several years, outsourcing various real estate services has become more common. In a sense the CMBS industry is an outsourcing vehicle that provides investors with originated and serviced investments and the ability to choose a given level of risk at a competitive market yield.

The CMBS industry pays one party for originating and closing the loan, another a fee for master servicing the loan, and often another for special servicing and asset disposition. The fees and profits in the CMBS business are still evolving.

As long as the origination and servicing functions add value, an increasing number of lenders will be willing to pay for that added value. There are still a number of institutions, however, that prefer the traditional parri passu arrangement where, although one lender may serve as lead, there is no servicing compensation.

These latest trends are issues of control. Mortgage bankers and brokers, correspondents, investment and commercial banks all derive income from "controlling their business." The ability to control, originate, close and service loan opportunities is reflected in origination and servicing fees. As more life insurance investment operations are charged with similar P & L responsibility (ie. profitability), they too will require fees for their services in deals that they control.

Co-lending can be an efficient way to boost origination, develop assets under management, diversify risk and exposure, and enhance yields. Improvements in the format, documentation and real estate legislation have given many institutions comfort that the structure is in place to solve problems that may arise in a recessionary real estate market or dealing with a troubled property.

This investment format provides benefits for both the originator/lead and the participant. Institutions actively co-lending can be found in either role. The benefit to the participant is often the leveraging effort on its production and servicing resources, as well as the opportunity to diversify into high quality assets with the strongest borrowers.

Time spent selecting a compatible co-lender(s) and addressing the procedures and voting rights within the inter-creditor agreement that govern the occurrence of, and reaction to, negative events will pay great dividends.

Look for an increasing number of life insurers to embrace the capital markets and commercial bank approach to co-lending-paying fees for originating and servicing loans. Co-lending has long been an attractive business strategy for commercial real estate lenders and it should continue to evolve in both efficiency and profitability.

Jeffrey Williams is a managing director with David L. Babson & Company of Springfield, Mass., a member of the MassMutual Financial Group. He is responsible for co-lending, loan participations and loan sales.

This article was previously published in the July 2000 Issue of Commercial Mortgage Insight.