On War Stories, Failure, And a Few Postmortem Conclusions (2Q17 Newsletter)
July 15, 2017
To: Customers & Friends
From: Christopher Weil & Company, Inc.
People love to tell “war stories” that put them in a favorable light. Not so common is the urge to tell war stories that describe personal failures. I’ve used this space in the past to talk about successes. Today, I want to talk about a failure, and some of the lessons to be learned from it.
The word “failure” itself has fallen out of favor these days. “Failures” have become “learning experiences.” But I like the word failure. It has an unambiguous meaning. In an age of alternative facts, slippery rhetoric and spin, there is something solid about “failure” that leaves no doubt in one’s mind as to the actuality and character of a particular event or decision.
Deriving lessons from failures is more art than science. Recall the old saying that if you are dealing with good people and bad contracts, things should turn out OK; but if you are dealing with bad people and good contracts, things are likely to turn out poorly. Well, by analogy, if you have made bad decisions but end up buying good assets, things may well turn out OK (although you might leave benefits otherwise due you on the table). You might even not count that a failure. By contrast, you can make a series of perfectly good decisions and still end up with troubled assets -perhaps by virtue of conditions over which you had no control (as was the case when a private equity investment with which I was involved was compromised when our lead executive--the one who had the smarts, the reputation and the ability to make it all happen--died unexpectedly). So I approach the exercise of labeling investments a “success” or a “failure,” and of deriving lessons from either, with some humility.
Fortunately, I have had only two truly consequential investment failures in my career, the first (believe it or not) almost forty four years ago and the second about ten years later. Despite the passage of time, the details and associated diagnostics of both are still clearly in my head (and, for all I know, in my DNA). I am going to focus here on the first of those failures, and in so doing, I hope, identify at least some of the ingredients that contributed to it.
I think the most efficient way of describing the experience is to set out the facts and circumstances and then list some of the postmortem conclusions. I hope that after reading this you (like me) will have a new (or heightened) sensitivity to where problems in private investments are likely to arise. Forewarned is forearmed. (Bear with me. Some of the text that follows is pretty dense).
In 1970, I was thirty three years old. I had been in the investment business as a broker (that is, a salesman) for seven years. I was ambitious and preparing to start my own firm (which I did in 1971). My experience to date had been almost exclusively with the sale of publicly traded securities, primarily mutual funds. But the early 70’s were not shaping up to be great years for market participants. There had been a major sell-off in 1969 (the end of the great conglomerate party, among other things) and the effects were still being felt.
So, as good salespeople will when a line slows, I looked for an additional line. And found one. A friend of mine worked for a real estate syndicator who packaged and distributed what was then an exotic real estate product designed to exploit the then-existing tax laws. Over simply, the syndicator would buy, from an eastern mortgage banker, a commercial building with a long-term net lease to a prime-credit tenant. Along with the property and the lease came a first loan equal to 100% of the purchase price. The lease income was roughly equal to the debt service. The syndicator would then put the property (with lease and debt) into a limited partnership, tack on a fee, and sell limited partnership interests to investors seeking tax shelter. And tax write-offs were all that there was in these deals, at least for the first ten years or so. (Remember: no cash flow, ever, as the lease income matched the debt service for the life of the loan.) When you added up the fee (deductible), the interest payment on the loan (deductible) and the depreciation (deductible), tax losses exceeded income for ten or so years. In the aggregate, the losses during this period exceeded the investment cost (meaning the fee) in the ratio of 3+ to 1, with most of the tax benefit being realized in the first three or four years. At a time when marginal tax rates were very high and real estate losses could be deducted against income from any source, this was a very big deal: you could invest $50,000 in the limited partnership and receive $150,000 or more in tax deductions over the first few years. The documentation was a little vague on what happened after ten years, although it was clear that the partnership would start to run in the black from that point forward, which could mean phantom income to the partners (which is to say, a tax without the corresponding income.)
I embraced the “product” with more enthusiasm than comprehension. In fact, I was so enthusiastic that I agreed with my friend that we (instead of the syndicator) should become co-general partners of the partnerships for which we raised money, sharing the fee with the syndicator. The syndicator agreed to this. He thought what he would lose by sharing the fee, he would make up on volume.
All went well for a year or so, then the mortgage banker’s supply of quality properties with quality tenants started to dry up. The syndicator, believing his business was in jeopardy (as it was), began to think of another asset class to use for this tax shelter scheme. He found one through a source that could provide him with roadside motels in the South. These were name brand franchises, typically one hundred or so rooms.
The syndicator, using the model with which he was familiar, set about recreating the “product” but with motels as the basis for investment. He strengthened his acquisition capability. He started a motel management company. And, most significantly, he designed a seamless package that he could then deliver into the hands of buyers (us and our limited partners) accustomed to trouble-free real estate deals. The package consisted of the property, a net lease from the syndicator and a financing instrument (not a first deed of trust, but instead what is known as a “wrap loan,” which included the amount of the existing first and an additional increment of debt which was basically a second loan).
From the point of view of my co-general partner and myself, it was business as usual. We formed a limited partnership to own each property we acquired from the syndicator. Each property we bought was fully net leased back to his company with a guaranteed income sufficient to pay debt service and (something new) cash flow to our partners. Each property came with a financing instrument in place. Trouble free, right?
From 1971 until 1973 my co-general partner and I formed nine partnerships to buy nine properties (Lexington, KY; Anniston, AL; Knoxville, TN; Arlington, TX; Lubbock, TX (2); Monroe, LA; Charlotte, NC; and (an outlier) Franklin, OH).
In October 1973, our syndicator/net lessee/financier filed Chapter 11 Bankruptcy. Shortly thereafter we received a call from the bankruptcy court informing us that it had determined the leases our syndicator had signed with us were a burden on the bankruptcy estate and were now terminated. Accordingly, we (that is, my co-general partner and I) needed to take over the operation of our properties immediately.
So: first, we had no entity to take over motel management (nor, for that matter, any property management experience, motel or otherwise); second, we had no material net worth; third, we began getting calls from motel creditors (phone, utility, equipment lessors) asking us to send money (we, in our innocence, were individual general partners in the partnerships and thus personally liable for property debts); fourth, we began getting hysterical calls from our staff at the properties describing the various metaphorical fires burning, most having to do with money and lack thereof; fifth, the country was dealing with the consequences of the OPEC oil embargo (it was 1973, remember?) and auto travel was down, dropping occupancy in highway-oriented motels like ours by 20% or more.
The whole thing was a physical, mental and emotional shambles. We should have declared bankruptcy ourselves but decided (bravely? recklessly?) to gut it out. We formed a management company. We negotiated and settled with creditors. We hired Jens Neelsen as CEO (we are still together). And we began what became a very long slog. We did what we could to save each property, but in the end we and our partners lost all but three of them.
How, I hear you ask, did I extricate us (myself and my co-general partners) from the mess? There were three factors, each more or less fortuitous.
First, just as the disaster began to unfold, I met a small merchant builder who was in need of buyers for his properties. I knew that if I was going to hold off aggressive creditors and angry partners, and pay my own bills, I was going to have to generate meaningful income. The builder, who was himself small and undercapitalized, represented an opportunity for me to do just that. Fortunately, I was able to attract investors to the partnerships I formed to buy properties from this builder. I had, after all, a disgraceful track record --and it didn’t help that my partnerships were buying a then new and untested form of real estate: the self-storage mini-warehouse. Still, my limited partners trusted me and came along. And a good thing, too. The builder turned out to be Public Storage and the properties we bought turned out to be wildly successful.
Second, circumstances conspired to remove my co-general partner from the picture. That may not sound like a good thing, but bear with me. The fact is, the pressure on us both following the bankruptcy of the syndicator was intense and non-stop. Initially, my co-general partner and I both fought the good fight, but at some point it all became too much for him and, in a dramatic act, he secretly packed up and left the country (to a nation which had no extradition treaty with the U.S., to protect himself from creditors). Although at the time I felt betrayed and abandoned, it turned out well. Up to that point, my co-general partner and I had been jointly and severally liable for our obligations, which meant that, in theory at least, I had responsibility for all liabilities of my co-general partner and myself, while owning only half of our assets. Now I had all of these assets as well.
Third, I found myself the beneficiary of a great truth about business and life, which I came to more fully appreciate in the workout process: namely, if you return your phone calls promptly, if you honor your promises, if you make a good faith effort to settle your obligations (even if you are forced to do so for less than their face amounts and in installments rather than lump sums) then you will be treated sympathetically by those to whom you owe a duty. And so it was in my case.
By 1977 (after four years in the wilderness, you might say) the whole thing was finally behind me.
What can be said about the “acts/decisions/misperceptions” that contributed to this investment failure that could be useful to investors considering any kind of private market investment today? Seven is my favorite number (having been born on 7/7, what choice do I have?), and I can identify seven important lessons:
The textbooks stress the importance of investing with managers who have the requisite competencies and track records. They are right. In the great majority of cases, competency and track record contribute to the probability of success. So it makes sense to play the probabilities. If, in spite of this, you are tempted to take a shot with your nephew who has no money or history but wants to start a company to develop a world-class widget (with your equity), then go for it; but only with that portion of your net worth you are happy to lose, and only with no personal guarantees and only with enabling documents (business plan, term sheet, partnership or LLC agreement) that you and your competent advisor have blessed.
There is nothing wrong with committing yourself to an enterprise headed by a salesperson --always assuming that the salesperson has surrounded himself/herself with talent that can successfully execute on the many non-sales tasks of the business. Business leaders with a history of sales success tend, often unconsciously, to view sales as the prime driver of business progress and so view other business functions, however important, to be of lesser priority. My co-general partner and I were salespeople (and surrounded by no one).
As a generality, net leases in real estate (leases in which the tenant pays all operating expenses) come with incremental additional costs to the buyer/investor. The costs include property pricing higher than would be the case if the property were sold without the net lease, and caps on net income that wouldn’t be in place if the property were sold without the net lease. There is an argument that these costs are justified by virtue of the reduced risks that come with the lease. True, for so long as the tenant/net lessee performs. Also, many investors who invest in properties subject to net leases with the expectation of a predictable long term income stream experience disappointment at some point in the lease term, even if all goes as advertised, when they discover that the lessee does not intend to renew. Ten years sounds like a long time for a lease, but those years pass quickly. It can be an unpleasant experience to discover in the ninth year that you are about to become the owner of an empty building. It’s not an insoluble problem, but it does mean that you convert from a passive to an active investor/owner and will have to bear some large unanticipated costs as well (foregone income, tenant improvements, leasing commissions).
It is unrealistic to expect passive investors to do the kind of close reading and analysis that disclosure documents associated with private market investments require. The problem for most investors is not the extent of the disclosure but how to interpret it. So get help from someone familiar with the business in which you are considering an investment and who understands the intricacies of governing documents of this sort.
There are no “trouble free” private market investments. To the extent you believe otherwise, it is probably because your managers are doing a (hopefully) good job of dealing with problems at the entity level without worrying you about them. But with private investments, periodic reports to investors should detail the good, the bad and the ugly. No news is bad news.
My co-general partner and I were not poor, but we did not have much spare change. Thus, we did not make material investments in our partnerships. Bad sign. It is now routine for investors to expect their managers/general partners to invest significant amounts alongside them (“significant” meaning 5% or more of equity).
Up to this point, I have talked about ‘generic’ lessons. Lesson number seven is one that is specific to the deal, but which also illustrates the importance of not taking ‘the numbers’ at face value. Had I been wide awake when presented with the motel purchase/lease/finance package, I would have quickly detected a number of its flaws. First, I would have noted that the price paid by the syndicator for the property was, presumably, its fair market value. I would then have more fully appreciated the true character of the mark-up tacked on to the property by the syndicator when he, in turn, sold the property to our partnership. And I would have noted that the mark-up was disguised, to an extent, because it came in the form of the “second” portion of the wrap loan. Second, I would have noted that the package was “priced for perfection,” meaning that the property level net income (paid to the syndicator) and the debt service (paid by us to the syndicator) was roughly equal to the debt service on the underlying first loan (paid by the syndicator) and the lease payment (paid by the syndicator to us). This, in turn, meant that any hiccough in the cash flow to the syndicator (a reduction in net income due to increased vacancy, for example) would put the syndicator into a negative cash flow position, jeopardize the continuity of our lease income and ultimately the integrity of the lease. Third, I would have noted that the net worth of the syndicator, which we would be relying on in the event his own cash flow went negative, was insufficient for us to have any confidence in his ability to sustain operations, much less his lease obligations, in a period of declining revenue and/or rising costs. Fourth, I would have noted that the syndicator had no significant track record in motel operations. His management company had been recently formed and was very much experiencing the problems associated with all early-stage companies. Fifth, I would have noted that the motel budgets he prepared for his own use materially understated the money needed to be reserved for capital improvements. (It was the combination of “excessive” capital expenditures and diminished revenue that put the syndicator into Chapter 11.) And so on and on.
I’ve listed seven lessons, but really there’s an eighth, and that’s to start with the right people. Insist on doing business with hardworking, competent, honest and investor-oriented people. Internalizing the truth of that lesson had an immeasurably positive impact on the subsequent success of my business.
I could go on ... but have gone on long enough. Questions? Comments? Criticisms? War stories of your own? Call me.
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