Top five ways developers can raise finance from private investors

Raising finance from institutional investors for commercial property developments has become significantly harder since the UK voted to leave the European Union, writes Paul Sutton. According to research by De Montfort University, total new lending to the commercial property market in 2016 was down 17% to £44.5bn from £53.7bn in 2015. New loans by banks and insurers to UK commercial property totalled £17.6bn in the first half of 2017, down 24% compared with the second half of 2016. While the fall in lending may be partly attributable to a heightened sense of caution on the part of developers, there are clearly many projects that developers are unable to progress for want of financing. A resolution is at hand In the current climate many property developments are not attracting institutional funding despite being high-quality investment opportunities. However, if a potential developer takes the correct steps to identify and engage with private investors, private financing may offer a financial resolution to funding issues and, beyond that, an opportunity to increase the scale and number of developments that an individual entity can undertake. Private finance can be applied to allow built environment professionals to become property developers, and thereby create long-term equity in projects rather than just taking fees as a contractor or adviser. Another benefit of engaging with private investors is that of speed: investors may be able to react more quickly to purchase projects, as they don’t necessarily have to comply with the lengthy paperwork and credit committee procedures associated with financial institutions and commercial lenders. Long-term relationships with private investors can also provide developers with more scalable access to funding for future development projects. Which structure to use? Broadly speaking, there are five typical legal structures which developers can consider when setting up a commercial property development project. Which is best for a given project depends on a range of factors, such as the number of investors involved and the nature of the return being offered to investors. As a rule, it is better for developers to focus on creating relationships with a smaller number of investors who have the capacity and willingness to invest larger sums, rather than the other way around. The main advantages and disadvantages of each of the five structures are detailed in the table below. Each of the structures will generally involve the establishment of a separate legal entity (known as a special purpose vehicle or SPV), which is usually a company that will hold the legal title to the underlying property, ring-fencing the project from risks associated with other projects. In reality, however, the structure adopted for any given project will often be a hybrid of different approaches. 1. Mezzanine loan The investor(s) provide loan finance to the SPV, which is secured on the SPV’s assets but ranks behind any senior debt. Advantages  Simple to set up Developer retains control over development Investor may receive profit as part of loan interest Well understood by commercial lenders who may provide senior debt   Disadvantages Developer generally needs to contribute equity May not be tax efficient for the investor 2. Joint venture The SPV is established as a company (or LLP) which is jointly owned by the developer (or the developer’s principals) and the investor(s). Investor(s) may contribute funds by way of share capital in the SPV, and also by loan. Advantages Flexible structuring arrangements Developers, shareholders and investor(s) may benefit from entrepreneur’s relief on the sale of the project Bank debt may not be needed Disadvantages Individually negotiated Investor will generally require control rights over the SPV   3. Loan note issue The SPV issues loan notes to multiple investors. An independent security trustee may be appointed to hold the benefit of security. Advantages Developer retains control of the SPV Disadvantages Marketing must be carefully managed to ensure compliance with financial services legislation Administration must be carefully managed 4. Private, self-managed syndicate A self-managed “club” or “syndicate” is established which comprises a small number of investors (usually fewer than 10). The syndicate may be structured as a company, LLP or trust. The syndicate vehicle may then act as lender to the project SPV, or enter into a joint venture arrangement with the developer. Advantages Can maximise access to capital from existing contacts Allows investors to spread their risk and access larger projects, while retaining control over their investment Bank debt may not be needed Disadvantages Marketing must be carefully managed to ensure compliance with financial legislation and regulations Syndicate must be administered carefully so it does not become a ‘Collective Investment Scheme’ 5. Crowdfunding / peer-to-peer lending In this structure, the developer uses a crowdfunding or P2P lending platform to access investment from large numbers of investors, either as equity or loans. Advantages Can be fast Developer may retain control over the SPV Disadvantages Fees and charges of the crowdfunding or P2P platform and corporate finance adviser Developer has limited opportunity to build personal relationships with investors Developer may need to provide personal guarantees Make structuring a priority Developers may mistakenly believe that the legal structure of a development project is a secondary consideration (assuming it’s a consideration at all). It is tempting for a developer to focus on the “bigger picture”, viewing the legal investment structure as a technicality, which will have minimal bearing on an investor’s willingness to finance a project. However, it is ultimately the legal structure that creates and protects a developer’s entitlement to financial reward for the value they create and for this reason a clear proposition from the outset as regards the structure and commercial terms of any developer/investor relationship is essential for creating a basis for productive negotiations. Having a defined set of criteria is a useful way to filter out prospective business partners and opportunities that don’t match with a project’s overall objective and potential funding partners are likely to be much more favourably disposed if the legal structure has been settled prior to their being approached. A “real life” example of how a property developer can achieve its objectives by predominantly tapping a relatively small pool of private investors can be seen in one of our long-standing clients, which has partnered with a small number of private investors over the years. In each project, the relevant property is held by a separate SPV, which contractually engages our client to deliver the development. When first starting out, our client used the mezzanine loan structure outlined above. In later years, it favoured joint venture arrangements. Typically, our client would provide 5% of the funding requirement for each project, with the balance being met by private investors and, in some instances, senior loans from commercial lenders. These structures have been used for multiple projects, with the profit split and documentation being negotiated each time. The speed with which this group of private investors has been able to assess and invest in the opportunities presented by our client has in part been down to our client structuring opportunities in the right way and being fully cognisant of any attendant regulatory risks. With commercial lenders having reduced appetite for property lending, a trusted network of private investors is in many respects a better alternative. Key questions to ask yourself if you are considering raising funds from private investors  Equity – how much equity are you are willing and able to contribute to each project? Personal guarantees – to what extent are you willing to give personal guarantees to investors/lenders? Senior debt – are you willing to source senior debt from banks / financial institutions? Control – to what extent are you are willing to give up or share control over decision-making on each project? Working capital – do you need additional working capital for your operations (as opposed to development capital for projects)? Track record – what kind of property development track record are you able to present to prospective investors? Pipeline – to what extent are you able to demonstrate a pipeline of projects? Transparency – to what extent are you willing and able to be transparent about your business and your processes for managing developments? Your contacts – to what extent do you already have contacts and connections with prospective investors? Media assets – what media assets do you have to support your messages to investors (eg, a blog, individuals’ status as acknowledged experts, etc)? Location of prospective investors – are any of your prospective investors likely to be located overseas (in which case tax considerations such as withholding tax on interest may need to be considered)? Entrepreneurs’ relief – are you and your investors likely to want to benefit from entrepreneurs’ relief and potentially IHT relief? Land sourcing – is the land for each project to be contributed from a land bank at developer level (in which case degrouping charges may apply)? Skills – do you have the skills and the appetite to administer arrangements with multiple investors? Paul Sutton is the co-founder of LCN Legal, an independent law firm specialising in advising clients on the legal design and implementation of corporate structures