An interesting thing happened this week.  Warren Buffet got his butt handed to him.  Let me set the scene.  Berkshire Hathaway is sitting on $128 billion in cash; but in comparison to the $2 trillion in cash that private equity firms are siting on, Warren Buffet’s massive cash hoard is chump change.  Haha!

Private equity typically refers to investment funds, generally organized as limited partnerships, that buy and restructure companies, many of which are not even publicly-traded.  A source of investment capital, private equity actually derives from high net worth individuals and firms that purchase shares of private companies or acquire control of public companies with plans to take them private, eventually become delisting them from public stock exchanges.  Most of the private equity industry is made up of large institutional investors, such as pension funds and groups of accredited investors.

Okay, so Tech Data is a publicly-traded company in Clearwater, Florida.  It’s a company that offers complete product lines in software, networking and communications, mass storage, peripherals and computer systems, from companies like Apple and Cisco.  In addition to distributing more than 75,000 products from over 1000 manufacturers and publishers, Tech Data provides extensive pre-sale and post-sale training, service and support.

Suddenly, Tech Data receives an unsolicited takeover offer for $130 per share from Apollo Global Management, a private equity firm with investors from all over the world.  The investment bankers, hired by Tech Data to advise on the transaction, take the deal to Warren Buffet.  He offers Tech Data $140 per share.

Then Apollo comes back and increases its offer to $145 per share, and Buffet bows out of the bidding.  I think that Warren Buffet made a mistake because the world is running out of stocks.

“Huh?  Running out of stocks?  George, you must be smoking that Colorado oregano.”

In order to explain an important concept, please humor me as I share an imaginary economics parable.

The year is 800 A.D., and the place is the imaginary island of Palm Tree, in the Solomon Islands.  The people of Palm Tree (“the Palms”) have just fought and won a bitter war against the headhunters of Guadalcanal, the same island that would, eleven-hundred years later, be the site of one of the bitterest battles of World War II.

In this bitter battle against the headhunters, the Palms lost two-thirds of their men and women (who had to fight alongside their men) between the ages of 14 to 55.  The island nation is now disproportionately old men, old women, and children.

Every day fewer than 175 fisherman, manning just 22 remaining fishing boats, head out to sea to bring back fish – one of the few sources of protein for the nation.  The problem is that 175 fisherman cannot catch enough fish to feed an entire nation of 6,500 souls.

The problem is not the availability of fishing boats (capital), but rather the lack of fishermen to man the boats.  Women are pressed into the fishing service, but the losses among the womenfolk (many of whom were carried away as slaves) were almost as large as the fighting men.  There are just not enough people of working age to take care of all of the old folks and young people.

When the fishing boats return to harbor at night, the bidding for the scarce fish steadily drives up the price of fresh fish.  Anxious not to starve, groups of elderly and wealthy islanders pool their valued oyster shells and start to buy up a partial ownership in the fishing boats and their precious crews.

You can’t eat oyster shells, so the bidding for the shares of the remaining fishing boats is fierce.  If you own a share, you get fish to eat.  If not… sorry, old man, but you starve.

The problem?  No matter how many oyster shells possessed by the elderly, there are only so many fully-crewed fishing boats.  To make matters worse, accidents and storms sink one or two fishing boats every year.

Obviously, the fully-crewed fishing boats, in my parable, are publicly-traded companies.  The accidents and storms represent companies that are purchased by private equity firms.  Once a company is purchased by a private equity firm, the shares of these companies no longer trade on any exchange.

And the bitter war against headhunters that greatly reduced the working age population?  That is the declining birthrate in the U.S., Europe, Japan, South Korea, and … are you ready for it?  China!

What is the moral of this story? I am just musing here, but if you own a share in a well-maintained fishing boat, don’t sell it. If you get a chance to buy a share in a well-maintained fishing boat, buy it. There is not an unlimited number of fully-crewed fishing boats. Central banks worldwide, especially the European Central Bank, keep creating new oyster shells like crazy.

By George Blackburne

A company named JCR Capital sent me an email flyer several months ago advertising their equity capital for value-add real estate investments.

Value-add commercial real estate investments typically target properties that have in-place cash flow, but they seek to increase that cash flow over time by making improvements to, or repositioning, the property.  In other words, the property has tenants, but they are paying substantially below the potential rent that the property could be getting.

In a value-add investment deal, the transaction’s sponsor makes an active effort to elevate the income stream of the property, typically through a significant capital improvement program, such as a partial or property-wide renovation.  Examples of such improvements might include new paint, new signage, renovating the lobby, and improving the security of the property and the parking area, etc.

In their marketing flyer, JCR Capital advertised preferred equity, joint venture equity, and programmatic equity.  Programmatic equity?  What the heck is programmatic equity?

Before we get into programmatic equity, lets first do a quick review of the term, “equity”.  Equity is not just the difference between what your house is worth and the balance on your first mortgage.

Equity – in the context of real estate – is the money that the owner stands to lose before “the bank” loses its first penny.  Obviously, “the bank” could also mean a credit union, a life company, a conduit, or any other type of real estate lender.

Equity is often referred to as the first-loss piece.  If anyone is going to lose any money on a real estate deal, the first guy to lose a chunk out of his tush is the equity holder (the owner).

Example:

ABC Development Company specializes in turning around big apartment projects that have become run down.  In downtown Washington, DC, ABC Development learns of a 360-unit apartment project within two miles of Capital Hill.  The well-located apartment project was once filled with ambitious, young political staffers; but when the old man died, and his wife took over the management, the condition of the property and the rents plummeted.

ABC Development can acquire the property for just $32 million, but the renovation costs are another $9 million.  With an interest reserve and the other necessary soft costs, the total project cost is $46 million.  The bank, with whom ABC Development has a relationship, will only loan up to 70% of the total cost because the project has become a big drug house and a gang hang-out.

A huge renovation project like this needs to be structured like a construction loan.  Who remembers the four elements of Total Cost?  Of course, there is the land cost (in this case, the cost of the land and the building), and then there are the hard costs (bricks and mortar).  What else?  Soft Costs – that’s right!  Good job.

But you are still forgetting the fourth element of Total Cost (of a development project). It’s the contingency reserve.  A good rule of thumb when computing the contingency reserve is to use 5% of hard costs and soft costs.  Why not 5% of the land cost?  Because by then the developer already knows the cost of the land.  There is NOT going to be a cost overrun in connection with the land.

Therefore the total cost of a development project is the land cost, plus the hard costs, plus the soft costs (interest reserve, architectural fees, engineering fees, points, closing costs, etc.), plus the contingency reserve.

Okay, now let’s get back to ABC Development’s big value-add deal.  We said the total cost was $46 million, and the bank was willing to lend $32.2 million – which is 70% of the total cost.  Therefore ABC Development will need to contribute $13.8 million.  The development company has $3.8 million to contribute, so it will need an equity provider willing to put up the remaining $10 million.

This is the type of value-add deal that would be perfect for the nice folks at JCR Capital.  Their transaction sizes include equity contributions of between $5 million and $50 million nationwide.  (We are talking large deal sizes here, folks.  The property should at least be worth $20MM.)

Okay, But What the Heck is Programmatic Equity?

As Sam explained to me, “Programmatic equity is where we provide a facility of capital, say $25 million to $50 million of committed capital, for a particular strategy that a sponsor is pursuing.”

Example:

Let’s suppose that a developer specializes in buying large, older, mobile home parks, and then the developer repaves all of the streets, tears out the landscaping and puts in far-nicer lawns and bushes, puts in a new pool and a new clubhouse, enforces the park rules about skirts and storage sheds, squeezes out the mobile homes being used as rentals, squeezes out the ugly and/or single-wide coaches, and then dramatically raises the rent.

When everything is stabilized, the developer then sells the mobile home park to a REIT.  This is his program.  He has flipped four parks already, and he has identified fifteen other parks in need of his program.  He needs just $3 million in equity to satisfy each bridge lender providing the underlying first mortgage, but in order to renovate all fifteen parks, he might eventually need a total of $45 million in equity.

A provider offering programmatic equity might go all the way down to just $3 million on each mobile home park because the sponsor will be doing 15 of these projects.   The provider might offer the developer a capital facility (kind of like a line of credit) of $30 million in equity to start renovating these large, old, mobile home parks.

By George Blackburne