Waterfall Construction Basic Theory

Transcription

1 Waterfall Construction Basic Theory ULI Waterfall Webinar 20 March 2012 III, FRICS (202)

2 Waterfall Diagram Pari Passu Pref Rate 1 st Tier 15% good proxy for Pref Non Pari Passu split Note: Explained in detail later 2 nd Tier 2 nd Tier rate N # Tiers N th Tier N th Tier rate Final Tier Example Final Distribution X % to Promote to Sponsor (1 X%) distribution Pari Passu 2 of 125

3 1) Interest Factors Agenda (Session 1) Basics of Accrual, Compounding, Effective Notional Annual Rate (ENAR) 2) Waterfall Functions (MS Excel) 3) Waterfall (General Concept(s)) 4) Pro Forma Structure 5) Waterfall (Construction) 6) Securitization (Time Permitting) 3 of 125

4 Agenda (Session 2) Waterfall Construction MS Excel Construction of Waterfall Four part construction 1) Project Summary 2) Tranche Structures 3) Tranche Cash Flows 4) Investor Cash Flows Deliverable: Final working model & process 4 of 125

5 Interest Factors Understanding of compounding rates

6 Compound Interest Interest-on-Interest Components (HP-12c) Initial Deposit (PV) Interest Rate (i) Time (n) Payment rate (PMT) Future Value (FV) Happy 30 th Birthday! 6 of 125

7 Future Value - Simple FV PV t I t 7 of 125

8 Future Value Simple (example) Libor (one-year) Where: i = Libor = 275 (2.75%) PV = $100,000,000 i t = ($100,000,000)*i = $2,750,000 FV t = PV + i t FV t = $100,000,000 + $2,750,000 FV t = $102,750,000 8 of 125

9 Future Value - Compounded FV PV 1 i t Interest Compounds 9 of 125

10 Future Value Compounded (example) Libor (two-year) Where: i = Libor = 275 PV = $100,000,000 FV t = ($100,000,000)*(1+i) 2 FV t = ($100,000,000)*(1+i)*(1+i) FV t = $102,750,000*(1+i) FV t = $102,750,000*( ) FV t = $105,575, of 125

11 Future Value Periods (Periodic Compounding) FV Where: n: periods, e.g. years PV 1 m: intervals within 1 year i: Annual Interest Rate i m nm 11 of 125

12 Future Value Periods (Periodic Compounding) cont d FV Compounding Periods: M=2: Semiannual M=4: Quarterly M=365: Daily PV 1 i m nm 12 of 125

13 Future Value Periods (Periodic Compounding) example1 PV = $100,000,000 (1 year) I = Libor = 275bps M(Compounding Periods) = semiannual (2) FV FV FV PV 1 i m 100,000, ,779,044 nm 100,000, ,000, of 125

14 Future Value Periods (Periodic Compounding) example2 PV = $100,000,000 (2 years) I = Libor = 275bps M(Compounding Periods) = monthly (12) FV FV FV PV 1 i m 100,000, ,647,414 nm 100,000, ,000, of 125

15 Effective Annual Yield (EAY) Annual equivalent yield Assumes annual compounding Converts period compounding to annual value a.k.a. APR EAY FV PV 1 15 of 125

16 FV FV FV EAY EAY PV 1 100,000, ,779,044 FV PV EAY (example1) i m 1 nm 100,000, ,000, ,779, ,000, % versus 2.75% (semi - annual) of 125

17 FV FV FV EAY EAY PV 1 100,000, EAY (example2) 102,795,183 (for 1 year) FV PV i m nm 100,000, ,000, ,795, ,000, or 2.80% (versus 2.75%) of 125

18 EAY (multiple Periods) Nominal Annual Rate Compounding Interval Periods/Yr EAY 5% Annual % 5% Semi annual % 5% Quarterly % 5% Monthly % 5% Daily % 5% Continuous Infinite % Note : FV PV rt 18 of 125

19 Effective Nominal Annual Rate (ENAR) Equivalent Effective Annual Yield (EAY) when adjusting for compounding EAY FV PV Where: M = compounding period(s) ENAR m m 19 of 125

20 EAY ENAR FV PV EAY 1 1 ENAR EAY m EAY ENAR Solved 1 1 ENAR m 1 1 1/ m 1/ m ENAR m m 1 1 m m EAY 1 1 1/ m 1 ENAR m 20 of 125

21 Future Value - Periods ENAR m EAY 1 1 / 1 m Where: ENAR: Equivalent nominal annual rate EAY: Effective annual yield m: Periods 21 of 125

22 Future Value Example1 EAY = 6.00% M = Monthly compounding ENAR ENAR ENAR ENAR or 5.841% 1 *12 1 * *12 22 of 125

23 Future Value Example2 EAY 1 ENAR m m 1 EAY EAY 0.06 or 6.00% 23 of 125

24 Waterfall Functions MS Excel Functions

25 MS Excel Functions End of Month: =EOMONTH() Count: =COUNT() Summation: =SUM() Absolute value: =ABS() Minimum: =MIN() Day: =DAY() XIRR: =XIRR(values,dates) XNPV: =NPV(rate,values,dates) 25 of 125

26 End of Month Function Returns the serial number of the last day of the month before or after a specified number of months =EOMONTH(start_date,months) Start Date = 1 January 2011 Last day of March 2011 =EOMONTH(1Jan11,2) Note: 1Jan11 must be value not a name 26 of 125

27 Count Function Counts the number of cells in a range that contains numbers =COUNT(values) A B C D E Roger 6 Count 4 27 of 125

28 Sum Function Adds all the numbers in a range of cells =SUM(values) A B C D E Roger 6 Count 4 Sum of 125

29 Absolute Value Function Returns the absolute value of a number, a number without its sign =ABS(value) -a = a; a = a 5 7 Absolute of 125

30 Minimum Function Returns the smallest number in a set of values. Ignores logical values and text. =MIN(values) 5 7 Absolute 5 7 Row1 Minimum 7 Row2 Minimum 5 30 of 125

31 Day Function Returns the day of the month, a number from 1 to 31 =DAY(serial_number) 2 Feb 11 6 Mar Apr May Jun 11 Day of 125

32 XIRR versus IRR IRR discounts on a periodic basis XIRR discounted on a daily basis Allows analyst to input actual dates of cash flows Recognized capital as a vector, not a static input Capital has both magnitude (Qty) and direction (date) Allows for accurate return of cash when received at irregular intervals 32 of 125

33 XIRR Requires two inputs: Values and Dates Each Cash Flow is discounted the day it occurs NPV 0 N i d d i1 P 1 rate i 365 where: d i = the i th, or last, payment date d 1 = the 0 th payment date P i = the i th, or last, payment 1 33 of 125

34 XIRR (cont d) MS Excel solves the equation using linear interpolation, i.e. iterative technique Third input can be added to assist MS Excel when appropriate assumptions can be made Note: XIRR function requires the analysis toolpak to be installed in MS Excel Excel Add-in 34 of 125

35 XIRR Example 1 Jan 11 1 Jul 11 1 Jul 12 1 Jul 13 1 Jul 14 (35,000) 12,000 5,000 20,000 22,000 IRR 20.85% XIRR 26.46% Delta 5.61% 35 of 125

36 MS Excel Add-Ins (Data Analysis & Solver) 36 of 125

37 Steps for MS Excel Add-ins 5 minute break for those that have it

38 Step 1 Office Button 38 of 125

39 Step 2 Excel Options (Select) 39 of 125

40 Step 3 Excel Options 40 of 125

41 Step 4 Add-Ins 41 of 125

42 Step 5 Add-Ins 42 of 125

43 Step 6 Select Solver Add-in & Analysis ToolPak 43 of 125

44 Step 7 Hit OK Select (Hit) OK in the lower right portion of your screen 44 of 125

45 Step 8 Data (once back in MS Excel) 45 of 125

46 Step 9 Data Analysis & Solver 46 of 125

47 Verify (Data Analysis & Solver) Under data on the ribbon bar verify that Data Analysis and Solver are there If not there and you are using a PC, please me,, after the program for assistance If not there and you are using an Apple, please contact your administrator. Unfortunately I do not know this process (but it should be very similar) 47 of 125

48 Waterfall Let the fun begin

49 Niagara (U.S. Side) (Do not end up on the rocks!) 49 of 125

50 Waterfall Method of distributing profits among partners within a transaction Allows for profits to NOT follow an even distribution Profits NOT distributed Pari Passu Pari Passu: division entirely by ownership %, 80% capital, 80% of ALL cash flows distributed, 80% of risk 50 of 125

51 Simple Waterfall: Bank Model Creditor is paid first Owner is paid second Net Operating Income (NOI) Payment by value NOT yield Waterfalls typically separate cash flows to owners (equity) DEBT Equity 51 of 125

52 Syndication versus Securitization Syndication separates cash flows according to ownership % 20% ownership, 20% of risk Securitization separates cash flows according to risk tranches Transformation of a portfolio of financial obligations into liquid form attractive to a myriad of investors 52 of 125

53 Syndication versus Securitization (graphic) Syndication Securitization Capital Stack Ownership Division 53 of 125

54 Structure Example (Generic) Bond 1 Bond 2 Bond 3 Bond n (y = 8.5%) TRUST Tranche 1 1 st Senior; y=6% Tranche 2 2 nd 10% Loss; y=7.5% Tranche 3 3 rd 10% Loss; y=15% Tranche 4 (Residual) 4 th 5% Loss; y=35% Waterfall 54 of 125

55 Syndication/Structured Single Bond $100.0m 10 years Interest only 6% Coupon WAM = 10 WAC = 6.00% Issue: Too large for single lender Result: Bifurcate into two tranches Senior A Piece Junior B Piece 55 of 125

56 Syndication/Structured Single Bond $100.0m 10 years Interest only 6% Coupon WAM = 10 WAC = 6.00% Tranche A $50.0m 10 years Interest only 4% Coupon WAM = 10 WAC = 4.00% Tranche B $50.0m 10 years Interest only 8% Coupon WAM = 10 WAC = 8.00% 56 of 125

57 Syndication/Structured (cont d) Tranche A $50.0m 10 years Interest only 4% Coupon WAM = 10 WAC = 4.00% Tranche B $50.0m 10 years Interest only 8% Coupon WAM = 10 WAC = 8.00% Tranche A Senior Piece Reduced Coupon Tranche B Junior Piece Higher Coupon Compensates for higher risk Prepayment Recovery Rate 57 of 125

58 Syndication/Structured (cont d) Order of Payments: 1. Interest Tranche A 2. Interest Tranche B 3. Principal Tranche A 4. Principal Tranche B - Residual Risk (σ) Prepayment 1. Refinance 2. Foreclosure 3. Sale Recovery Loss % Tranche A $50.0m 10 years Interest only 4% Coupon WAM = 10 WAC = 4.00% Tranche B $50.0m 10 years Interest only 8% Coupon WAM = 10 WAC = 8.00% 58 of 125

59 Single Bond ($100.0m) (No Prepay/Default/100% Recovery) Principal 100,000,000 WAM 10 Interest 6% WAC 6% Term 10 Prepay Date 10 Recovery 100% Period BoP 100,000, ,000, ,000, ,000, ,000,000 Interest 6,000,000 6,000,000 6,000,000 6,000,000 6,000,000 Principal 100,000,000 EoP 100,000, ,000, ,000, ,000, ,000,000 Cash Flow (100,000,000) 6,000,000 6,000,000 6,000,000 6,000, ,000,000 IRR 6.00% 59 of 125

60 Tranche A & B (No Prepay/Default/100% Recovery) Transformation Investor A Senior 4.00% BoP 50,000,000 50,000,000 50,000,000 50,000,000 50,000,000 Interest 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 Principal 50,000,000 EoP 50,000,000 50,000,000 50,000,000 50,000,000 50,000,000 Invstor A Cash Flow (50,000,000) 2,000,000 2,000,000 2,000,000 2,000,000 52,000,000 IRR 4.00% Investor B Junior 8.00% BoP 50,000,000 50,000,000 50,000,000 50,000,000 50,000,000 Interest 4,000,000 4,000,000 4,000,000 4,000,000 4,000,000 Principal 50,000,000 EoP 50,000,000 50,000,000 50,000,000 50,000,000 50,000,000 Invstor A Cash Flow (50,000,000) 4,000,000 4,000,000 4,000,000 4,000,000 54,000,000 IRR 8.00% 60 of 125

61 Single Bond ($100.0m) (2-year prepay/90% Recovery) Principal 100,000,000 WAM 10 Interest 6% WAC 6% Term 10 Prepay Dat 8 Recovery 90% Period BoP 100,000, ,000, ,000, ,000, ,000,000 Interest 6,000,000 6,000,000 6,000,000 6,000,000 6,000,000 Principal 90,000,000 EoP 100,000, ,000, ,000, ,000, ,000,000 10,000,000 Cash Flow (100,000,000) 6,000,000 6,000,000 6,000,000 6,000,000 96,000,000 IRR 4.95% 105bp loss 61 of 125

62 Tranche A & B (2-year prepay/90% Recovery) Transformation Investor A Senior 4.00% BoP 50,000,000 50,000,000 50,000,000 50,000,000 50,000,000 Interest 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 Principal 50,000,000 EoP 50,000,000 50,000,000 50,000,000 50,000,000 50,000,000 Invstor A Cash Flow (50,000,000) 2,000,000 2,000,000 2,000,000 2,000,000 52,000,000 IRR 4.00% No Loss Investor B Junior 8.00% BoP 50,000,000 50,000,000 50,000,000 50,000,000 50,000,000 Interest 4,000,000 4,000,000 4,000,000 4,000,000 4,000,000 Principal 40,000,000 EoP 50,000,000 50,000,000 50,000,000 50,000,000 50,000,000 10,000,000 Invstor A Cash Flow (50,000,000) 4,000,000 4,000,000 4,000,000 4,000,000 44,000,000 IRR 5.98% 202bp Loss 62 of 125

63 Tranche B Sensitivity Recovery % Prepayment years Tranche B % 8.00% 8.00% 8.00% 8.00% 8.00% 90.0% 6.28% 5.98% 5.59% 5.06% 4.33% 80.0% 4.26% 3.60% 2.74% 1.59% 0.00% 70.0% 1.80% 0.68% 0.77% 2.70% 5.36% 60.0% 1.40% 3.16% 5.43% 8.43% 12.55% 50.0% 6.11% 8.98% 12.70% 17.65% 24.40% Tranche A suffers no losses (exposed to reinvestment rate risk) 63 of 125

64 Waterfall Considerations Separation of cash flows according to owners agreement Separation of cash flows by yield, NOT by order Order: Bank vanilla example Pref Rate: Preference Rate Generally provided to Investor Acts as a coupon rate, e.g. Preferred Equity 64 of 125

65 Waterfall Diagram Pari Passu 1 st Tier Pref Rate 15% good proxy for Pref Non Pari Passu split 2 nd Tier 2 nd Tier rate N # Tiers N th Tier N th Tier rate Final Tier Example Final Distribution X % to Promote to Sponsor (1 X%) distribution Pari Passu 65 of 125

66 Waterfall Split Pref Rate: Up to 15% IRR 10% Sponsor 90% Investor 15% - 20% IRR Split 20% Sponsor 90% Investor Over 20% 40% Promote (Sponsor) 60% Split (10% Sponsor; 90% Investor) 66 of 125

67 Waterfall Split Graphic 15% IRR Sponsor 10% 20% IRR Sponsor 20% 20% + IRR Promote Sponsor 40% Sponsor 10% Investor 90% Investor 80% Investor 90% 67 of 125

68 Pro Forma Structure Incorporating the Waterfall

69 Pro Forma Structure/Logic Flow Inputs Section (s1) Amortization Page (s3) Analysis (s4) Summary Page Pro Forma Page (s2) 69 of 49

70 Pro Forma Structure/Logic Flow (Waterfall Addition) Inputs Section (s1) Summary Page Analysis (Project) (s4) Waterfall Page (Investor) (s5) Amortization Page (s3) Pro Forma Page (s2) 70 of 49

71 Waterfall (Step 1) Quantify Equity Contributions Modeled in Sources/Uses Sources 549,000 Operations Units I/P Finance I/P Equity 99,000 Unit 1 One Bedroom per mont 1,500 Tranche 1 Investor 1 80,000 Unit 2 Two Bedroom per mont 2,000 Principal 400,000 Investor 2 19,000 Unit 3 Two Bedroom per mont 2,000 Term (years) 20 Debt 450,000 Unit 4 Two Bedroom per mont 2,000 Interest Rate 8% Tranche 1 400,000 Interest Only Tranche 2 50,000 Vacancy % Origination Fee 1% Vacancy % Uses 549,000 Vacancy % Tranche 2 Purchase Price 350,000 Vacancy % Principal 50,000 Renovation 165,000 Term (years) 20 Legal 3,500 Rental Escl 2% Interest Rate 15% Bank 2,000 Interest Only Personal 1,500 Management per Net Rev 5% Origination Fee 1% IDC 24,700 Repairs per Net Rev 5% Tax Escrow 1,300 Janitor per year 2600 Valuation I/P Finance Cost 4,500 Heat per year 2130 Cap Rate 10.9% Electricity per year 1000 Sales Expense 6% Surplus/(Deficit) Water per year 1200 Discount Rate 10% Property Tax per year 7800 Insurance per year 2600 Sales Period Year 10 Expense Escl 2% 71 of 125

72 Waterfall (Step 2) Quantify the project cash flows for distribution, i.e. cash distributions Modeled on pro forma page Cash flows must not be accounting values, i.e. no earnings, free cash flows distributed to investors AFTER debt service 72 of 125

73 Waterfall (Step 2) (cont d) (Note: not yet ) Periods Revenue Year Unit1 Rent 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 Unit2 Rent 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 Unit3 Rent 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 Unit4 Rent 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 Total Rent 7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500 Vacancy Vacancy Vacancy Vanancy Total Vacancy Total Revenue 7,125 7,125 7,125 7,125 7,125 7,125 7,125 7,125 7,125 7,125 7,125 7,125 Expenses Management Repairs Janitor Heat Electricity Water Property Tax Insurance Total Expenses 2,157 2,159 2,161 2,164 2,166 2,169 2,171 2,174 2,176 2,178 2,181 2,183 Net Operating Income 4,968 4,966 4,964 4,961 4,959 4,956 4,954 4,951 4,949 4,947 4,944 4, of 125

74 Waterfall (Step 2) (cont d) ( yet) Debt Tranch 1 3,346 3,346 3,346 3,346 3,346 3,346 3,346 3,346 3,346 3,346 3,346 3,346 Tranch Tranche 1 4,004 4,004 4,004 4,004 4,004 4,004 4,004 4,004 4,004 4,004 4,004 4,004 Sales Proceeds Sales Price Sales Expense Principal Repay Tranche 1 Principal Repay Tranche 2 Net Sales Proceeds Reversion FCF Operating FCF Total FCF (99,000) Note: No bifurcation (Operations/Reversion) 74 of 125

75 Waterfall (Step 3) Quantify project characteristics Is project viable as a whole? Modigliani and Miller Total Profit Internal Rate of Return (IRR) Multiple (Profit/Invested Capital) 75 of 125

76 Waterfall (Step 3) (Project Valuation) Valuation: Year Revenue Rental 90,000 91,800 93,636 95,509 97,419 99, , , , ,558 Vacancy 4,500 4,590 4,682 4,775 4,871 4,968 5,068 5,169 5,272 5,378 Total Revenue 85,500 87,210 88,954 90,733 92,548 94,399 96,287 98, , ,180 Expense Management 4,275 4,361 4,448 4,537 4,627 4,720 4,814 4,911 5,009 5,109 Repairs 4,275 4,361 4,448 4,537 4,627 4,720 4,814 4,911 5,009 5,109 Janitor 2,624 2,677 2,731 2,786 2,842 2,900 2,958 3,018 3,079 3,141 Heat 2,150 2,193 2,237 2,282 2,329 2,376 2,423 2,472 2,522 2,573 Electricity 1,009 1,030 1,050 1,072 1,093 1,115 1,138 1,161 1,184 1,208 Water 1,211 1,236 1,260 1,286 1,312 1,338 1,365 1,393 1,421 1,450 Property Tax 7,872 8,031 8,193 8,358 8,527 8,699 8,875 9,054 9,237 9,423 Ins ura nc e 2,624 2,677 2,731 2,786 2,842 2,900 2,958 3,018 3,079 3,141 Total Expenses 26,040 26,564 27,098 27,644 28,200 28,767 29,346 29,937 30,539 31,154 Net Operating Income 59, ,646 61,856 63,090 64,348 65,631 66,941 68,276 69,638 71,026 Debt Tranche 1 40,149 40,149 40,149 40,149 40,149 40,149 40,149 40,149 40,149 40,149 Tranche 2 7,901 7,901 7,901 7,901 7,901 7,901 7,901 7,901 7,901 7,901 Total Debt 48,050 48,050 48,050 48,050 48,050 48,050 48,050 48,050 48,050 48,050 Net Sales Proceeds 308,167 Reversion FCF 308,167 Operating FCF 11,410 12,596 13,806 15,040 16,298 17,582 18,891 20,226 21,588 22,977 Total FCF (99,000) 11,410 12,596 13,806 15,040 16,298 17,582 18,891 20,226 21, ,144 DSCR Minimum 1.24 Cash on Cash 11.53% 12.72% 13.95% 15.19% 16.46% 17.76% 19.08% 20.43% 21.81% 23.21% Minimum 11.53% PV Reversion 118, % PV Operating 98, % Total 217,428 CF0 99,000 NPV 118,428 IRR 22.42% 76 of 125

77 Waterfall (Step 4) (Structure) Construct Waterfall addition for pro forma Four Sections: Project Summary Tranche Structures (Accruals) Tranche Cash Flows Investor Cash Flows 77 of 125

78 Waterfall (Step 4) (Structure) Waterfall Period (Units) Total 1/31/2010 1/31/2011 1/31/2012 1/31/2013 1/31/2014 1/31/2015 1/31/2016 1/31/2017 1/31/2018 1/31/2019 1/31/2020 1/31/2021 Project Cash Flow Contributions (200.0) Sponsor 10% (20.0) (20.0) Equity Partner 90% (180.0) (180.0) Total 100% (200.0) (200.0) Project Summary Cash Proceeds for Distribution Project Cash Flow (200.0) Profit $350.0 IRR 22.43% Multiple 2.75x A. Project Summary STRUCTURE Tier % Daily Rate BoP Balance 0.0 (200.0) (180.0) (157.0) (130.6) (100.2) (65.2) (25.0) Equity Contributions (200.0) (200.0) Accrual 15.00% (128.8) 0.0 (30.0) (27.0) (23.6) (19.6) (15.0) (9.8) (3.8) Paydown EoP Balance (200.0) (180.0) (157.0) (130.6) (100.2) (65.2) (25.0) Cash left for distribution IRR Check 15.00% (200.0) Tranche Structures Tier % Rate (Accruals) Daily Starting Balance 0.0 (200.0) (190.0) (178.0) (163.7) (146.4) (125.7) (100.9) (71.1) (35.3) Equity Contributions (200.0) (200.0) Accrual 0.0 (40.0) (38.0) (35.7) (32.7) (29.3) (25.1) (20.2) (14.2) (7.1) % Paydown Balance (200.0) (190.0) (178.0) (163.7) (146.4) (125.7) (100.9) (71.1) (35.3) Cash left for distribution IRR Check 20.00% (200.0) B. Tranche Structures Cash Flows to each tranche: I. Pari Passu to an IRR of 15.00% Sponsor 10.00% Equity Partner 90.00% II. Splits up to an IRR of 20.00% Sponsor 20.00% Equity Partner 80.00% Tranche Cash Cash left for Distribution Flows III. Sponsor Promote 40.00% C. Tranche Cash Flows Cash to Equity 60.00% Sponsor 10.00% Equity Partner 90.00% INVESTOR CASH FLOWS SPONSOR Equity Investment (20.0) (20.0) Proceeds CF 85.1 (20.0) Profit $85.1 % of Total Profit 24.3% IRR 30.03% Multiple 5.25x Investor EQUITY PARTNER Cash Equity Investment (180.0) (180.0) Flows Proceeds CF (180.0) Profit $264.9 % of Total Profit 75.7% IRR 21.13% Multiple 2.47x D. Investor Cash Flows Check TRUE 78 of 125

79 Waterfall (Step 4) (Project Summary) Waterfall Period (Units) Total 1/31/2010 1/31/2011 1/31/2017 1/31/2018 1/31/2019 1/31/2020 1/31/2021 Project Cash Flow Contributions (200.0) Sponsor 10% (20.0) (20.0) Equity Partner 90% (180.0) (180.0) Total 100% (200.0) (200.0) Project Summary Cash Proceeds for Distribution Project Cash Flow (200.0) Profit $350.0 IRR 22.43% Multiple 2.75x Note: Years 3 8 hidden 79 of 125

80 Waterfall (Step 4) (Tranche Structures (Accruals)) STRUCTURE Tier % Daily Rate BoP Balance 0.0 (200.0) (25.0) Equity Contributions (200.0) (200.0) Accrual 15.00% (128.8) 0.0 (30.0) (3.8) Paydown EoP Balance (200.0) (180.0) Cash left for distribution IRR Check 15.00% (200.0) Tranche Structures Tier % Daily Rate (Accruals) Starting Balance 0.0 (200.0) (100.9) (71.1) (35.3) Equity Contributions (200.0) (200.0) Accrual 20.00% 0.0 (40.0) (20.2) (14.2) (7.1) Paydown Balance (200.0) (190.0) (71.1) (35.3) Cash left for distribution IRR Check 20.00% (200.0) Note: Years 3 8 hidden 80 of 125

81 Waterfall (Step 4) (Tranche Cash Flows) Cash Flows to each tranche: I. Pari Passu to an IRR of 15.00% Sponsor 10.00% Equity Partner 90.00% II. Splits up to an IRR of 20.00% Sponsor 20.00% Equity Partner 80.00% Tranche Cash Cash left for Distribution Flows III. Sponsor Promote 40.00% Cash to Equity 60.00% Sponsor 10.00% Equity Partner 90.00% Note: Years 3 8 hidden 81 of 125

82 Waterfall (Step 4) (Investor Cash Flows) INVESTOR CASH FLOWS SPONSOR Equity Investment (20.0) (20.0) Proceeds CF 85.1 (20.0) Profit $85.1 % of Total Profit 24.3% IRR 30.03% Multiple 5.25x Investor EQUITY PARTNER Cash Equity Investment (180.0) (180.0) Flows Proceeds CF (180.0) Profit $264.9 % of Total Profit 75.7% IRR 21.13% Multiple 2.47x Check TRUE Note: Years 3 8 hidden 82 of 125

83 Waterfall Construction

84 Project Summary (Part a) Waterfall Period (Units) Total 1/31/2010 1/31/2011 1/31/2017 1/31/2018 1/31/2019 1/31/2020 1/31/2021 Project Cash Flow Contributions (200.0) Sponsor 10% (20.0) (20.0) Equity Partner 90% (180.0) (180.0) Total 100% (200.0) (200.0) Project Summary Cash Proceeds for Distribution Project Cash Flow (200.0) Profit $350.0 IRR 22.43% Multiple 2.75x Models Contributions from Investor(s) and Sponsor separately (Can be spread or Point-in-Time) Assigns dates with specific cash flows Models Cash Distribution (after debt service) Quantify Project performance (check with pro forma) 84 of 125

85 Tranche Structures (Accruals) (Part b) STRUCTURE Tier % Daily Rate BoP Balance 0.0 (200.0) (25.0) Equity Contributions (200.0) (200.0) Accrual 15.00% (128.8) 0.0 (30.0) (3.8) Paydown EoP Balance (200.0) (180.0) Cash left for distribution IRR Check 15.00% (200.0) Tranche Structures Tier % Daily Rate (Accruals) Starting Balance 0.0 (200.0) (100.9) (71.1) (35.3) Equity Contributions (200.0) (200.0) Accrual 20.00% 0.0 (40.0) (20.2) (14.2) (7.1) Paydown Balance (200.0) (190.0) (71.1) (35.3) Cash left for distribution IRR Check 20.00% (200.0) Calculate Daily rate (note: daily, i.e. 365/year) from target Calculate Accrual amount for Tranche Calculate distribution from accrual Check the IRR (verify) 85 of 125

86 Tranche Structures (Accruals) (Part b) (Hints) Daily Rate Daily Rate 1 Pref_Rate DR Accrual Accrual Accrual Accrual Days 1 DR BoP of 125

87 Tranche Cash Flows (Part c) Cash Flows to each tranche: I. Pari Passu to an IRR of 15.00% Sponsor 10.00% Equity Partner 90.00% II. Splits up to an IRR of 20.00% Sponsor 20.00% Equity Partner 80.00% Tranche Cash Cash left for Distribution Flows III. Sponsor Promote 40.00% Cash to Equity 60.00% Sponsor 10.00% Equity Partner 90.00% Separate tranches by split percentages (X2) Calculate remaining split for promote Calculate Cash to Equity after promote 87 of 125

88 Investor Cash Flows (Part d) INVESTOR CASH FLOWS SPONSOR Equity Investment (20.0) (20.0) Proceeds CF 85.1 (20.0) Profit $85.1 % of Total Profit 24.3% IRR 30.03% Multiple 5.25x Investor EQUITY PARTNER Cash Equity Investment (180.0) (180.0) Flows Proceeds CF (180.0) Profit $264.9 % of Total Profit 75.7% IRR 21.13% Multiple 2.47x Check TRUE Create Final Cash Flows for Sponsor and Investor Review cash flow distribution, i.e. IRRs Built in Self-Test 88 of 125

89 Securitization (Detail) Time Permitting

90 Securitization Transformation of a portfolio of financial obligations into liquid form attractive to a myriad of investors Value of obligations depends on ability/willingness of obligator to pay, i.e. Risk Financial Obligation Portfolios (Examples): Mortgages (Commercial & Residential) Automotive Loans Credit Card Loans 90 of 125

91 Structuring Transforming financial obligations into palatable financial assets by means of cash flow segmentation & risk Types of Instruments 1) Direct obligations of corporates and sovereigns 2) Derivatives, e.g. Swaps & Futures 3) *Securitized & Structured Financial Assets 91 of 125

92 Direct Obligations Obligation created by issues for investors Equities Treasuries Corporate Debt Convertibles 92 of 125

93 Derivatives An asset whose value depends upon an underlying asset Swaps & Futures (see other lectures) Represent zero sum game (In Theory Only) 93 of 125

94 Securitization Transforms raw assets into tradeable units Allows bifurcation of Origination & Investment Functions Structuring rearranges cash flows and risk Structuring financial instruments similar to transforming physical Real Estate assets Working the Asset 94 of 125

95 Major Asset Classes 1) MBS Residential Commercial 2) Credit Cards 3) Automobile Loans 4) Home Equity Line of Credit (HELOCs) 5) Manufactured Housing 6) Student Loans 7) Equipment Leases 95 of 125

96 Critical Concepts to Consider 1) Collateral 2) Credit Enhancement 3) Standardization 4) Liquidity 96 of 125

97 Collateral Raw commitments that support transaction (Mortgage, i.e. home) Cash Flow & Credit Characteristics determine performance + drive structuring Must understand collateral of specific asset + portfolio consideration (Critical) 97 of 125

98 Credit Enhancement Process of protecting payment stream to investors Result from: External guarantee Interesting structuring Subordination Waterfall Structure Order of payments 98 of 125

99 Standardization Process of taking dissimilar loan types and terms & transforming within a portfolio Portfolio versus Asset Analysis Each Asset has individual characteristics, i.e. exposed to unsystematic risk Asset 1 Asset 2 Asset 3 Asset 4 Asset 5 Asset 6 Asset 7 Asset 8 Asset 9 Portfolio of Assets 1 9 Standard: Coupon Terms Diversified, standardized Portfolio, i.e. exposed to systematic risk only (allegedly) 99 of 125

100 Liquidity Ability to transfer assets among investors Increasing liquidity goal to securitization Measures: Bid-Ask Spread Amount of time to sell a Fair Value, i.e. not deeply discounted 100 of 125

101 Tax, Accounting, Legal Issues 1) Tax Will there be Trust Level 2) Accounting Securitization treated as Sale or Financing? 3) Legal Does Trust or legal entity have sufficient title to assets? Issuing firm protected from bankruptcy &/or disruptions 101 of 125

102 Mortgage-Backed Security Process Realtor (Paid Immediately) = High School John & Jane America want a home J&J meet mortgage broker Mortgage Broker and Mortgage Banker meet to originate loan M. Banker sells loan to Dealer Dealer structures loan and sells Norway purchases loan structure Education High School High School College Graduate School Unknown Unknown No Recourse (Paid Immediately) Default Losers = John&Jane & Norway 102 of 125

103 Dealer/Risk Sharing Paid up-front (immediate) Structures product with assistance Lawyers, Accountants, Rating Agencies Sells product into Capital Markets Risk born by John/Jane & Capital Markets (Norway) NO risk by Mortgage Broker, Mortgage Banker, and Dealer (or Realtor!) 103 of 125

104 Loan Servicer Receives payments and distributes to investors according to agreement Handles paperwork for loan Responsible for collections in event of default Low-risk business Paper administrators 104 of 125

105 Default Case Guarantor called to cover any losses Servicer Special Servicer passes payments on to appropriate investors Servicer Special Servicer, guarantor and trustee compensated immediately for services No risk 105 of 125

106 Allocation of $$$ (T = 0) Mortgage Broker Mortgage Banker Dealer Realtor paid at T = 0 Investor Pays Borrower Receives 106 of 125

107 Allocation of Interest Payments Guarantor Servicer Spread to Investor Option Cost to Investor Duration Cost to Investor Investor Receives Funding Cost to Investor Borrower Pays 107 of 125

108 Securities Investment Characteristics 1) Principal repayment timing 2) Amount & form of interest payment 3) Credit quality of instrument (Risk) t Risk of Receiving Price of Asset Interest Pay (Form and Quantity) 108 of 125

109 1) Spread Risk Measures Difference between the yield on the investment and yield on base instrument (Compensates for Risk) 2) Rating (Provide independent risk assessment) S&P, Moodys, Fitch 3) Duration/Convexity (See Whitepaper) Duration: Measure of sensitivity of price to interest rates (Rate of change (1 st Derivative)) Convexity: Change in Duration as interest rates change (Rate of change of change (2 nd Derivative)) 109 of 125

110 Securitization - Classification Sale versus Financing Issues: Financial Regulatory Tax Accounting Strategic 110 of 125

111 Financial Advantages Asset Sale (Off-Balance Sheet) Risks 100% transferred to buyer (Seller has Reps/Warrants) Cost lower than securitization Financing (Securitization) Several classes created & sold (Off-Balance Sheet) Issuer retains residual class Residual considered equity 111 of 125

112 Financial Transaction (versus sale) Financing expenses Sale Expenses 1. Coupons Paid Corporate: 2. U/W fees 1. Debt 3. Administration Costs 2. Equity Which is cheaper/beneficial? How each changes risk of institution? - How changes makeup of corporate BS Securitization 112 of 125

113 Securitization & Capital Structure Firms generally limited to amount of debt on Balance Sheet (Capital Structure) Structure Off-Balance Sheet activities in Special Purposes Entities (SPEs) Remember Repo 105 (classic example) Securitization may permit greater debt issuance Free equity for more transactions 113 of 125

114 Residual Interest Equity like Held by issuer Illiquid & Complex instrument Bear prepayment & credit risk Generally no risk beyond tranche (residual) Risk is loss of interest only 114 of 125

115 Regulatory - Securitization Rated security have lower capital requirements Rated securities may allow firms to lower capital requirements Lower capital requirements increase leverage Double edged sword 115 of 125

116 Tax Securitization Issues general prefer financing tax treatment Asset sale requires immediate recognition of gain/loss on transaction Asset types: 1) Trading 2) Available-for-Sale 116 of 125

117 1) Trading Asset Types Must market value and/or fair value 2) Available-for-Sale Held on lower of: Cost Market value (hence Bear Stearns bailout) 3) Loans in Portfolio Considered Held-to-Maturity Held at original cost 117 of 125

118 Accounting - Securitization Firms prefer to record securitization as sale (Reduces capital requirements) Strengthens Balance Sheet - generally Can lead to income instability How flow through accounting statements?: Depends on how residual classified Sale versus Trading 118 of 125

119 Strategic - Securitization Increase origination of loan product Adjust portfolio of assets Securitize to maintain control of assets Lost leader but strategic play Increase assets under control while reducing capital requirements 119 of 125

120 Balance Sheet Pre-Securitization Assets ($m) Ratios Calc Value Cash 25,000 D/E 340/ Loans 300,000 Current 25/ Investments 60,000 PP&E 50,000 Assets Delta Total Assets 435, ,000 30, ,000 Liabilities ($m) Liability Reduction 280,000 Short Term 45,000 45,000 30,000 15,000 Long Term 340, ,000 75, ,000 Total Liabilities 385,000 Equity (Gain on Sale) Equity ($m) 50,000 50,000 60,000 10, of 125

121 Balance Sheet Post-Securitization Assets ($m) Ratios Calc Value Cash 25,000 D/E 75/ Residuals 30,000 Current 25/ Investments 60,000 PP&E 50,000 Previous Values: Total Assets 165,000 Ratios Calc Value D/E 340/ Liabilities ($m) Current 25/ Short Term 30,000 Long Term 75,000 Total Liabilities 105,000 Equity ($m) 60, of 125

122 Balance Sheet Cost of Capital Securitization can decrease cost of capital (reduced corporate risk ) If securitization coupon < Corporate WACC Cost of Capital reduced * Firms value point of WACC minimization 122 of 125

123 Securitization Factors - Balancing Strategic Financial All five Accounting Tax Regulatory must balance 123 of 125

124 Structuring Entity Generally structured as Trust Trust not subject to taxation Trust issues securities Established legal separation between issuer & pool of assets Bankruptcy Remote of Trust 124 of 125

125 Structure Example (Generic) Bond 1 Bond 2 Bond 3 Bond n (y = 8.5%) TRUST Tranche 1 1 st Senior; y=6% Tranche 2 2 nd 10% Loss; y=7.5% Tranche 3 3 rd 10% Loss; y=15% Tranche 4 (Residual) 4 th 5% Loss; y=35% Waterfall 125 of 125