Mortgage Funds used to be the primary means of capital in private lending.
Today, there is so much institutional capital in the market that many lenders defer to selling loans, correspondence, or table funding. Many existing fund managers struggle with these market conditions. Some have even asked me: “Should I just shut it all down and just sell my loans to the institutions?”
This article will talk about a very popular strategy for mortgage funds that enhances yield without leverage while embracing current market conditions and capital availability: Funds.
Funds Grant Flexibility
Funds allow you to have more flexibility because they are more diversified. You can be more specific about which loans you want to keep and which ones you prefer to get rid of. Lenders will also be able to get rid of some of the loans that are not as strong as others. If you want to have more flexibility with your investments, funds offer you this.
Funds Reduce Risk
Funds can be a lot less risky than investing in institutional capital. They reduce risk through pooled assets, diversification, and flexibility in asset management strategies. If you want to be more cautious with some of your capital, funds are a less risky option and may be better for you.
Funds Offer Greater Economics for the Lender
Funds offer greater economics for the lender, even in the short term. A more popular strategy is to utilize a fund as a capital solution to originate, fund, portfolio and sell loans to an institutional buyer or aggregator. We call these funds “Gestational Funds” because the fund is designed to hold the loans for a short period of time.
What is a Gestational Fund?
This gestational fund strategy may require existing fund managers to revisit their fund’s existing economics and business plans. Combined with sensible leverage, Gestational Funds allow for significant yield enhancement with much less risk compared to funds with significant leverage on top of fund equity.
Furthermore, Gestational Funds allow investors to earn a significant rate of return even when local markets are suffering from rate compression. This is thanks to a combination of cycling capital, yield spread, and sharing fees.
Gestational Fund Structure
The typical Gestational Fund has the same structure as a mortgage fund/pool, except for some key differences. One key difference is the fund manager will typically share origination fees and/or spread income derived from the sale of loans with the fund’s investors. This process is a bit outside the norm, but because the fund is funding and selling loans frequently, it creates more alignment with the investors regarding the allocation of income. It also allows the fund to combat yield compression and maintain a healthy or improved coupon rate to investors while still maintaining a healthy income stream to themselves. In Gestational Funds, we typically advise to avoid any secondary hurdle rates because it will limit the upside potential from selling loans.
Funds Can Be More Lucrative
With the extensive availability of secondary market aggregation, having a balance sheet to lend, hold, and earn income, points, and fees is very lucrative for investors and the fund manager.
Here’s a real-world example of why Gestational Funds can be more profitable. Let’s take a conservative example: a fund has $10M in the capital, and the fund originates $10M in loans at an average coupon of 8% with 2 points. This fund chooses to sell these loans and repeats this cycle 5 times per year. Assuming loans remain performing for the year, this means that the average interest coupon will be 8% for the calendar year, but origination fees in total will amount to 10% (2%x5). This creates a gross coupon of 18% for the year. Add in any arbitrage from leverage and yield spread given by the loan purchaser, and you have an even greater coupon.
By sharing origination fees and retaining an identical preferred return and carried interest model, Gestational Funds can distribute significant returns to investors. This strategy not only combats yield compression challenges, but it creates significant upside for the investor.
Why Not Keep All the Points for Myself?
Some fund managers may say, “Well, why don’t I just keep all the points?” This would ruin your investor relations because savvy investors will identify it as an issue: if the fund’s objective is to fund, hold, sell, and cycle the capital – and the origination fees are 100% payable to the manager – the investors will identify this as an imbalance of income streams.
It is also unnecessary to keep the additional points. The increase in yield by cycling funds will allow the fund manager to make more income than if they used a correspondent program.
Keep in Mind
There is one big downside to this strategy: it is premised on two key requirements: (1) deal flow; and (2) liquidity from capital markets. This strategy will require significant deal flow to feed the cycle and meet the expected returns. In addition, it relies on the assumption that capital markets will always be available to provide liquidity. We learned in 2020 that this can change very quickly. This means it is important to temper investor expectations and not market outlandish numbers like 36% returns per year – even if they are easily achievable.
However, the beauty of having a Gestational Fund strategy is, even if capital markets were to dry up, the Gestational Fund still has the capability to originate and fund loans on its own, albeit limited. This is exceedingly important from sustainability and future growth standpoints.
Why Not Sell Everything Without a Fund?
You may be wondering, “Why can’t I just sell everything without a fund? I can just get a line of credit at 8% with a 100% advance rate.”
These lines of credit are fantastic for lenders without an existing fund who need a working capital solution. However, the terms of these alternative financing lines of credit are typically around 8-10% and increase significantly over time. Additionally, funds usually have a lower floor rate of return and offer flexibility because they are equity investment as opposed to these credit lines, which are strictly debt obligations. Furthermore, Gestational Funds offer a healthy balancing act to maintain your balance sheet through a fund, manage assets, and still earn a very healthy return for investors regardless of the ability to sell loans. As stressed above, this is exceptionally important if there is any type of withdrawal by capital markets from our industry.
As you can see, utilizing the institutional capital to purchase loans from a Gestational Fund (with the proper waterfall structure) will create an increase in returns to investors over the year. Funds of all sizes struggling with rate compression may want to consider this solution.