Alternative Assets

The negative effects of COVID-19 on the commercial real estate market have been well-documented over the last several weeks, although at this juncture, some assessments may be more speculation than fact. The effects on hospitality, travel, sports, and food and beverage assets are obvious; others, such as data centers and dedicated logistics, may be more muted. The trough in the commercial real estate space will lag the macroeconomic trough by about six months (probably eight or longer given the stimulus Band-Aid). The timeframe for normalization in the aforementioned industries will be significant.

Without delving into nuances among Section 1031 product, development and existing assets, then layered again over various asset classes, the broader effects of COVID-19 and the resulting severe recession are apparent in three areas:

1. Net operating income (“NOI”);
2. Financing availability and pricing; and
3. The resulting valuation challenges

NOI. This metric will vary significantly by asset class. With select-service hotel rates now as low as $19 to $25 (at least in the Midwest), fixed and variable expenses are barely covered. That means debt service will be a challenge. In the multifamily arena, moveouts, rent concessions and deferrals could easily drop NOI by 20% (industry sources I have spoken with believe the May 1 rent payment (or more accurately non-payment) metrics will be the telltale sign of multifamily asset performance for the balance of the year). If you follow the Mick Law, P.C. due diligence opinions and asset class reports, storage was already trending to the long-term mean of low- to mid-80s occupancy and cap rates approaching 8%. There should not be much more downside to storage, and some postulate that storage will get an intermediate bump with household relocations and students moving home from last month through the summer. Retail will be adversely affected (even the prior stalwart necessity neighborhood strip necessity retail – think Chinese food, hair salon and dry cleaners), and triple net-lease restaurants and other entertainment will be crushed. Even Subway, Mattress Firm, Cheesecake Factory and others have publicly stated they are withholding rent. On the bright side, data centers, logistics, tower, life science/health care and manufactured homes should fare pretty well.

Financing. Availability and rates are both negatively affected. A contact with NorthMarq Capital put out a Class A apartment project to 15 lenders last week, and nine were not quoting, even at a 50% loan-to-value (“LTV”). Commercial mortgage-backed securities are, for all practical purposes, nonexistent. Life insurance companies and other portfolio lenders allocate capital based on yield – when GE 10-year investment grade bonds are yielding 3.90%, why would a lender originate real estate debt at anything near 4%? Some will say that rates should be more attractive with the 10-year treasury moving from 1.52% on February 20 to 0.62% on April 20, but the problem is that the government-sponsored enterprise lenders are instituting floor rates (Fannie Mae at 90 basis points and Freddie Mac at 75 basis points), and spreads have widened. Sub-3% debt in multifamily has moved to 4% if you can get it, and higher across other asset classes.

Valuation Changes. This gets us to point #3, which since the beginning of time has been a function of #1 and #2 (add a spread for capitalization rate (“cap rate”), of course). Let’s assume your multifamily asset had a trailing NOI of $2 million on February 15. With financing costs at 3% and a cap rate of 4%, that results in a valuation of $50 million. That same asset on May 15 could easily have an annualized NOI of $1.8 million, with financing costs at 4%. Assuming the same cap rate spread (a generous assumption), a 5% cap rate values that asset at $36 million. At a 60% original LTV, 56% of the investors’ equity has disappeared. Assess many other asset classes on the same basis, and the exercise gets uglier. The name of the game will be to ensure commercial real estate sponsors have the wherewithal to support and operate portfolio assets to a period of normalization in 2021 (forget that “V” recovery), as early liquidation will not be a pleasant experience. As always, opportunity funds, distressed debt players and select development/OZ deals will have a window to provide potential upside for savvy investors.

Evaluating Oil/Gas Assets
Bradford Updike, JD, LLM

As a result of COVID-19, oil prices in the United States and worldwide have experienced significant changes recently. In contrast to 2019 and the first couple months of 2020 when WTI prices ranged from $50 to $60 per barrel (“bbl”), oil prices expected to test a lower $10 to $20 bbl level in upcoming months as a result of COVID-19 and its effect on the global demand for crude. Prices for natural gas, while not as sharply affected, have also come down in recent months, with NYMEX spot prices of $1.60 to $1.80 per mcf observed recently (i.e., which is about 30% lower than the futures prices predicted a couple of months ago). While the futures markets anticipate a pricing recovery beginning in late 2020 as the COVID-19 crisis gradually subsides, evaluations of oil/gas program assets must account for the recent change in pricing to serve the best interests of program subscribers.

On a more positive note, Raymond James recently published oil pricing expectations of $55 bbl WTI for 2021 based upon its expectations regarding changes in world-wide supply/demand, while also cautioning that lower price levels, as mentioned previously, will be tested in the upcoming months as a result of the COVID-19 driven supply/demand imbalance. On a related note, it is perhaps worth mentioning that the economics of drilling programs marketed in 2020 will generally be driven by oil/gas prices in 2021 and perhaps early 2022 when production of program wells comes online.

Notwithstanding the sentiments about the possibility of a pricing recovery in late 2020 or 2021, we believe a fair and balanced underwriting approach must factor, at least in part, the economics of drilling, royalties, and opportunity funds at current yet depressed NYMEX-based pricing conditions. As a higher-case analysis, conditions that assume a balancing of supply/demand in 2021 and future years may also be analyzed as long as the model results are considered side-by-side with the lower NYMEX-based assumptions (which would perhaps involve models premised upon oil pricing held flat at $50 to $55 bbl beginning in 2021/2022 or possibly later). As we have endorsed prior to the COVID-19 outbreak, prudent underwriting of oil/gas assets must analyze the economics of the respective programs on an offering-adjusted basis after factoring loads, sponsor compensation, drilling/completion capital expenditures, royalty burdens, operating costs that include water management expenses, and, perhaps most importantly, oil/gas pricing adjustments based upon gathering/transmission costs and local discounts. Prudent underwriting will also include oil/gas production assumptions based upon collective operator experience in the field being drilled, as opposed to the use of production decline curves that incorporate the very best results in the field. While adjustments might be warranted in some cases due to an observed pattern of better results achieved under certain drilling/operating methods, caution must be exercised (which should require feedback from independent technical experts, such as geologists and engineers who are not affiliated with the sponsor whose program is being evaluated).

State of BDC Market
Kevin Vonnahme, JD, LLM

A Business Development Company (“BDC”) is a special type of closed-end investment company that was created by Congress in 1980 to provide capital to small, developing, and financially troubled companies lacking access to public capital markets and traditional sources of equity and debt capital. A BDC is subject to numerous statutory requirements under the Investment Company Act of 1940 (the “1940 Act”), including certain annual distribution requirements, portfolio valuation and net asset value (“NAV”) requirements, and asset coverage requirements (i.e., limitations on leverage).

BDCs have been hit especially hard by the COVID-19 pandemic, as most BDCs invest in loans, bonds, and other debt instruments with private, small-cap and middle-market companies. Although a BDC’s investment portfolio is commonly broadly diversified by industry, some BDCs may have relatively large exposures to particularly vulnerable sectors such as travel, leisure or energy. In many cases, the middle-market companies will not be eligible for SBA loans or other relief available to small businesses. Since many of the underlying portfolio companies have fallen into distress (as a result of government mandated shutdowns, reduced demand, supply-chain disruptions, etc.), BDCs have suffered substantial reductions in portfolio valuations and may be forced to cut dividends as their source of income is negatively impacted.

In the case of listed BDCs, the share prices may trade at a discount or premium to NAV. Historically, many BDCs have traded at a discount to NAV even before the COVID-19 pandemic, and the discount has greatly expanded in recent weeks. According to a recent Fitch Ratings’ Report dated April 7, 2020, BDC stocks were trading at a 39.1% average discount to NAV on March 27, 2020, compared to a 6.6% average discount to NAV on February 28, 2020.

BDCs commonly use leverage as part of their investment strategy, which has resulted in additional challenges during this downturn. As the portfolio valuations have declined, many BDCs are struggling to maintain the asset coverage requirements under the 1940 Act and separate covenant requirements under lines of credit. Although the SEC recently granted an exemptive order providing certain temporary relief relating to the asset coverage test, the relief is relatively limited. As a result, many BDCs may seek to raise additional equity (at a discount to the already reduced NAV), which is dilutive to existing shareholders. In sum, a BDC’s ability to weather this storm may largely depend on the composition of its investment portfolio, the exposure of the portfolio companies to vulnerable industries, and the BDC’s ability to access debt and equity capital.

Private Equity
Grant Mathey III, JD

Determining the potential effects of COVID-19 on private equity performance and fundraising is not an easy task due to the uncertainty of duration of the current global pandemic and how markets will react during the subsequent recovery. As with any syndicated alternative investment, there are two levels of risk to assess: at the sponsor level and at the investment or portfolio company level. While the risks at the sponsor level are primarily the same regardless of the investment class, for private equity, the range of risk tolerance at the investment level must be analyzed by industry, as each industry faces its own challenges. Further, the difficulty is amplified if the investment vehicle is a fund that deploys capital in more than one industry. Depending on the industry, unemployment and customer engagement will determine the ability of a portfolio company to navigate the uncertain climate. Industries that have the infrastructure in place prior to the government mandated stay-at-home orders, such as fast-food or quick-service restaurants with drive thru, carry out, and delivery options, or those that have been deemed “essential” and are allowed to operate under such guidelines, clearly possess the best chance to weather the storm since they are actually still operating. Nevertheless, expect performance to lag across all industries.

Many portfolio companies lack the HR expertise and infrastructure required to manage during a crisis, thus sponsors could be required to provide more hands-on management and guidance, or an injection of capital. As commonly reported in numerous media outlets over the past few years, private equity firms have had record amounts of cash on hand, ready for investment. That investable cash could now be required to keep portfolio companies afloat until some semblance of normalcy returns. While the federal government has implemented policies to help aid small businesses, some of these programs might not be available in every circumstance, but sponsors should be evaluating the opportunities available while being cognizant of the restrictions associated with some of these loan programs before committing. An injection of cash, additional lending, or debt restructurings could have tax consequences or impede the ability to pay dividends or distributions to investors. While the majority of sponsors may seek to aid portfolio companies during the crisis, as many private equity deals are structured as debt investments, depending on the covenants, some private equity sponsors, whether labeled as savvy or savage, may attempt to capitalize on portfolio companies that run afoul of such covenants.

As far as dealmaking going forward, a number of new targets will inevitably present themselves, and it would be logical to assume that competition will decline as lesser capitalized sponsors will be unable to compete. With the public markets depressed and potential corporate buyers holding onto their cash, the better private equity sponsors are well positioned to be the buyer for any asset that does come up for sale. As far as exits go, there will be an inevitable drop as holding periods for some assets will extend, as sellers sit tight and wait for the markets to recover. The only people selling in this market are those that are in dire need of capital, which again presents opportunities to capitalize upon for private equity sponsors.

Without exit opportunities and a likely drop in portfolio valuations, expect returns to take a hit in the short term. The true impact will not be known for some time, as there is a lag in private company pricing compared to the public markets, but it is safe to assume that private equity sponsors will drop valuations steeply and the most prudent sponsors will do so as soon as possible. This will serve to benefit sponsors in two respects. First, they will only have to report bad news to investors once (hopefully) rather than engage in a long, dragged out process of reporting gradual declines in valuation. This one-time, severe drop in valuation can be easily justified due to the current crisis. Second, by taking the hit early and hard, each successive report should bring good news and instill investor confidence as valuations begin to rise, thus posturing the sponsor’s current investor base for future fundraising. Although fundraising will take a short-term hit, as investors are likely reevaluating their own investment portfolios and goals, eventually, fundraising will return to normal, and those sponsors with an inspired investor base will have a leg up on the competition.

Overall, given the uncertainty surrounding the global pandemic crisis, it is nearly impossible to determine the longer-term impact on performance, primarily due to the uncertainty of the duration of the current lockdown and the responses that will be taken during the subsequent recovery. Since most deals done prior to the crisis were done at high valuations, there will be an inevitable drop in performance. Nevertheless, history has shown repeatedly that crisis and economic downturn provides the best opportunity to source attractive investments. Sponsors who are able to raise capital and deploy it as soon as possible will be best positioned to capitalize on the opportunities that will arise from the fallout of the current global crisis.