Hard equity: The Adventure of the Six Simoleons
“I have observed,” said Watson, studying the Essential Posts, “that we have discussed” —
‘We,’ murmured Holmes wryly.
… “soft equity, soft debt, and hard debt, but I infer that there remains yet one essential post on the four kinds of money. Having eliminated the previously blogged, whatever remains must be the topic: I infer it is hard equity.”
“Capital, Watson!” Holmes laid down his S notebook. “You positively scintillate this morning. Indeed, of all four kinds, hard equity is the most important.”
We have previously established, Holmes went on, that every transaction requires both debt and equity, with equity providing the risk absorption that gives lenders comfort their money will be safe despite future vicissitudes. Hard equity is real cash contributed by an investor in the expectation of return — and unlike soft equity, whose return comes from non-property sources (i.e. government-authorized tax benefits), hard equity requires a hard economic return.
Asked Watson, “Isn’t that the same as hard debt?”
“Not at all. Lending is renting money — I let you use it for a while, then you give it back to me, plus a certain agreed rent (interest).
“But the equity investor also lets me use his money for a while.”
“Not for a while,” Holmes replied with some asperity, “indefinitely. An equity investment is selling money. You buy my money from me — I have no means of getting it back. In exchange you give me a financial object — ownership in a venture. So my investment decision is quite different. When I lend, I look at your collateral — the security for my repayment. When I invest — when I sell you my money for stock certificates or other pieces of paper — I have to bet on your venture. I have to believe that the business will be worth more, and if I want to realize cash for my ownership, either it flows from the business’s profits, or I have to on-sell my shares to a greater fool who believes what I no longer do.”
There once was a fellow named Ponzi …
“The irrevocability of the sales bargain inherent in equity investment is a topic I shall take up another day.”
Hard equity thus offers the following critical structuring benefits:
The control principle:
control correlates with volatility
The more control one has, the more one’s returns should be volatile.
1. Provides accessible capital at all stages of the process. The property development life-cycle can be divided financially into five stages:
- Exploration. Deciding whether to create/ build/ acquire the property.
- Development. Spending large sums to turn
- Operations. Owning a property for a long time while inflation and demography do their work of steeping appreciation into the property.
- Refinancing/ interim equity takeout. Tapping built-up equity for mid-course corrections.
- Disposition/ closeout. Exiting from an investment that is no longer appropriate.
“People come, people go. Nothing ever happens.”
Greta Garbo, limited partner, Grand Hotel
At every one of these phases, equity is the most flexible, most accessible form of capital. It is the mortar that holds in place all other kinds of money.
2. Places the sponsor in first loss position. Following the control principle, in almost every well-designed program — this includes loan-origination models as well as ownership models — the lead operator takes 100% of the first loss. Since you can lose only what you have contributed¹, hard equity makes that first-loss exposure meaningful.
¹ Actually, that’s an oversimplification. In cases where there is recourse debt or recourse guarantee obligations, a sponsor can lose more than the cash equity contributed. However, extracting this cash after the fact is often problematic, especially when the operator is normally controlling the venture while it goes down — where the operator can normally obtain a general release from liability in exchange for surrendering control. (Early in my career, I once paid a reprehensible general partner $5,000 to buy washing machines that I was morally certain he did not own, as part of a settlement to get him to stop ruining a property in which our investors had the substantial — non-controlling — interest.
Hard equity is the miner’s canary.
“It’s rung down the curtain and joined the bleeding choir invisibule! This — is an ex-parrot!”
3. Shows the borrower has some financial wherewithal. As a general principle, people part with cash only when they have truly earned it. Demonstrating financial wherewithal commensurate with the scale of the enterprise (that is, one’s equity contribution as a percentage of the total capitalization) is a great predictor of whether a sponsor is up to the challenge.
“No, really, I can handle it!”
Also significant is that ripening any concept into an opportunity takes cash. The cash spent is by definition equity — it has no certainty of return until the investment financing is assembled. Indeed, this cash is the highest risk (venture capitalists call this “Stage zero financing“).
“How much money do you have permission to lose?”
Unless an investor has some money — some material amount of money — that she is prepared to lose, she is not an entrepreneur in the genuine sense.
“Putting up hard cash is proof that you have hard cash to put up?” Watson concluded dubiously.
“Have it, earned it, risked it,” replied Holmes. “Equity is the evidence of a demonstrated capacity for saving.“
4. Gets the borrower’s undivided attention. “When you’ve got them by the wallets, their hearts and minds will follow.” — with apologies to John Wayne.
“Who you apologizin’ to, pilgrim?”
No matter how much economists wish people were rational calculating machines, we are more complex than that. (It is a weighty economic conundrum why some people walk up escalators.) Not all money is emotionally equal –
“Mine’s bigger than yours, George.”
– psychologists have demonstrated that people will work harder to recoup losses than they will to increase gains. “Having skin in the game” is more than a metaphor, it’s an apt expression of the human subconscious expressing anxiety at having an integral organ hostage to fortune. Developers will go to the ends of the earth to recover their invested simoleons.
“The realization that one is filing Chapter 11 in the morning concentrates the mind wonderfully.” — with apologies to Dr. Samuel Johnson.
5. Demonstrates the borrower has an investment mindset. Where, asked Holmes, does hard equity come from?
Everyone’s parents, thought Watson.
“Besides everyone’s parents,” Holmes added hastily.
From investors, he added after a painful moment of Watson’s cogitation, people who have liquid cash, enough of it to lose, and who nevertheless commitment it. It is the ultimate act of financial bravery:
“Equity!“
Equity is thus the catalyst, the essential component that animates the other types of money. “But they must still be stitched together in what I call” — Holmes paused for the blogger to type italics — “a financing quilt.”
Oh God, thought Watson, not another blog post yet to come!
Holmes just smiled …
“It slowly vanished, beginning with the tail and ending with the grin, which remained for some time after the rest of it had gone.”
