Private Investors Pour Capital Into Debt Funds

by Jeff Shaw

Financing vehicle enables private equity firms to open another revenue line while offering borrowers an option when lenders are scarce.

By Jeff Shaw

The growing popularity of private equity-backed debt funds is a win-win for many of the players involved.

Rather than use their capital to buy more properties, private equity investors can lend money as a lower-risk, fixed-income alternative to owning assets.

Borrowers have another source of debt, especially at a time when lenders may be scarce. Just as banks, for example, were re-entering the seniors housing fray following the COVID-19 pandemic, two huge banks — Silicon Valley Bank and Signature Bank — collapsed in March, and the long-term impact of those collapses is not yet known. 

Debt funds may be able to fill the capital markets gap in seniors housing if banks retreat to the sidelines once again.

With that outlook, it makes sense that many private investors have launched debt funds. Last May, Kayne Anderson Real Estate closed its most recent debt fund (Kayne Anderson Real Estate Debt IV) after raising $1.9 billion from investors, easily surpassing its original target of $1.5 billion. The fund is targeting seniors housing, among other asset types such as student housing, medical office and self-storage.

Locust Point Capital’s most recent fund, Locust Point Seniors Housing Debt Fund II, closed in March 2021 after raising more than $428.5 million and surpassing the original fundraising target of $425 million. The fund focuses exclusively on seniors housing and care. 

Locust Point’s first fund aimed at seniors housing closed in 2016 after raising $312 million. Approximately three-quarters of the commitments for Fund II came from U.S.-based investors, with the remaining coming from European investors.

“Fund II’s strategy is to provide subordinate debt, preferred equity and opportunistic senior mortgage loans to owner-operators of seniors housing and care facilities in the United States,” a press release from the company said at that time. “The owner-operators use Fund II’s capital to acquire, build, expand or renovate independent living, assisted living, memory care and skilled nursing facilities throughout the United States. This strategy provides owner-operators with a short-term, non-
dilutive and flexible financing solution.”

In 2018, Greystone closed its debt fund (Greystone Senior Debt Opportunity Fund) at $750 million. Investors include a variety of institutional capital and large public pension funds. The eight-year fund lends to a wide range of commercial real estate properties, including seniors housing. With leverage, the fund has an investment capacity in excess of $2.5 billion for loan products such as bridge and mezzanine financing.

“There has been a material increase in debt funds pursuing seniors housing over the last several years,” says Joel Mendes, managing director of capital markets at JLL. 

“Debt funds are attracted to seniors housing because of the strong demographic story, as well as the ability to secure higher yields than they can get in some of the other asset classes that historically have had more lending participants competing. Over the past few years, about half the lenders with whom we have closed seniors housing deals we would classify as new entrants.”

“In the seniors housing sector, debt fund transactions are typically expected to be short-term,” explains Mendes. “When the property or portfolio is achieving performance that supports permanent financing, the borrower will usually refinance into less expensive debt (or sell), which would denote a successful transaction from the debt fund’s perspective as well.”

Why debt funds?

Kayne Anderson is committed to buying, selling and lending in the seniors housing space for the same reason as many other players in this sector: The demographic wave of incoming baby boomers is compelling.

“Kayne Anderson Real Estate’s debt fund, like all of our real estate investments, is focused on sectors that benefit from the tailwinds created by the country’s demographic trends,” says Andrew Smith, senior managing director and head of real estate debt. “Given the acceleration of the aging population in the United States (demand) and that there is not nearly enough product (supply) to meet that demand, seniors housing is a clear example of how we capitalize on such trends.”

The 75-to-84 age cohort is projected to grow from 17 million in 2020 to 21 million in 2025 and 25 million in 2030.

Tony Ruberg, senior managing director of VIUM Capital, which launched a debt fund in early 2022, cites “a combination of factors” for why the investment vehicle is growing.

“First, a debt fund can provide flexible capital to sponsors, particularly on acquisitions. Rather than sourcing funds from multiple places (banks, mezzanine lenders, etc.), a debt fund can often handle the full debt stack in one stop.

“Second, we had investors approach us with interest in the space. I imagine this is not unique to VIUM. However, most investors who are new to senior living understand the need to partner with someone with a certain level of expertise. 

“Some investors prefer to partner with operators and acquire assets. Others look at investing in a debt fund as a way to gain exposure to a growing asset class without some of the risks and difficulties associated with owning the assets directly,” explains Ruberg.

Investment firm AEW similarly sees an opening in the market as the traditional capital sources — banks, government-sponsored agencies and insurance companies — remain gun-shy about seniors housing.

“Although those [traditional] lending sources remain active in the seniors housing sector, the availability of debt capital has generally declined due to the lingering effects from COVID-19 and the more recent impacts of rising interest rates and high inflation that have negatively impacted property values, cash flow and operating margins,” says Justin Pinckney, head of private debt for AEW. 

“As a result, many seniors housing properties have difficulty sourcing debt capital from traditional lending sources on competitive terms today, despite supportive long-term fundamentals and improving operating performance for the sector,” observes Pinckney.

Pinckney’s colleague, Dean Dulchinos, head of debt portfolio management at AEW, adds that debt funds are there to step up when banks are being more conservative in their lending.

“Many private lenders have control over their capital commitments, allowing the investment manager to exercise discretion over the loans that it chooses to make on behalf of its investors. As a result, debt funds tend to be a ‘through-the-market-cycle’ lender and not one that constrains originations during challenging market conditions,” explains Dulchinos.

“Further, debt funds often have subject matter expertise in the real estate sectors where they are active as a lender, offering a collaborative counterparty to property owners, and at times more patient capital as business plans are executed,” adds Dulchinos.

Ruberg says that the rise of debt funds in the seniors housing space is a strong sign that the sector is healthy overall, and a recognition that it is becoming less of a fringe asset class.

“Seniors housing has become a more widely accepted asset class within commercial real estate, attracting more outside capital. There was also a need for more flexible capital and more debt capital, generally speaking, as transaction volume has increased in recent years due to consolidation of smaller operators and divestitures made by some large REITs, particularly skilled nursing assets.”

Brokers see the rise

Although there’s no data on how much seniors housing lending activity is tied to  debt funds, those that arrange financing say that the number of debt funds lending in the space — as well as the popularity of debt funds among borrowers — is growing. They point to two main factors: flexibility in lending terms and the growing seniors housing demand. 

The big disadvantage they cite is higher interest rates, leading to more “expensive” capital. Debt funds expect higher return on investment in exchange for their flexibility and willingness to accept risk.

“Advantages of debt funds would primarily center around a flexible capital solution, which could include some combination of favorable loan proceeds, recourse or structure,” says Taylor Mokris, senior vice president of seniors housing and care at Bellwether Enterprise (BWE). 

“This flexibility has become paramount in an environment where deal metrics today are vastly different from the prior rate environment. One of the key disadvantages of utilizing debt fund financing is, given the lender’s return requirements, usually a higher cost of capital relative to a bank execution,” continues Mokris.

“As banks continue to tighten the credit screws, debt funds become an important source of capital to the industry — especially for transitional assets and special situations,” concludes Mokris.

VIUM’s Ruberg suggests that it’s simply the nature of banks to have more requirements and strict underwriting standards.

“Whereas banks are highly regulated and tend to need to fit deals into a specific box, debt funds have the ability to be much more creative in how they solve the need for the borrower,” he explains.

JLL’s Mendes is quick to note that banks frequently play an important role when it comes to debt funds, albeit in a more roundabout way.

“Oftentimes the debt fund has underlying bank financing behind its capital,” says Mendes. “So, the banking system remains an important aspect of debt-fund lending. A key consideration for borrowers to minimize execution risk is to understand the construct of the debt fund’s capital stack.

“Conventional banks will have lower interest rates, but rate is only one part of the overall debt structure. Leverage, recourse and covenants are also important, amongst other considerations.”

As for why private equity funds have increasingly chosen to start debt funds, Mokris says there’s also a supply-and-demand factor at play. Private equity investors need to borrow money to purchase properties unless they pay all cash, meaning the run-up in interest rates hinders their ability to buy. Choosing to lend money instead both fills a gap in the marketplace and allows the investors to make use of their dry powder.

In short, the supply of capital is low and the demand is high, making lending look that much more attractive than buying.

“Sophisticated and proven management teams that have a debt fund vehicle have become an attractive option to continue to deploy capital, but in a more defensive strategy that still produces adequate risk-adjusted returns,” says Mokris. “Simply put, debt feels like a good position to be in during such a time of uncertainty, still generating meaningful returns but in a defensive stance.”

Mokris adds that refinancing deals will be in high demand for borrowers as many loans closed before the pandemic are dealing with the challenges presented by the combination of depressed occupancy, heightened inflation and higher interest rates. A refinancing might allow an owner or operator to “survive ‘til 2025,” a rallying cry many in seniors housing have begun using to refer to the present challenges.

“These situations need the flexible capital solution many debt funds provide to bridge to a better environment,” says Mokris.

Kayne Anderson’s Smith summarizes the attractiveness of debt funds from the point of view of both lenders and borrowers.

“Traditional lenders have been highly constrained in the terms that they can offer in the seniors space, paving the way for funds like ours to lend to market-leading borrowers looking to benefit from the considerable flexibility we can offer them. Furthermore, the compelling opportunities in the space — supported by demographic trends — suggest a bright future for the sector. If there is one thing you can bet on, it’s that private equity debt will meet opportunity.”

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