Will 2018 be the Year of Concentration across our market? “The Urge to Merge” was the title of a January 2, 2007 Economist article. It resonates today. The cover photo was two camels copulating, which some of the Economist readers, surely a high-brow and sensitive bunch, apparently found offensive, as the picture is nowhere to be found on the internet. They would not allow me to republish the pic. A priggish fastidiousness that does not reflect well.
Seriously, 2018 could be the year of significant concentration across much of the CRE non-bank space, and perhaps some portions of the prudentially regulated bank space as well. Recently, we completed a couple of M&A assignments for clients adding materially to AUM and it felt like a harbinger of a trend. The Commercial Mortgage Alert beats out a steady rhythm of M&A news on top of gossip and whispers about potential transactions. The CMA often gets it right and they are right here that something is afoot. Over the past year we have seen a number of entrances and exits in the CRE lending space. And although property prices appear to be close to their peak, there is a lot of liquidity out there and PE buying is at an all-time high. These data points collectively seem to me to be a strong augury for what’s afoot.
Listen, I have as much confirmation bias as anyone and maybe I just want to see a pattern in disparate bits of data because it would be fun! But I hear what I hear and see what I see, and I see a coherent story about a wave of concentration soon to break over our industry. I understand that just because I want something to happen doesn’t mean it will. On the other hand, just because you’re paranoid doesn’t mean that you’re not being followed!
So here’s the argument. Having come out of the depths of the Great Recession, everyone who could went out and raised money and built lending and investment platforms. The credit culture was solid and demand for credit was strong. Now, nine years on, a lot of the money’s been spent and achieving success in our market is getting harder. So …
Let’s start with the money. It’s always the hardest thing to do. Anyone can spend it (Ok, not everyone wisely), but raising it is tough and the data suggests that, while the rich have gotten richer, everyone else is struggling for access to investable dollars. A lot of folks in smaller or even mid-size shops will stare at the task of refilling the coffers and say, “No más.” The thought of getting on another plane and spending months in delightful places across the Mideast and Far East, smiling and shuffling for investor dollars, reconciling every different investor’s special need with every other difficult investor – and getting to close – is daunting. Groveling probably has its pleasures, but they are indeed distinctly, shall we say, unconventional.
There’s an awful lot of non-bank lenders out there and a cacophony of pleas for additional funding, but it can be a tough slog unless the story is compelling or the platform is strong.
You notice the regulatory state hasn’t gone away? Notwithstanding the endless bellowing and bloviating about regulatory relief, even in the throes of this Trumpian experiment with deregulation, the government is still there. Dodd-Frank is still the law of the land and running a successful lending platform is pretty damn complex. As a military man might say, “Your teeth to tail ratio is out of whack.” The embedded cost of investor relations, legal and regulatory compliance, recordkeeping, added documentation and the like are a drag on profitability and these are largely fixed costs. When an enterprise is larger, these fixed costs are easier to bear. Tail can kill you without scale. Did you think it is a coincidence that 44% of the committed equity in closed-end funds is sitting in one of five shops?
Closed-end debt funds have both their appeals and their limitations. They continue to dominate the alternative lending space. When the end of a re-investment period is nigh, doesn’t permanent capital sound lovely? Can’t go public or otherwise nail permanent capital without real scale! Moreover, given the relatively short life cycle of closed-end funds, your transactional appetite inevitably cycles up and down with the periodicity of the fundraising cycle. When you’re out raising funds, you’re not attending to the day job, and you need a steady deal flow. These vehicles need to be a consistent and reliable counterparty to the borrower and broker community. A lender captures deal flow only by being consistently relevant to the borrower and brokerage community. If you’re not on the brokerage top ten list, are you going to see the deals? Are you going to see the good deals? If your engagement with the deal community is intermittent, it’s sand in the saddlebags in the race to success.
And if the managers are tired, just think about the investors. A lot of investors want to monetize their investment. Annoyingly, they periodically want out. This feels like one of those times.
How about the buy side?
There are similarly very good reasons to be a buyer right now. Especially for the richest franchises, investing in onesies and twosies can sometimes feel like the proverbial tail chase, and if there are opportunities to buy scale through the acquisition of enterprises or portfolios, that should look really appealing right now. And while property is relatively expensive, merging with or buying smaller operators might be a better place to put harvested gains.
Size just plain matters. If you’ve got excess capacity to service and underwrite, couldn’t you use a larger brokerage force? (Oops, I mean a mortgage banking force.) Couldn’t you use more access to deal flow, and if some of that deal flow is in silos different from the ones you currently own, isn’t it time to buy into those silos, too? 60% of US REIT mergers announced in early 2017 were, after all, aimed at allowing entry into new markets or new property types to build scale. Suppose you already have a big brokerage network and you do CRE bridge lending, could you lever that network with a GSE license? How about SFR? How about core CMBS? Staple these new products on and the incremental cost is not enormous.
Size matters, part two. It’s really hard to scratch your head and pat your tummy. Many lenders are under scale to, for instance, raise money and put money to work, or manage a securitization but continue to pursue a steady, robust deal flow. If the day job is making loans and you hand your team another huge undertaking to raise money or get leverage, the system begins to break down.
Talent is not in unlimited supply, and increasing the talent on the team is perhaps easy to overlook, but is no less essential component to success. As they say in Vermont, in order to make a gallon of maple syrup, you first start with 100 gallons of maple sap. M&A may allow you to buy the sap and end up with the syrup.
As a buyer, it will be apparent that a lot of platforms with a public floatation are trading below NAV. Great time to buy and grumpy investors as mentioned above may make for motivated sellers.
Finally, there’s plenty of lever out there. God knows maybe too much, with the spread between high yield and Treasuries at all time low (what could possibly go wrong?), but it’s a great time to borrow. There’s plenty of repo money out there to lever portfolios and the securitization markets are open and ready for business. Liquidity is the lifeblood of any acquisition strategy and right now it’s there in spades.
So, my friends, back to where I started. I see a period of concentration ahead of us. There are manifold reasons for platforms, particularly smaller platforms and smaller portfolios, to be sold, and there is an equal number of very good reasons to acquire AUM, platforms and competencies. We are at a time in the cycle where making money is no longer easy, and the pressures to recycle capital and manage complex business in a highly competitive market will drive concentration. The solution is scale and now is the time to do it.
So make my day, folks and get acquisitive. Not everything out there is as ugly as a camel.