Loans with profit share
The aim in most cases is to reduce the cost of debt finance or reduce the equity contribution required. In return for giving up a portion of profit on the project. Often the use of leasebacks, convertible stocks, and defined lease strucutures to apportion rental flow.
Profit sharing can be structured so that the both parties share in the risks and rewards of the operation, otherwise known as a sidde by side arrangement. Or it might be structured in a different way in which the developer takes all the equity risk, while the bank or financier takes all the rewards if the project is successful, such as in taking a large profit share of the arrangement.
This can be illustrated with an example. lets say a development costs £100 million pounds. If the financers are prepared to lend £80 million which is 80% the the developer has to find the additional £20 million.
Some possibilities include the developer obtaining mezzanine finance for £15 million or another strategy might be to get mortgage indemnity insurance. This would therefore require the developer to come up with £5 million.
Mezzanine finance often require the developer to pay a higher rate of return than a conventional loan (such as a Libor loan). So the developer would give up a percentage of the profits in this way. Or it could be structured with a lower interest rate and the developer giving up a share of the profits.
The size of the profit share will be determined by many factors such as the business climate, how profitable the project is expected to be, and the IRR (Internal rate of return) of the project. For example if the development is expected to be very profitable, the financier might require a lower percentage of the total return.
Generally speaking the big commercial banks usually stick to providing senior debt and only proving the loan up to 80% of the construction cost value. The do not get involved in the profit sharing arrangements. This is because the loan can be easily evaluated and also it is difficult to syndicate a loan that has a profit sharing arrangement.
Although some lenders provide both profit sharing arrangements and senior debt most profit sharing arrangements are usually the province of specialist lenders.Some firms dont proovide debt at all and just arrange the financing structure for a fee. If the firm provides both senior debt and mezzanine finance and the project is big, the senior debt may be syndicated to other lenders.
Profit sharing arrangements in the Uk need to be carefully structured because the British tax regime sometimes specifies where debt is created whereby rate of interest is tied to the profits of the enterprise. Then it can be treated for tax purposes in much the same way as equity and the tax relief on interest payments would be lost. In order to get round this problem the lender often takes payment in the form of a fee. In other words the fee would be related to the ultimate profit and the loan documents would be strucutred this way.
Another point is that profit may not be a straight percentage split. For example it might be structured in such a way that the developer receives the first 20% profit on cost, subsequently the lender receives the next 10%, and then the profits above that level are split 50/50. Financiers can also struture loans where they take a percentage if the final constrcution costs exceed the costs exceed the projected costs. This creates an incentive for the developer to come in on buget. Also there is an obvious disadvantage to the developer if he has to give up a percentage of the returns. On the other hand it may allow him to undertake a greater size of development with a smaller amount of equity. For example keeping 70% of the profit on a bigger development may be more profitable than taking 100% of one.
Finally another it must also be noted that many of these specialist lenders only provide loans for 2 to 3 years maximum. This can create a problem for the developer if he wants to hold the property after completion. Therefore what the developer can do is refinance on a longer term mortgage with a longer term amortization. In this case the lenders profit share will be based on a valuation rather than a sale.