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Family offices becoming more aggressive players in real estate arena

Credit Analytics Case Study Poundworld Retail Ltd

Segment

IFRS 9 Impairment How It Impacts Your Corporation And How We Can Help

The Market Intelligence Platform

Real Estate

Real Estate Solutions Overview


Family offices becoming more aggressive players in real estate arena

Family offices have become much more aggressive in the competition for real estate deals on behalf of their wealthy clients, in part because attractively priced assets are hard to find and in part because the number of beneficiaries has increased.

In interviews, these private-wealth managers and lawyers who serve high-net-worth families, with investable assets ranging from $50 million to $30 billion, described a new vigilance and conscientiousness in their client base. There are as many different family office real estate strategies as there are family offices, but on balance they have become more proactive and more aggressive, and their strong cash positions allow them to capitalize on the disruption in real estate that has followed the rise of online retail sales, the trend toward renting and other secular changes.

Jonathan Adelsberg, partner at the law firm Herrick Feinstein, said many high-net-worth families, some now in their third generation, have to accommodate an exponentially growing list of beneficiaries, all the while negotiating a real estate market with rapidly changing space demands. For example, the upheaval in the retail arena took some families by surprise, he said, citing declines in shopping center values of 30% or more.

"Traditionally, you'd have people who just manage the real estate, so you have a portfolio of income-producing property. You would re-lease it, you would refinance it, you would refurbish it, and that's the extent of what you would do. That's great ... but the world has changed," Adelsberg said.

David Friedman, founder of Ella Valley Capital, described a new vigilance and adventurousness in the generation now in middle age. They are more willing to take on debt in projects to keep properties clean and operations modernized.

"I think the younger generations are starting to become a little bit more institutional in their approach," he said.

Friedman, whose business focuses mostly on multifamily and office properties, noted that high-net-worth families, because they typically plan to hold assets for generations, are willing to pay steeper prices for desired properties. A tighter cap rate is not a deterrent in a prospective deal.

"That long-term view allows them to do things that maybe other investors can't," he said.

Client appetite for risk varies widely. Jeff Sica of Circle Squared Alternative Investments, which works with small to medium-sized portfolios with $50 million to $500 million of investable assets, said his client base is more interested now than ever before in new development typically a higher-risk, higher-reward enterprise. They are eager to move money from stocks into "something real" and, encouraged by the increased popularity of renting over home ownership, multifamily developments have become especially popular.

?"Their main difficulty has been access to quality deals," Sica said. "The family offices have to compete with the institutions and the pension funds, so they're not finding as many opportunities. The way they're finding them is through good development opportunities."

However, Jonathan Epstein, managing director at GreenOak Real Estate Advisors, said his clients — with $1 billion to $30 billion of investable assets — have pivoted toward longer-term, cash-flowing deals with relatively little prospective downside. They will forgo a potentially lucrative new development for an attractively priced, stabilized asset, even if the return prospects are more moderate.

"Their bucket for lower-risk investments has increased, and the bucket for higher-risk investments has decreased, as the recovery is now in its eighth year," Epstein said.

Epstein noted that the ultra-high-net-worth set, with investable assets of $10 billion or more, are focused primarily on coastal gateway cities, where they perceive more stability. "I think they feel like the recovery has run its course and they should be looking at lower-risk, longer-term, cash flow-related deals," he said.

Herrick Feinstein's Adelsberg, for his part, said his clients are pursuing more development deals, as well as preferred equity and mezzanine positions. The goal, in whatever they do, is about long-term growth, rather than immediate gains.

"To a great extent, family offices have the opportunity, because they tend to have a lot of cash," he said. "In my mind, there's going to be a tremendous amount of opportunities for high-net-worth individuals to capitalize on real estate changes and shifts in the market."


Credit Analysis
Credit Analytics Case Study Poundworld Retail Ltd

Highlights

Co-written by Elijah Harden, Risk Services

Aug. 29 2018 — Bankruptcy Summary

Poundworld Retail Ltd (Poundworld) is a discount store operator located in the United Kingdom that on June 11, 2018, while operating around 350 stores, filed for administration in order to work to find a buyer for the chain1. S&P Global Market Intelligence’s Fundamental Probability of Default (Fundamental PD) increased nearly fivefold from 1.69% (an implied credit score of ‘bb-’2), a level that was better than the median general merchandise store in the U.K., to 10.39% (an implied credit score of ‘ccc+’) between fiscal year (FY) 2015 and FY 2016. To summarize, the increased Fundamental PD is similar to a credit score decline from ‘bb-’ to ‘ccc+’. The following year between FY 2016 and FY 2017, the Fundamental PD increased nearly 72% from 10.39% to 17.84% (an implied credit score of ‘ccc-’).

As of the reporting date November 10, 2016 for the period ending March 31, 2016, 19 months before the company filed for bankruptcy, Poundworld fell into ‘ccc’ range and was unable to recover. Poundworld’s inability to recover was due to competing in an increasingly competitive discount retail environment where there was less foot traffic to traditionally populous town centers and exchange rate pressure due to importing goods while the pound was weaker than the dollar3. This resulted in increasingly narrow margins, higher leverage, and decreasing profitability.

Exhibit 1: Fundamental PD Escalation

Business Description

Poundworld operates a chain of discount department stores in the United Kingdom and sells products through its online shop. It offers food and drinks, cleaning and laundry products, health and beauty products, home products, garden and outdoor supplies, pet care products, electrical products, stationery items, toys, baby products, party and gift products, and leisure time products. Poundworld was founded in 1974 and is based in Normanton, United Kingdom.

Fundamental Probability of Default Analysis

The analysis of S&P Global Market Intelligence’s one-year Fundamental PD reveals Poundworld had consistent implied credit scores in the ‘single b’ range for 10 of its 13 reporting periods from FY 2005 to FY 20174. In the time after FY 2012 the volatility of the implied credit scores increased in response to the volatility of Poundworld’s net income. As recently as FY2015, Poundworld, with a PD of 1.69% (implied credit score of ‘bb-‘), sat in the top half of UK general merchandise stores. However, in FY 2016 the company fell into the worst 25% of its UK peers with a PD of 10.39% (implied credit score of ‘ccc+’), roughly a year and a half before filing for administration. Subsequently, in FY 2017, it approached the worst 10% of its UK peers with a PD of 17.84% (implied credit score of ‘ccc’). This shows a notable escalation in risk, both on an absolute basis and with respect to its peers.

The Fundamental PD as of August 16, 2017 for the reporting period ended March 31, 2017 (FY 2017) highlights business and financial risk were significant problems for the company with vulnerable and highly leveraged scores, respectively. The most noteworthy factors contributing to the increased PD were total revenue, profit margin (net income to total revenue), a ratio of how much of every dollar earned is kept within the company, and current liabilities to net worth, a measure of how leveraged the company is/how much debt is used to finance the business. Poundworld experienced a revenue growth rate decline of 57.15% between FY 2015 and FY 2016 from 22.32% to 9.56% with a subsequent decline of 40.88% ultimately ending with a profit margin of 5.65% by FY 2017. As revenue growth for Poundworld slowed, the company became exceedingly leveraged. The average current liability to net worth ratio between FY 2013 and FY 2017 was an extraordinary 667%, signaling the company was unable to pay off debt obligations that were due within a year. In addition to the increasing leverage, Poundworld was battling diminishing profit margins until they eventually became negative, with an average profit margin of -0.02% between FY 2013 and FY 2017. Poundworld’s illiquid position made the company particularly vulnerable to the other operating expenses which totaled approximately £9MM in FY 2016 and FY 2017, which only carried the company closer to the brink of bankruptcy.

Source: S&P Global Market Intelligence as of July 19, 2018. For illustrative purposes only.
Note: Current Liabilities to Net Worth ratio in FY 2017 is actually -1317%, but the model assumes the worst possible profile and assigns the value of 10842%

Source: S&P Global Market Intelligence as of July 19, 2018. For illustrative purposes only.

1 Unless otherwise noted, all information sourced from the S&P Capital IQ platform as of July 24, 2018.
2 S&P Global Ratings does not contribute to or participate in the creation of credit scores generated by S&P Global Market Intelligence. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence PD scores from the credit ratings used by S&P Global Ratings.
3 Source: Financial Times, Poundworld files for bankruptcy, as published on June 11, 2018. https://www.ft.com/content/5f00154e-6d54-11e8-852d-d8b934ff5ffa
4 Source: S&P Capital IQ platform as of July 24, 2018.

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Credit Analysis
IFRS 9 Impairment How It Impacts Your Corporation And How We Can Help

IFRS 9 is a reporting standard for financial instruments that replaces IAS39 (the previous incurred loss standard) with the introduction of provisions for expected credit losses (ECLs) on all financial assets, such as those held to collect contractual cash flows, or held with the possibility of being sold.

The date for adoption was January 1, 2018 and is mandatory for public non-financial corporations (and financial institutions) across a number of jurisdictions outside the United States, including many European countries.

The two key changes introduced by the IFRS 9 accounting standard are:

  • Calculation and provisions must be performed on all affected financial assets, not just the impaired ones, as per the standard it replaces
  • New expected credit loss calculations

Additional challenges will be presented when making assessments for low default asset classes, and companies may find it difficult to access models and sufficient data history.

Impact for non-financial corporations

Non-financial corporations will have some material exposure to many of the financial assets that are defined under IFRS 9. These include investment portfolios, intercompany loans, lease receivables, contract assets, and trade receivables, as illustrated below and further explained in our webinar on IFRS 9 for non-financial corporates.

This, together with the need to assess losses on performing and non-performing assets, might have a material impact on the profit and loss (P&L) of such companies.

ECL calculations under IFRS 9

The IFRS 9 accounting standard introduces new expected credit loss (ECL) calculations that require more data and new models. The key requirements are:

  • Significant increase in credit risk (SICR): Expected loss needs to be assessed at each reporting period to identify a SICR since initial recognition
  • Explicit macro-economic forecasts need to be considered using factors such as the relevant GDP growth, unemployment rate, and stock market index growth figures
  • Credit risk metrics such as probability of default (PD), credit rating, credit score, and loss given default (LGD) need to be adjusted to point in time (PiT), versus through the cycle (TTC)
  • Calculations need to be extended over the lifetime of the assets for underperforming exposures, or in standardized calculations

General versus simplified approach

When performing ECL calculations for trade receivables, the company can choose to take a general or simplified approach (the company is presented with a choice between the two depending on the type of exposure).

  • The general approach uses the 12-month ECL calculation for performing assets (Stage 1 assets) and lifetime calculation for the assets whose creditworthiness has deteriorated since recognition (Stage 2 assets)
  • The simplified approach uses the lifetime ECL calculation for all performing and non-performing assets

The simplified approach can have a bigger impact on P&L expense, as all losses are calculated over the lifetime of the asset, while the general approach can have more impact on P&L volatility, as assets might move between stages incurring 12-month and lifetime calculations.

How S&P Global Market Intelligence can help

A best practice approach used by many financial institutions, which non-financial corporations can also use to comply with the new provision, is to use the existing TTC metrics and convert them into PiT metrics to reflect the current credit cycle, as well as include the required future macroeconomic considerations.

S&P Global Market Intelligence has developed models and tools to help your business undertake the relevant ECL calculations. These models can also be used to assess the creditworthiness of your counterparties and recovery of your exposure in the context of your core business process such as customer credit, supply chain risk, vendor management, and selection and transfer pricing.

The calculation method involves four steps:

  1. We calculate the TTC metric, i.e. the S&P Global Market Intelligence Fundamental PD, CreditModel™ score, for the concerned entity.
  2. We apply our macro-economic model, which weights user defined macro-economic scenarios to produce weighted average forecasted PDs.
  3. We apply a credit cycle adjustment, which converts the TTC risk metric into a PiT PD, leveraging the difference between observed default rates from S&P Global Ratings’ rated universe over last year versus over the past 30+ years.
  4. In addition, as a best practice, we also offer the option to incorporate market-based forward looking information. This is done by further adjusting the PD with the analysis of PD Market Signals country and industry benchmark trends over the past three months versus the past year.

In addition to this quantitative approach available on the Credit Analytics platform, we also offer scorecards that cover low default asset classes for PD, LGD, and point in time adjustments.

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