The Deal that Wasn't Done: Putting Investors First | How Due Diligence ensured the safety of investor funds
By: Josh Will
Earlier this year, a $27,000,000 equity raise was commenced through Fortress Real Capital (a syndicate mortgage product offered by Centro Mortgage Inc.). These funds were being raised to finance the servicing and development phase for a subdivision of high-end custom residential homes; the final phase in a mature neighborhood. This picturesque site provided homes with sprawling views, including some waterfront lots.
Investors were excited about the project’s potential and attractive term, in addition to the return they would make by participating in the funding. There was a strong completion bonus (deferred lender fee) waiting for them upon exit. This enthusiasm was shared by future homeowners with 25% of the lots already pre-sold and strong demand for these highly sought after lots.
In a short period, $13,000,000 was raised and ready to close in the first tranche. But the executive team made the difficult decision not to close the investor funds, forfeit all fees and incur the costs of repatriation for both clients and advisors. It was the right market with the right product and the right term... so what happened?
Fortress had completed full due diligence and the closing of investor funds was conditional on the refinancing of the 1st mortgage (held by the primary mortgage lender). This would allow our funding to be in line with the senior land loan in front of us and ensure the two loans worked in tandem.
Being Diligent About Due Diligence
One of the risk points we identified was that the maturity date on the developer’s current mortgage was prior to Fortress’ exit. In the event that the developer was not able to extend or secure additional financing, the primary lender (who is entitled before investors) could decide to force the sale of the property.
In that scenario, the developer would lose control of the project, and it could be sold to a new owner. This would cause a significant disruption to the investors and was an unacceptable risk.
Resigning Opportunities, Reconciling Investors
After more than one deadline for the borrower (the developer) to secure a new 1st mortgage had passed, we went to the current mortgage holder and asked them to work with us by extending their financing to be congruent with our term.
We were hopeful for their cooperation as part of the funding we would be providing would be giving them some much needed liquidity and be positive for their balance sheet.
The wheels were in motion for the new funding to close; a well-known lender was providing a loan facility. It would have clearly been advantageous to the first mortgagee for us to close and protect their investment. But what if the new financing didn’t close? What if this tri-party agreement was delayed or hit a snag?
We tried several different approaches and tactics to have the current mortgage holder give us the comfort we were looking for. Let me be very clear: we wanted this closing. Up until this point the deal had satisfied everything we look for. There was a great return for investors, a great location, and strong demand for the consumer product. It was a good deal. We had gone to market and had front funded huge expenses for legal and offering documents, marketing materials, multiple due diligence trips including bringing over 50 agents in from out of province and even a $10,000 donation to a local charity. Cancelling this deal would mean forfeiting recovery of tens of thousands in costs and even more in fees; additionally, advisors and clients waiting to get paid for positioning their funds and making them available would also feel put out.
We wanted this closing as badly as the sales force but we knew the right thing to do was not to close and withdraw our commitment. We committed the full resources of our 30+ staff and worked with agents and investors to redeploy their capital to a different project.
Shortly after we pulled out of the project, the would-be borrower failed to secure and close on the new funding or extend/refinance the 1st mortgage.
Consequently, the mortgage lender started pursuing enforcement options. Had we closed and funds been advanced to the borrower, we could have potentially been embroiled in a distressed asset situation. This would be a strategically advantageous outcome for the current mortgage lender, as they would have received some liquidity from us and now also have us as an exposed party to the enforcement action - the more people on the hook, the better, right?
This would have resulted in the project being locked up for an indefinite period of time in legal challenges and nothing but headaches and heartaches for both advisor and investor.
Making Things Right
With approval from investors, funds raised were transferred to other Fortress projects. This came at a significant cost to us (hundreds of thousands of dollars) but we knew long term, we will only be as successful as our investors and agents. We were under no contractual obligation to compensate investors; all of their contracts clearly stated that they were not entitled to any interest until funds closed into the project they subscribed to.
We voluntarily compensated clients for monies that sat safely in trust accounts and paid them a premium return for taking no risk and no deployment. Additionally, we worked with all dealing representatives and compensated them, at our own cost, for the extra work needed to rewrite all the cancelled business. It was a frustrating time for everyone involved, but a disciplined approach to due diligence means making the hard decisions.
So why did we do this? Spirit, dedication, principal. Yes for all those reasons. As important as those factors are, the fundamental factor that underpins our process is people. People whose education and training is sound. People whose judgment is calm and perceptive. People whose actions are deliberate and definitive. When difficult times came, we were not swept up by these series of events. Our people were ready. At the end of the day, people are who we do business with and that’s what we rely on.