The structural answer to protect a developer’s position and possibly eliminate any remaining personal guarantees may be a “silo.” The silo approach isolates the cash flow related to the silo lender’s collateral within the silo and effectively “cross-collateralizes” partnership interests owned by the parent/sponsor/guarantor
within that silo.
Over the past decade, commercial real estate (CRE) lending saw significant growth as financial institutions competed vigorously for new loan and fee originations. As average projects, borrowers, and relationships grew larger, CRE loans became increasingly complex, and each new project often incorporated multifaceted legal structures involving numerous entities. During boom times, many developers also managed to persuade lenders to eliminate personal and/or corporate holding company guarantees. Given the current fallout in CRE values and the pullback from CRE buyers, developers now face a situation in which their outstanding loan balances are at a higher percentage of project value than expected, liquidity has all but evaporated, and many projects have stalled.
However, even in this current distressed CRE environment, developers have options. Consider the case of a CRE developer with multiple projects and multiple lenders:
It is typical for large CRE developers to use a single-purpose entity (SPE) approach to manage the legal structuring side of their developments, and to provide lenders with a single corporate sponsor to guarantee the debt for all the SPEs.
In these cases, usually a few lenders have financed a majority of the projects, and, as a result, these lenders hold the majority of the debt owed by the SPEs.
Within the group of larger lenders, the developer may determine that certain lenders are in a better collateral and/or legal position if the projects they have funded are isolated from all the other projects in the developer’s portfolio.
There may also be single project lenders who demand interest, principal, or full payouts exceeding the cash flows on the projects they have financed, or lenders whose collateral positions are overleveraged. As such, these lenders may find themselves more reliant on the guarantor/sponsor to repay all obligations.
If you, as a developer, determine that projects with a given lender are in a better position compared with those held by other lenders, you need to ask yourself how to protect the cash flows related to those projects in a better position.
The Silo Approach
The structural answer to protect a developer’s position and possibly eliminate any remaining personal guarantees may be a “silo.” The silo concept involves isolating all projects related to a particular lender and transferring them into a new subsidiary roll-up entity that is still 100 percent owned by the sponsor/guarantor. In this way, all the assets specific to that lender’s loans are owned by the new midtier silo entity (see figure 2). This provides the developer and the silo lender the opportunity to:
capture excess cash flow generated by assets within the silo;
accumulate interest reserves;
support less successful projects within the silo;
make scheduled debt payments; and
provide a safer mechanism for providing additional funding to certain projects.
The silo approach isolates the cash flow related to the silo lender’s collateral within the silo and effectively “cross-collateralizes” partnership interests owned by the parent/sponsor/guarantor within that silo.
This approach has benefits for the developer. From the parent/sponsor/guarantor perspective, the silo structure segregates issues for the silo lender and allows the developer to implement the business plan for the projects within the silo. It also allows the borrower and lender to agree to extension terms of the debt inside the silo, and can often eliminate the need for the continued guarantee of the parent/sponsor.
From the silo lender’s perspective, this structure allows the lender to control its own destiny, while at the same time reducing restructuring costs. The restructuring costs paid to third parties may be lower because the silo entity can be bankruptcy-remote should the developer or related entities file for bankruptcy protection related to other projects. The lender’s internal restructuring costs may also be lower due to the lender’s ability to focus attention only on the projects in the silo. It should be noted that the timing of the transfer into the silo may set the preference-period clock if a bankruptcy for the parent/sponsor ultimately occurs.
These advantages for both parties may encourage the developer and lender to work cooperatively to develop a silo approach.
Steps to Create a Silo
When considering this approach, the first step is to develop (or update) project-level cash flows for each of the individual projects in the silo lender’s collateral pool. Because an accurate assessment of project-level cash flows and roll-up models typically will be required by the lender, the developer may find it prudent to involve a disinterested third party such as a financial adviser to develop the information. A thorough review of the project-level cash flows and the roll-up consolidating cash flow will be necessary because certain projects may need to be left outside the silo due to the extent of losses, poor future outlook, or problems associated with these projects. In addition, a borrower should always seek legal advice from counsel with a good track record in real estate restructuring.
The next step is to negotiate a new loan agreement related to the new silo entity. Once the silo roll-up financial projections are vetted, decisions can be made regarding the loan agreement related to the silo. Items the lender will ask the developer to agree to may include:
requiring lockbox arrangements to capture cash flow related to the silo projects;
requiring interest reserves to be replenished or created;
limiting transfers of cash outside the silo;
requiring debt amortization based on an overall reduction in debt rather than a project-level reduction;
accumulating funds in the silo to support cash needs at underperforming silo projects with positive cash flow from other silo projects; and
providing additional funds to certain silo projects while protecting the silo lender’s overall risk structure.
Developers should anticipate that the silo lenders will increase the level of performance monitoring. Upon agreement on the cash-related terms of the restructure, the silo lender may also consider the creation of an independent manager position for the silo projects. The developer may want to resist this additional cost and oversight, but if the lender is adamant, it will be in the developer’s best interest to be involved in the selection process and to work with this independent manager.
The independent manager would operate with the best interests of the silo projects in mind and typically is a watchdog to ensure that the terms of the agreed-upon silo arrangement are met. The developer who establishes a strong working relationship with this independent manager will have greater influence over the decision-making process. While a developer may resist the independent manager concept, accepting the manager may provide the developer with other important concessions from the lender, such as term extensions, elimination or reduction of guarantees, and even additional loan proceeds.
Developers often suggest a global settlement approach to all lenders from whom they have borrowed funds for projects. Initially, the concept is that larger lenders—those with disproportionately higher levels of debt compared with other lenders within the same developer relationship—can be asked to fund underperforming projects originally financed by smaller lenders who flex their muscles as a “squeaky wheel.” However, if the developer analyzes each of the projects and then aggregates the projects by lender, one or two lenders may hold the majority of the projects that the developer thinks will perform satisfactorily or recover value more quickly. Certain projects may be in better financial condition than others, yet the global settlement approach fails to differentiate its use of funds across projects and lenders.
The silo approach allows a developer to isolate the cash flows from better projects focused with one or two lenders from the demands placed on the developer’s cash flow by other projects with third-party lenders. The silo projects can pool cash flow to support each other’s needs before necessitating additional borrowings from the silo project lender to support cash shortfalls. This approach permits the developer to continue a working relationship with one or more of its larger lenders and allows the projects to continue. The developer’s equity recovery may be delayed as silo projects assist in funding each other; however, the developer’s equity in the silo projects would also be protected from the projects financed by other lenders.
To accomplish this objective, it is imperative that the developer have accurate, detailed cash flow projections by project, which are then rolled up to a lender-specific cash flow. The silo structure should be created by competent restructuring counsel with experience in this arena. The developer may need to agree to appointment of an independent manager who provides oversight on the silo projects; however, a strong relationship with that independent manager can work to protect the developer’s role in driving project completion. The equity recovery may be delayed while the lender works to require projects within the silo to fund each other; however, the developer would retain the equity recovery.