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Some lessons learnt in securitizing emerging market assets
by W. Earl McClure
W. Earl McClure is Managing Director of International Projects Group, Inc., a firm devoted to international project and trade finance, joint ventures and marketing services. Further information is available at the firm's Web site at (http://www.ipg-inc.com), or contact by email at projint@erols.com or by telephone at 703-237-8249.
Our firm's introduction to securitization
has come about as a result of searching for practical ways to advise
clients on obtaining financing for cross-border undertakings in emerging
country markets. We are still traversing our learning curve in the matter,
and I offer here some "lessons learned" as we, hopefully,
refine our knowledge and approach to securitization.
In one instance, my firm explored securitizing
packages of operating equipment leases in Latin America on behalf of
a client that wished to increase balance sheet liquidity and to obtain
additional working capital for expansion. Here, our efforts focused
upon assembling a diversified pool of equipment leases with generally
strong companies and then placing the pool with one or more institutional
investors. Conceptually, we would be selling a stream of income that
would, within about five years, amortize the equipment cost and provide
an attractive return to investors. While conceptually feasible, we discovered
that truly "the devil is in the details."
- 1) Operating leases by definition do not fully amortize the total cost of the underlying asset. This means the investor relies to some extent upon the residual value - post lease - of the asset and the ability to sell the asset for some targeted amount. In our case, the residual value assumption was 15% - 20% of original cost. Therefore, to mitigate this component of risk to the investor's return, one must either have a forward commitment to sell the off-lease equipment - perhaps as a "put" transaction - to a new user or underwrite this risk separately by a strong creditworthy party. In reality, operating leases do not, in my opinion, lend themselves well to securitizations for this residual value problem alone. In a cross-border deal with currency exchange risk, it is even a greater problem.
- 2) Currency exchange risk, the risk that a non-U.S. dollar currency might devalue so substantially against the dollar that an otherwise healthy obligor cannot produce enough local currency earnings to convert to U.S. dollars to service its debt. One solution is to deal only with obligors that generate U.S. dollar revenues, either through exports or tourism facilities, and to capture those revenues in some structured fashion that assures debt service will be achieved. Unfortunately, this was not our situation with many of the equipment lessees, which further compounded our problem. While a select group of leases could be packaged that provided U.S. dollar coverage for debt service, the total amount was insufficient to create what we believed to be a minimum critical mass of U.S. $50 million for a securitizable pool.
- 3) A final complication of our equipment leases package was the staggered nature of underlying lease expirations. Leases were written for periods ranging from twenty-four to sixty months, meaning that our securitized pool would be in a constant flux in terms of principal reduction. This forces investors to re-deploy these funds on an on-going basis, complicates bookkeeping and generates a shorter investment time horizon than most investors desire. Theoretically, this problem could have been solved by recycling lease proceeds into new, similarly underwritten leases, but the uncertainty about credit, country and other risks down the road make this approach difficult to sell. Again, we are talking cross-border, emerging market risk.
A second instance of "close but no cigar" securitization structuring involved an idea to pool mortgages on new franchised hotels, again in an emerging market. The concept here was to place the long-term mortgages of numerous hotels into a pool with certain key risks mitigated through structure. The most favorable risk mitigation element available to this pool was a local currency tied to the U.S. dollar. This was achieved through the proven monetary discipline of limiting the issuance of local currency, in this case Argentinean pesos, to the amount of U.S. dollar reserves available to back up each peso. This currency board or "dollarization" meant then that, barring some cataclysmic event or the loss of resolve by monetary authorities, there exists little or no exchange rate risk, as was present in the former example discussed. Nevertheless, other problems replaced the exchange rate risk.
- 1) The Argentinean hotels were to-be-built and required construction loans, since the intent was to place only permanent mortgages into the securitized pool. The idea was to avoid construction risk and to allow some "seasoning" of hotel operations before placing the corresponding mortgage into the pool. Unfortunately, construction money was tough to come by at reasonable rates, and the time required to construct and season multiple hotel properties was a further obstacle to the concept. A "warehousing" line might have helped, but it probably would not have been possible to keep it in place for the two or three years required to complete the diversified pool.
- 2) Several structuring elements were suggested
to the U.S.-based franchisor in
order to mitigate operating risks, e.g. a reserve fund to be established for each hotel, franchisor's agreement to purchase any defaulting hotel, a construct-lease-to-franchisee approach to ownership (to replace the franchisee's credit with that of the franchisor) and similar approaches. The franchisor, however, was having great success in expanding within the U.S. and was not intensively focused upon foreign expansion. Further, the franchisor had taken the strategic decision that it would not encumber its own balance sheet to back-stop franchisees financially. This is, in hindsight, not unreasonable, since one of the principal purposes of franchising is to grow with other people's efforts and credit.
In summary, the Argentinean hotel securitization is probably only feasible once the subject hotels have been constructed and have operated for a sufficient time to demonstrate a reliable stream of cash flow with which to service debt. The dilemma, of course, is that local construction lenders look to permanent financing commitments to replace (take out) the construction loans. Since the securitization pools may not be able to commit to such take-outs until the hotels are operationally seasoned, both phases of the financing could possibly be blocked. One solution, nevertheless, might be found in convincing the construction phase lender to extend the credit's tenor to, say, five years with no prepayment penalty. The hotel owner can then replace this financing with the securitization lender once the hotel achieves the requisite operating thresholds to be considered "seasoned." These challenges convinced us, nevertheless, that we should, in the absence of a third party guarantor willing to underwrite major risks, shift our focus to the later-stage financing of existing hotels and not attempt to securitize loans which involve construction-phase risk.
My final example is a work in progress, the structuring of a US$ 100 million pool of ten year mortgages on a chain of existing hotels in another Latin American country. Having learned a few things, we believe the present structural elements are sufficiently sound to warrant, under normal conditions, the funding of these mortgages into a securitized pool. I emphasize the phrase "under normal conditions," however, since the world financial system is presently reeling from shock waves caused by economic crises in Russia, Japan and the rest of Asia. Further, the commercial mortgage securitization market is presently in some turmoil, with nervousness about global financial and economic conditions significantly constricting investors' appetite for packaged cash flows, especially those viewed as "high risk." Accordingly, our present efforts may be doomed not by serious structural defects, but by the collective fear of the market.
The following is a summary of how we hope to structure this securitization:
- 1) Select a minimum of ten hotels from
the client's chain of properties. The
ten hotels will reflect a diversification of location and seasonality
of earnings. There will be a mix of resort type properties and interior
business hotels. Each hotel will have a minimum of three years of
profitable operations.
- 2) Approximately 45% of our hotels' collective
revenue is received in U.S. dollars.
The remaining 55% is in local currency. A trustee account acceptable
to the securitization pool will be created through which all revenues
will be channeled. Overall, the debt coverage ratio for the ten hotels
will be approximately 2.2, counting both U.S. dollar and local currency
receipts. However, by carefully selecting the ten hotels from the
larger hotel chain pool, we can demonstrate historical U.S. dollar
receipts that will cover 100% of debt service, e.g. produce a U.S.
dollar coverage ratio of 1:1. The local currency revenue then is essentially
a cushion against any U.S. dollar revenue shortfall. (Operationally,
the client converts all local currency receipts not needed for local
currency expenses into dollars on a daily basis.)
- 3) Over-all, the loan to value ratio of
the ten hotel package will not exceed 55%,
further cushioning investors against adverse conditions. Hotel valuations
will be based upon appraisals conducted by certified U.S. appraisers
with knowledge of the country market. Appraisals will consider prior
operating performance of the hotels but will also reflect conservative
assumptions about occupancy, average daily rates and expenses, e.g.
performance assumptions will be capped at conservative levels irrespective
of prior performance.
- 4) There will be provisions for cross default and cross collateral within the hotels package. Further, a formula has been developed to compensate, in the form of a guarantee fee, those hotels which provide, through their higher dollar receipts, a disproportionate amount of dollar earnings to back-stop the total pool. A few other bells and whistles are structured into the transaction, but the above constitute the primary risk mitigation elements.
We plan to continue to explore creative ways to support our clients' financing needs, including some of the approaches mentioned here. Whether or not the outcome is in each instance a formal securitization, the various structures used to mitigate risks by the securitization industry will assist us in having a broader array of tools to enhance the credits we seek on behalf of our clients.
COPYRIGHT reserved with the author - reproduced with permission.
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