Fundamentals of Structuring Upper Tier Partnerships for LIHTC Investments: Part 2
Investment Selection, Approval and Funding
So the sponsor and the investor have created a fund. Now what? They have to go find some deals to invest in! This installment will take a look at how that sausage gets made.
Investment Selection
A proprietary fund may not have a very defined strategy at the outset like a multi-investor fund usually does. More typically the investor will give the syndicator informal guidance on what types of assets and markets it is looking to invest in on a proprietary basis. Again, for banks, a large portion of proprietary investments are likely going to be driven by CRA considerations, which change on a year-to-year basis, as well as the economics. Certain geographic footprints and product types are going to take on more importance in certain years. But deal size and developer concentration are not necessarily going to limit possible investments explicitly, although different investors have different internal rules governing those exposures.
Nevertheless, a proprietary fund will still likely be governed by some set of formal investment guidelines that govern the underwriting process. These guidelines may vary in form from investor to investor, both in their scope and their application. But as a starting point, the industry has generally coalesced around the the Affordable Housing Investors Council’s underwriting guidelines. The guidelines cover five broad categories: (i) the development team, (ii) the development budget, (iii) deal structuring analysis, (iv) due diligence best practices, and (v) syndicator review. The development team section provides criteria for evaluating the experience, capacity, and financial strength of the developer, guarantor, property manager, general contractor and other professionals involved in the project. The development budget section focuses on the sources and uses of funds to construct and stabilize the project, including certain standards for debt, equity, grants, developer fee, construction-period reserves and other contingencies. The deal structuring analysis section assesses the operating projections, revenue and expense analysis, operating period reserves, operating guarantees, investor capital contributions, credit adjusters and key economic, tax and operational provisions of the lower tier operating partnership agreement. The due diligence section discusses the standards for the market study, appraisal, environmental assessment, seismic analysis, construction review and generally accepted tax structuring principles. The syndicator review section provides guidelines and templates for analyzing syndicator capacity, performance, and financial sustainability of syndicator partners sponsoring upper tier funds.
Some investors adhere more closely to the guidelines and explicit acquisition criteria than others. Each investor has its unique “hot button” issues, usually based on past (bad) experience. Institutions have different risk tolerances, investment objectives and overall capabilities in evaluating, closing and managing tax equity investments. Many hours of thought, time and resources went into authoring the AHIC guidelines by some of the leading investors and their various advisors. They represent a set of best practices written by some of the most experienced voices in the industry. People who, quite literally, vet hundreds of deals every year. So they are written from the perspective of needing to assess risk across a national footprint with developers and projects of all shapes and sizes on a large scale. But when sitting down to do a proprietary fund and come up with a workable set of acquisition guidelines, investors (particularly those with more limited internal staff devoted to tax credit investments) should determine what their specific acquisition strategy and underwriting requirements will be. And they should closely consider what the key risk points are for their institutions and how these investments fit into the broader context of their business objectives and regulatory requirements. It does little good to have a set of investment criteria that no one uses or are too broad (or too narrow) given the investor’s needs and preferences. At the very least, guidelines help prevent surprises during the diligence and closing process by surfacing issues that might require some resolution fairly early on in the approval process.
Preliminary Approval and Mechanics of Due Diligence
As the sponsor identifies potential investments that generally line up with the investor’s acquisition guidelines, it will periodically present the investor with an opportunity to “bid” on the tax equity component of projects at a “price per credit” that the investor approves. Once pricing is approved, the sponsor will issue of a term sheet to the developer at the agreed upon pricing.1
Pricing is a bit of art as well as science. It is obviously market driven, and one value-add that a syndicator provides is its constant interaction with the equity market on behalf of several investors at any one time across geographies and product type. Additionally, the LITHC equity market is mature and fairly transparent. There are several industry publications that regularly publish equity pricing data. Existing relationships with certain developers may factor in at times as well. And there are a host of other macro-type factors that drive pricing changes across the market over time as well, such as an investor’s tax liability (which is affected by changes in the tax code as well as the investor’s expected profitability), the CRA motivations mentioned above and the potential pre-tax and after-tax returns on other types of similar assets. That is why you will see LIHTC investment yields benchmarked to the ten year Treasury rate like other real estate investments. The spread of LIHTC investment returns over Treasuries is watched closely by most institutional investors.
One additional note on pricing touched on in the linked article that is important to remember. Some investors may use different internal metrics to help evaluate a LIHTC investment’s return instead of just a traditional internal rate of return, such as return on equity or a similar measure. The reasons are somewhat obscure and each investor has its own formula. It mostly has to do with the public accounting rules and other esoteric concerns such as the the investor’s own cost of funds (even for the largest banks, money ain’t free!). So competing investors will often arrive a slightly different value conclusions for the same asset. Although these specifics may not make it into the fund documents, an investor and sponsor will want to have a fairly thorough understanding as to the investor’s preferred metrics for measuring returns, and how certain components of the economics of these investments affect the investor’s calculations. Some of this thinking may be closely guarded by certain investors. But, it is best to be on the same page on pricing factors from the outset as that affects the sponsor’s bidding strategies and negotiation of certain other deal terms such as capital contribution adjustments. Some investors may also ask the sponsor to model fund-level returns using their preferred metrics.
As potential investments are identified, priced and committed to, most fund agreements will usually require some sort of preliminary summary and financial presentation to the investor by the sponsor that will go through the strengths of the investment, major risks and an overall evaluation of why the fund should acquire the asset. For some investors this is a formal process called preliminary approval or something similar. For others, it may be more more informal. But in any event, it will need to contain the key information the investor needs to be prepared to commit its own resources to underwrite and close the investment, as well as authorize the sponsor to start incurring significant diligence and closing costs on the fund’s behalf to acquire the asset (that the investor will ultimately be responsible for).
Again, each investor is different in this respect. At a minimum, most investors require some combination of (i) a breakdown of the development team and their overall track record, (ii) the preliminary financial projections, (iii) construction and leasing schedule, (iv) a description of the asset and target population, (v) analysis of the local market and comparable projects, (vi) key risks and mitigants, (vii) any major exceptions to the acquisition guidelines, and (viii) previous projects with the market or developer. A guiding principle here should be what are the key inputs the investor needs to start creating its own investment committee approval document. The timing may also vary from investor to investor. Some investors may require a leaner preliminary summary but need more lead time from preliminary approval to closing to digest the underwriting. Some require a more comprehensive preliminary analysis, but can move more quickly through diligence. Investors and sponsors should consider how to efficiently combine the two processes so that investment approval goes smoothly. Then the fund agreement should incorporate the general roadmap to be used.
After preliminary approval is granted, the investor will get going on its diligence review in earnest. The sponsor is likely already engaged in the closing process as it will have usually have a firm indication from the investor that the investment is likely to be approved. To be a broken record, each investor/syndicator relationship is different. But there should be an understanding on a few key points in the fund agreement. One, there should be a defined scope of materials that the investor will require for its own diligence review, which should then be incorporated into the fund agreement. It will overlap with syndicator’s own checklist that is used at the project level. But that way, investor requests will not be randomly coming out of nowhere. A few other items that should be addressed by the diligence requirements as well:
The investor and sponsor may want to agree on a set of “model” equity investment documents that will be used at the lower tier level, which usually includes at least the form of project partnership agreement, guaranties and development agreement. Larger investors will tend to have their own preferred forms, although all investors will want to have an agreed-upon set forms to start from on each new development team relationship.
All institutional investors require a “should-level”, reasoned lower tax opinion covering the basic structuring requirements of institutional investors in LIHTC projects. These should be incorporated into the fund agreement. At a bare minimum, these will cover the following issues:
the status of the lower tier operating partnership as a partnership for federal tax purposes,
the fund’s status as a partner in the operating partnership,
the validity of the tax allocations under the operating partnership agreement,
the tax ownership of the project by the operating partnership,
a “true debt” analysis of all project-level loans,
the ability to include non-recourse financing in the partnership’s tax basis in the project,
tax treatment of the project for depreciation purposes,
the ability of the operating partnership to utilize the tax credits, and
the ability of the fund to realize the “material benefits” of its investment.
At the initial closing of the fund, the investor will also require a number of legal opinions covering its admission as a partner to the fund, its ability to realize the tax benefits of its investments in the fund and compliance with certain applicable securities laws.
Final Approval
Once the investor has completed its diligence and is ready to authorize the investment, there will be a requirement for final written approval or consent for the fund to make the investment, which is in the form of what is known as a capital commitment agreement or consent and capital contribution agreement (the “CCCA”). Whatever it is called, this agreement will contain all of the specifics of the investors approval of the proposed investment, including:
the total amount of the investor’s capital contribution,
the expected amounts and dates of subsequent capital calls,
the fees and reimbursements due to the sponsor from the initial capital installment,
a project-level benefits schedule showing key investor return metrics, and
any outstanding items to be completed prior to the next capital call.
Essentially, the “CCCA” is a simple funds flow of the expected capital contributions. At the time final approval is given, the investor will make its first capital contribution according to the terms of the approval.
Again, the dynamic that will need to be addressed by the final approval provision of the fund agreement is the tension between the investor’s own internal approval process (usually full investment or credit committee approval, which can take time) and the sponsor’s need for responsiveness once the request for final approval is submitted. In a proprietary fund, nothing is final until the investor says it is. But sponsor does not want to leave the period for approval open-ended either. The sponsor will want a basic understanding of the back and forth necessary to obtain final approval so that it can manage expectations with either its warehouse lender or the development team if a simultaneous close is contemplated. If a simultaneous closing process is anticipated, the fund agreement should map out how the flow of diligence will go from the project to the sponsor up to the investor to meet that timing. If a lengthier investor closing process is contemplated with the fund closing into the project ahead of the investor giving final approval, then there will need to be some outside date for final investor approval giving the sponsor comfort that the investor will be there at some point. The point here is not to pin down every last detail of the process with minute precision, but rather for the parties to have some basic expectations of how the process will work for both institutions. This is especially important where the investor and sponsor may not have partnered together previously.
Exclusivity
Once preliminary approval is given and the investor starts to expend its own resources to review the proposed investment, it will want some certainty that the investment will not be shopped to other investors by the sponsor. So most fund agreements will contain a fairly innocuous exclusivity provision where the investor will have some period of time, usually anywhere from 60 to 120 days after preliminary approval, to give final approval for the fund to take down the investment. Now, in practice, these deadlines may not be strictly enforced. In practice, a sponsor is not going take an investment back to market once the investor gives preliminary approval unless the investor firmly indicates that it will not be able to obtain final approval under any circumstances. So the promise of exclusivity is more relationship-driven than what may be included in the documents. However, in times of extreme market dislocation, a sponsor make need to invoke the provision so that it can complete a syndication of an asset it has committed to at the lower tier.
Sponsor Fees and Reimbursements
The investor’s initial capital contribution will be used to make the fund’s initial capital contribution to the operating partnership as well as reimburse the sponsor for certain transaction closing costs such as legal fees and third party due diligence reports. The sponsor will also be paid its acquisition fee based on a percentage of the total capital contribution allocated to the subject investment. The reimbursements and the acquisition fee are commonly known as the “load.”
Loads, particularly the acquisition fee component, are highly sensitive to market conditions and the economic profile of each specific deal. In a proprietary fund, they are frequently calculated and negotiated on a deal-by-deal basis as they affect the return to the investor and the sponsor’s profit margin. And depending on the volume of investments the investor is expected to make, there may be more “relationship” considerations in determining the overall calculation methodology across the life of the fund (the investment period is usually two years from formation). The fund agreement may include some sort of cap on the load and expense reimbursement for any single investment. But, that is really more of an upper-end guideline.
So now the investment has been made. What’s next? The construction and stabilization process, and then managing the operations during the period the investor cares about. So stay tuned for the next installment covering those topics.
So for example, if a project is projected to generate a total of $10,000,000 in LIHTC and the price per credit is $0.90, then the investor equity commitment will be $9,000,000.