Loan Syndications–The Art of Slicing and Dicing
- Dec 22, 2016
Most commercial mortgages are bundled with other mortgages and securitized or simply held on the lender’s balance sheet. However, major loans over $25 million may be syndicated with other lenders–this activity has steadily increased as commercial mortgage volumes have experienced tremendous growth since the depths of the Great Recession.
Commercial banks have curtailed or limited their risk appetite on development and construction projects partly in response to more stringent credit standards and regulatory capital requirements under Dodd Frank and Basel III. This has opened the door for a new class of non-regulated lenders such as hedge funds, private equity funds, family offices and REITs, who are willing to provide greater flexibility and more leverage than banks. These lenders may team up to fund a project, or a larger fund may originate the mortgage loan and then sell off participations to others.
Loan participation (or syndication) is the process of slicing the loan into pieces that are sold off to other lenders. Loan participation interests can take the form of vertical or pari passu shares in the loan, or A/B transactions in which the loan is split into senior and subordinated tranches. These structures add a layer of complexity to major transactions, which requires careful due diligence.
Pari Passu Participations
Some loan syndications take the form of a direct participation or “club” deal, in which a small group of lenders partner in a transaction that would exceed the risk tolerance of each individual lender. In such transactions, each lender co-underwrites the loan, participates in negotiations, becomes a direct party to the loan documents with the borrower on a pari passu basis, and closes simultaneously with the other lenders. More commonly, a lead lender (the “agent”) underwrites and closes the loan, and co-lenders purchase a pro-rata interest in the loan from the agent after the loan closes. In such cases, the co-lenders may have little or no input on the underwriting and structuring of the transaction. The lender group enters into a syndication or co-lender agreement, which defines the respective rights and obligations of the agent lender and co-lenders.
Senior-subordinated participations are typically structured as an A/B bifurcation of the senior mortgage. Such structures are often utilized to provide higher-than-customary leverage or to take on other risks that exceed the exposure more traditional lenders will allow. In an A/B syndication, the lender sells a subordinated slice of the loan to an investor who earns a disproportionate share of the total interest rate in exchange for accepting first-loss risk position. Alternatively, a private equity or hedge fund may originate a highly leveraged transaction and sell a senior participation interest to another lender at a reduced interest rate, retaining the subordinated tranche and levering up its return.
Many borrowers and lenders alike lack a deep understanding of the arcane world of slicing and dicing syndicated loans. Syndicated loans involve much greater complexity, transaction risk and cost for borrowers, requiring agreements with multiple lenders and the risk of unanticipated future conflicts. All parties should exercise considerable due diligence and caution, and should consult with experienced professionals, before entering into a syndicated loan transaction.