Transitional Capital
A New Credit Model for High-Growth Real Estate Firms
Today’s memo is an extension of a white paper I co-authored with Robby McDonald of Cherry Lawn Capital. Transitional Capital focuses more on real estate-related consumer finance companies, but the ideas and concepts are applicable across the real estate operator space. Additionally, trends around financialization and the evolution of asset management touch on many of my prior posts. You can find the paper at the link below:
Apollo’s Scott Kleinman spoke at the Barclay’s Financial Services Conference earlier this week. In the seemingly inexorable rise of private credit, Apollo has appeared prescient in positioning its credit business to benefit. Apollo’s yield-focused assets under management have grown by $140 billion since Q2 of 2022 or nearly 20% per year. Kleinman told conference attendees,
“[T]he single most important factor for an alternative asset manager is origination capacity…That is the single biggest constraint on growth, not capital formation, not how many people you have. It really is built around can you originate enough attractive assets to meet your needs.”
To say that capital formation for credit is “not a constraint on growth” is no small statement. The demand for debt securities in a lower growth, higher rate environment has driven credit spreads lower, even as bankruptcies and other signs of credit strains have mounted. A few weeks ago, I argued that we are in the early stages of a secular trend toward debt-led capital markets. Where does that leave real estate?
A VC once told me, “Ideally, capital structure will match whatever is the alpha factor of a given cycle.” Equity, specifically venture equity, was the ideal capitalization for a momentum-driven regime. Should we find ourselves in an environment where high prices no longer beget higher prices, yield and spread become the alpha factor. That has significant implications for real estate firms, for whom relatively cheap equity was once abundant.
Over the past 18 months, many real estate operators have seen that a levered equity model cuts both ways. Most have stayed glued to charts of the 10-year treasury, anticipating a “return to normal” when the legacy model would again drive capital formation around real assets. I liken it to learning a card trick, then one day finding that the trick no longer works. Instead of learning a new trick, they wait anxiously for the right cards to pop out of the deck again.
The Old Model
Fundamentally, there are two proven business models in real estate: Be an asset-light operating company that either leases or manages real estate for a fee or be a principal owner of real estate engaged in asset management activities. The former has been historically funded by traditional or venture equity. The latter has taken a private equity approach, putting real assets in either funds or SPVs and participating in the resulting fee streams.
The tension of “OpCo” versus “PropCo” financing has left both types of firms stranded by their respective capital providers. The rapid rise in interest rates and the resulting decline of real estate asset prices froze both the venture capital and real estate markets simultaneously. Further, there appears to be a structural shift away from capital willing to take on the equity mandate. Even GP stakes investing, which is nominally equity, relies on the inherent leverage of LP capital.
Skeptics may point to the growing pool of real estate “dry powder,” claiming pent-up demand for real estate equity. I would argue that much of that dry powder will be deployed in more structured ways, either by taking REITs private or via JVs like the recent Sixth Street & Plymouth deal. Further, undeployed private debt mandates outstrip all alternative asset classes except traditional private equity.
The bottom of capital stacks is shrinking, both because of a lack of actual risk capital available and the unrelenting demand for assets that can reasonably check the “Credit” box. The traditional view is that we are in the late stages of a credit cycle, that a “Minsky Moment” will lead to rapid contraction of credit that again makes equity a better risk versus reward proposition. This assumes that the capital allocation mechanism works to capitalize assets efficiently. I would argue that financial markets have effectively crowded out this response in favor of security creation.
What if real estate operators leaned into their role of fundamentally being asset originators? In an earlier era where bank lending dominated real estate debt, operators served the role of creating bank assets. Today, the demand for debt has shifted from banks to new types of firms and forms of securities, and as Kleinman points out, demand is robust. Debt secured exclusively from the cash flows from real estate will remain constrained by the shortage of equity described above. If capital markets are hungry for debt, give them something they can lend against.
A New Form of Real Estate Capital
In forming capital around real estate assets, firms create various fee streams and real estate-related assets in both the Operator and Principal Owner space. Those fee streams and the control rights of real estate represent untapped potential for security creation that could at least partially supplant traditional equity, funding the OpCo and PropCo simultaneously.
Imagine a sponsor of primarily industrial assets capitalized in the conventional private equity structure. The sponsor OpCo collects asset management fees, has claim equity performance above a hurdle, and may also have property management or other origination-like fees.
Those fee streams are contractual and, except carry, unrelated to underlying asset values or investment performance. The sponsor could theoretically pledge them as collateral against a loan, further enhanced by managerial control of the assets. A $100 million portfolio of assets might produce $1.5-2 million per year of fee income when accounting for the accrued performance fees. With a weighted average deal life of five years, the discounted value of the fee streams at 8% is ~$7 million. The sponsor could, in effect, securitize a portion of that value to equitize either their OpCo or to serve as new equity in the PropCo.
Asset-light real estate companies, broadly “PropTech” firms that leverage technology applied to real property ownership, face a similar challenge when capitalizing assets. These companies are developing solutions for accessing home equity, operating sub-institutional assets, or managing passive real estate investments that created hybrid structures with technology elements and an asset management component.
These businesses are not merely building portfolios of real estate assets; they are also creating new cash flow streams from management fees, servicing rights, and options that are unique assets derived from real property ownership. While traditional real estate finance has yet to evolve to serve these firms, the burgeoning Private Credit market creates new opportunities for companies that can originate new assets at scale.
While it elides a concise definition, private credit is essentially any debt originated outside of the traditional banking system. In this way, real estate pioneered private credit. Debt funds, hard money lenders, and mezzanine providers were all early innovators of what would be recognized as private credit. Yet, the capitalization of real estate businesses remains siloed in an older model of capital markets. I expect private credit will lead in evolving lending to real estate operators under the umbrella of “fund finance.”
These structures share similarities with the growing GP stakes business, where investment firms buy equity positions (effectively, future contractual cashflow streams) in alternative asset managers. However, this collateralized approach takes the basic leverage embedded in GP economics and transforms it into a debt instrument for which a large and developed end-buyer market already exists.
Private Credit is Expanding Its Horizons
If this seems obtuse (or even fanciful), you need to look more closely at what is happening in the private credit space. With traditional private equity-backed LBOs sidelined, private credit wants to expand its remit aggressively. In my March review of the Grant’s Private Credit Conference, I recounted John Zito’s entertaining french fry analogy:
“John Zito of Apollo Global Management, used French fries and Wikipedia to illustrate the point. French fries, he explained, take a variety of forms and can be prepared in a multitude of ways. He noted that the Wikipedia page for French fries has a word count of nearly 4,000 and has been edited over 1,400 times. Private credit, undoubtedly more complex and varied, has just 500 words and less than 100 edits. Zito's point, "We need to make private credit more like French fries,” meaning that the investment community should appreciate and segment the multiple expressions of private credit, which is after all, just lending.”
That has meant an intentional foray into asset-backed lending. Banks and other institutional investors have historically financed debt related to education, car loans, equipment, and credit cards. Private capital is now getting more creative, looking at assets like music royalties, movie rights, and the kinds of assets originated by real estate sponsors.
According to an April Bloomberg report, asset-backed deals collateralized by “unusual collateral” have risen considerably in the post-pandemic era1,
“Esoteric ABS deals — backed by collateral other than student, auto, credit card and equipment loans — have risen to about 31% of the ABS market from 9% over the last decade, according to Barclays Plc. Collateral pools have also become more diversified, with investors seeking out novel structures to earn excess returns as ABS spreads tighten, dropping more than 30 basis points since November. Meanwhile, interest rates are expected to stay higher-for-longer, meaning the benefits to borrowers of waiting to come to market have dissipated.”
Mike Nowakowski, head of structured products at Conning, told Bloomberg that the relative lack of historical data usually demands concessions to the benefit of investors. He added that insurance companies have started looking more closely at these deals as they get more creative with deploying capital.
Creating New Asset Classes
The combination of new financial products and a growing pool of assets with debt mandates has led to increased demand for debt origination outside of the traditional categories. The institutionalization of Home Equity Agreements provides a useful guide to how nascent financial products can ascend the capital markets.
The Home Equity Agreement (HEA) market emerged in the early 2000s as an innovative financial solution for homeowners. Pioneers like EquityKey and FirstREX (later Unison) introduced this concept, offering homeowners a way to tap into their home equity without taking on debt.
As the 2008 financial crisis reshaped the lending landscape, HEAs gained traction as an alternative to traditional home equity loans and HELOCs. A Home Equity Agreement (HEA) is a financial arrangement where homeowners sell a portion of their home's future appreciation in exchange for a lump sum of cash today. Unlike traditional loans, HEAs don't require monthly payments or accrue interest. Instead, the investment company receives its agreed-upon share of the home's value when the homeowner sells the property or buys out the agreement, typically within a 10-30-year term.
This market saw significant growth in the 2010s, with new players like Point, Hometap, and Noah (formerly Patch Homes) entering the scene. These companies leveraged technology to streamline the HEA process and expand accessibility.
By 2024, the market had matured, with established leaders like Unison and Point competing alongside newer entrants such as Unlock Technologies and New Avenue. These companies had to innovate their funding models to continue to grow their portfolios alongside their operating companies. Until recently that has meant a mix of private real estate investment and growth equity.
Now, seven securitizations of Home Equity Agreements have come to market, representing nearly 10,000 originations. The most recent HEA-backed issuances from Unlock and Hometap, have each been rated by BBB (investment grade) Morningstar DBRS. These securitizations represent an important advancement in the creation of a more robust alternative credit asset class.
Home Equity Agreement Securitizations
What this Means for Capital Providers
If capital formation for debt is broadening, anyone responsible for allocating capital should take note. As increasingly esoteric debt exposures come to market, investors must consider whether their risk exposure is novel and if the limited data surrounding it creates opportunity.
The growth of alternative and private assets has revealed that the fee business's cash flows are considerably more stable than those from the underlying investment exposure. Capitalizing a growing asset management platform is a distinct bet from capitalizing the platform's assets.
For real estate, there is a flywheel in which unlocking new liquidity can drive asset prices and the fee streams they generate. This form of what might be called “transitional capital” suffers no setback should the appetite for equity return. Other alternative asset classes have undergone some version of this evolution—venture capital begat venture debt, which helped bridge companies to new equity rounds. Private equity has long used subscription lines, and now, NAV lending to leverage their platforms for continued growth.
In my experience, the arrow of financialization moves in one direction. I recently found some writing I did over a decade ago in which I was deeply concerned about leveraged loans from the broadly syndicated loan market finding their way into ETFs. A decade later, these products have neither blown up nor have they ever posed any real systemic risk. I can hand-wring about Apollo trying to put private credit assets into an ETF, convince myself it is a late-cycle phenomenon, or I can at least consider that markets evolve.
The nature of private asset ownership is changing, and investment management is becoming its own ecosystem of value creation. In The Distribution Layer I wrote,
The largest managers have provided a release valve for unprecedented liquidity but now find themselves with a similar deployment challenge as the capital they manage.
My overall thesis was that capital deployment would become more mediated, with smaller alternative managers incorporated into a broader investment management value chain. Financing the growth of asset management platforms allows larger pools of capital to leverage their strength in capital formation while smaller managers focus on what has always been their core competency: asset origination.
I always learn something from you. Thanks