Read the full February edition of Originate Report here.
Crises are often described as accelerants for change. Actions once considered unlikely or improbable quickly become everyday commonplace. The COVID-19 pandemic brought about disruptive changes to the private lending industry that have forced many of us to reconsider not only the types of loans to originate, but also the types of capital needed to adequately service our clients.
When the pandemic began to disrupt all our daily lives, the first reverberations in our industry were felt in the secondary market, where large institutional or traditional loan buyers paused their purchases, or drastically altered their respective credit boxes for loans. Consequently, loan volume was reduced overnight and lenders who primarily sourced capital via these channels were forced to pivot and forge new capital relationships to fulfill their respective loan pipelines. Unfortunately, establishing these new relationships can take time and the world of private lending can move quickly, causing undue duress on borrower relationships or potentially losing high quality loans. It takes a significant amount of time to establish a streamlined process that satisfies both borrower and investor needs. What every lender needs to ultimately decide is this what kind of capital partners they want to have for the long term and get a better understanding of how their respective capital partners will behave amid moments of crisis as it relates to the loans being originated. What our industry has seen repeatedly with each subsequent financial crisis is that traditional loan buyers in the secondary markets can change their risk profiles and as a result, their capital allocations, just as easily as an individual investor.
When sourcing capital for private lending, there are various types of capital and they all come with varying degrees of cost, risk profiles, liquidity needs, compliance, duration, and hurdle rates. When a lender evaluates their loan pipeline, they need to also make sure that the capital they are sourcing is appropriately matched across all these variables within their loan pipeline. When these two parties are not appropriately matched, the lender is consciously tolerating a degree of counterparty risk, or a risk that one (or both) of the parties in the transaction will not perform, which ultimately leaves the lender bearing the brunt of those costs. These costs can be painful and some in the industry took material haircuts (or left the industry) because of these mismatched relationships.
Sourcing capital for private lending can often be just as challenging as originating a high-quality loan. Cautious investors will often underwrite loans to evaluate risk, so too should private lenders when evaluating their capital sources satisfy their loan pipeline. Common risks relating to capital include concentration, behavioral, and reputation risk. Concentration risk can best be described as sourcing too much capital from only one source. Behavioral risk relates to the likelihood of an investor changing their risk profile. Reputation risk in this context would be if a capital partner were to leave a lender “at the altar,” potentially damaging the lender’s standing in the market and jeopardizing future loan opportunities, which ultimately puts all capital partners at risk. Managing all these types of risks can be a challenging endeavor. However, if they are adequately addressed, they can make for a rewarding and virtuous cycle.
The COVID-19 pandemic created an impetus for private lenders to reconsider aggregating capital either through a mortgage fund or to turn back towards individual accredited investor relationships with individual capital partners, shifting away from the institutional capital partners. While this pivot undoubtedly can have a dramatic effect on the scale and capacity of loans that can be originated, it can often insulate a lender from daily shifts in the market and allow the lender to maintain control of their loan pipeline. As mentioned, this pivot can be challenging to overcome and requires significant amounts of time invested in prospecting, educating, and informing your capital base about what to expect from investing in hard money loans. Maintaining a clear and open line of communication is essential to managing any reservations or concerns with your capital partners. Furthermore, transparency is a key element to not only assuaging these concerns but also in helping to build long-lasting relationships.
However, it should also be noted that aggregating capital within a mortgage fund does not completely insulate a lender from these pressures. At Socotra Capital, we faced redemption pressures much like other managers within our industry, and we were forced to temporarily pause investor withdrawals, something we never would have considered prior to the pandemic. Our ability to process those requests in a transparent, fair, and equitable fashion (for both departing and legacy investors alike) was challenging, to say the least. What we found was that all capital partners had varying degrees of concerns regarding the pandemic and its impact on the industry. Our investors acknowledged that it was unreasonable to expect every loan to be 100% current, no matter the circumstances. However, those investors can (& should) rightfully hold the manager accountable to an action plan on how they intend to work out of problematic loans. While the investor may not agree with the approach, they are owed a degree of communication that informs them about the status of the mortgage fund and what any future investor should expect if they were to begin investing today.
Throughout the past twelve months, we have come to accept that every investor will not always share our philosophy and approach to this asset class. This constant journey to find the right capital partner is just another obstacle we face and forces us to constantly test our investment thesis. As a result, our guiding principle as it relates to raising capital has been to seek like-minded partners that desire an attractive risk-adjusted return for their allocation needs.
Tony Ingoglia is the Chief Strategy Officer and Chief Investment Officer at Socotra Capital. He is responsible for establishing investment fund strategies, investor communications, and all fund management at Socotra Capital. Since its inception, Socotra Capital has originated over 1,500 loans in excess of $800M and has raised over $250M in capital.