Loan Guarantee Fees in Investment Programs: Risk Compensation or Rent Seeking?

by Kevin Kirkeby

Company owners and other executives often receive compensation for providing a personal guarantee to a commercial loan their investment program is seeking. The size of this personal guarantee fee varies considerably, as does the level of disclosure. We believe the personal guarantor should be compensated, but it must be commensurate with the risk the guarantor is taking on. Drawing upon FactRight’s experience in reviewing private real estate and other alternative investment programs, this blog post focusses on personal guarantees (rather than corporate guarantees), discusses the typical range of fees, and reviews the factors that influence a reasonable fee amount.

Why provide a personal guarantee?

Lenders frequently require a guarantee as a condition for providing a loan; this is particularly true among private real estate programs that tend to be more thinly capitalized. (Large companies with a lengthy track record of borrowing have more ability to negotiate loan terms and limit lender recourse.) The guarantee is a credit enhancement that provides the lender with a layer of protection beyond the collateral. In some instances, the inclusion of a personal guarantee allows the lender to offer a lower interest rate or increase the principal amount.

A guarantor can be a company, like the borrower’s parent entity or an investment fund, as well as the company owners or executive officers. Lenders often prefer a personal guarantee, in which the guarantor pledges their personal assets in support of the loan. A corporate, or commercial, guarantee limits the assets the lender can go after to just those of the entity, while protecting the personal assets of owners and executives.

When should a guarantor be compensated?

Financial markets are built on the premise that at-risk assets should earn a return commensurate with the degree of risk. This holds true for a personal guarantor as well, who is putting their own assets at risk. It might be thought of as granting the lender a put option that triggers if the borrower defaults on the loan obligation.

In contrast, we see limited rationale for compensating a corporate or commercial guarantor. If, for example, the guarantor is the investment fund itself, or the general partner, there may be few assets beyond the collateral at risk. The investment fund is in the business of taking risk and already stands to benefit from the guarantee through an improved interest expense and higher net income. Similarly, the general partner is compensated for this risk by means of the promote and other fees.

The challenge is measuring the embedded risk and determining an appropriate return for a personal guarantor. As with most aspects of the alternative investment space, each situation is

unique. For the remainder of this blog, we will examine the types and amounts of guarantee fees that we’ve encountered recently and what provisions are typically included in the guarantee agreement.

What is the typical guarantee fee?

Determining the typical fee is made more challenging by limited disclosure and variations in how the fee is presented. While the loan guarantee agreement is a standard component of the loan documents package, the personal guarantee fee agreement is not. We have encountered a small number of private program borrowers that specifically provide for guarantee fees in their operating agreements. A little more frequently, the fees are encountered in regulatory filings of the publicly-registered programs in the related party transaction section. A very small subset of these publicly-registered programs file the actual agreement in the SEC’s EDGAR database.

Based on the collective experience of FactRight’s team, guarantee fees most often fall in a range of between 1% to 2% of the loan principal. However, our colleagues have encountered guarantee fees ranging from near zero to 10% of the loan principal.

But that’s not the end of the assessment. Also pay attention to frequency of payment. Some entities provide for a one-time upfront payment within that range, while others opt to pay the fee (in monthly installments) for the duration of the loan. For instance, a fee of 0.033% paid monthly for five years would approximate a single front-end payment of 2%. A 1% annual fee for the duration of a 10-year mortgage is significantly more costly.

It is also relatively common for there to be more than one guarantor earning a fee, which makes it important to consider the guarantee fee in aggregate. Two guarantors that each receive an annual fee equal to 1% of total principal effectively represent a 2% aggregate fee per year. Some fee agreements specifically state that the fee be split pro rata among guarantors.

Factors to consider in determining whether a fee is reasonable

The guarantee agreement likely contains ominous adverbs like unconditionally and irrevocably, along with modifiers like continuing and unlimited to signify the guarantor cannot rescind or back out of the agreement until the full amount owed has been paid no matter how long it takes. Still, the likelihood that the guarantor will be called upon, and how much the guarantor may owe in that case are key determinants in what a fair and reasonable guarantee fee should be.

Among the factors impacting how much the guarantor may owe, arranged by what we consider order of magnitude, are:

Guarantee of payment or collection. A guarantor may be on the hook for two very different amounts of money depending on the agreement structure. A guaranty of payment means the lender can directly seek payment of the entire amount from the guarantor without first having to attempt collection from the borrower. A guarantee of collection requires that the lender

pursue all possible remedies first, including foreclosure and sale of the collateral, before seeking payment of the net remaining amount from the guarantor.

Associated expenses. It is worth noting that the amount owed by a guarantor may far exceed the initial loan principal. Nearly all guarantee agreements specifically include legal and collection fees as part of the total liability. Other agreements, however, specifically include provisions including repair of physical damage or deterioration to the collateral, plus any costs the lender incurs in operating the defaulted property until it can be sold. In situations where the collateral includes a flow through of rent payments, the guarantor may be responsible for these payments if a tenant goes out of business and is no longer making lease payments.

Joint and several liability. Most guarantees are joint and several, meaning all guarantors are individually and collectively responsible for the full loan amount. If one guarantor is unable to pay, the other would be responsible for paying the entire amount.

However, some borrowers have negotiated a guarantee that specifically caps the exposure of particular guarantors. This is typically expressed as either a fixed dollar amount or as a percentage of the amount owed.

Additional recourse limitations. Different assets and loan variations often result in unique guarantee fee provisions. Development projects, for example, may provide for a step down in potential guarantor liability as certain milestones are reached, like construction completion or stabilization. A FactRight colleague pointed to an agreement where the guarantor would be released from all obligations if the debt-service-coverage ratio at the underlying property exceeded 1.20x for six months. This was an underperforming hotel property that had a well-defined turnaround plan.

Turning to the likelihood of the guarantor being required to repay the obligation, there are a few contractual factors that warrant consideration:

Default triggers. A careful review of the events of default is important, considering there may be provisions that increase the likelihood the lender demands full payment from the guarantor. The number of covenants, particularly in loans from regional and smaller lenders, has generally increased over the past few quarters, while cure periods have shortened.

There are the standard event-of-default triggers like missed interest or principal payments and uncured interest coverage ratio issues. Arguably, these factors take into account the risks associated with the underlying asset class and macroeconomic environment.

The COVID pandemic showed that borrowers and lenders could work together to address potential defaults when it was in the best interest of both parties. However, we caution that the language in most guarantee agreements permits the lender to declare the obligation immediately due and payable upon breach of any covenant, even for something like being late with a property tax payment or not paying a contractor, which leads to a lien against the property.

Cross collateralization. One recent guarantee reviewed by FactRight as part of a multi-loan facility included a cross collateralization feature, whereby a default on any one of the underlying loans would trigger a facility-level default. In this case, the guarantor had risk exposure to over 20 separate multifamily properties as part of the loan facility. Not only is the guarantor exposed to the operating risk for each property, any hiccup at one property could put the guarantor at risk for the full facility amount.

More disclosure required

Due diligence assessments of private offerings often overlook the loan guarantee fee. In our view, closer scrutiny is needed. More often than not, the fee is an expense of the borrower, the investment fund. It should be treated no differently than other affiliated compensation, like acquisition and disposition fees, as well as loan origination and refinance fees. The guarantee fee, as noted earlier, can be as large, if not larger than these other fees, which are routinely disclosed in the PPM and other offering documents. While we would prefer to see the guarantee fee directly addressed in the PPM, one of my colleagues pointed to a recent private offering where potential future guarantee fee payments were proactively addressed in the operating agreement. For that blind pool offering, the sponsor established a specific cap on any guarantee fee that the investment fund might be required to pay as part of its future financing efforts.

How much is enough?

Every investment program has its own set of unique risks. An assessment of alignment of interests and affiliated dealings is just one piece in the due diligence process. In this post, we’ve more narrowly focused on factors influencing the reasonableness of personal guarantee fees.

The industry appears to have converged on a guarantee fee range equivalent to a one-time payment of between 1% and 2% of loan principal. However, as discussed throughout this blog, there are a number of factors, that could justifiably skew the fee to the top of this range or the bottom.

There may even be factors that justify a higher fee, however this should also be balanced with an understanding of the specific benefit of the credit enhancement from the guarantee and how that theoretically should enhance investor returns in the absence of such a guarantee. Additionally, the inclusion of guarantee fees should also raise questions about the inherent risks of the broader investment program, be it that the guarantor has a superior understanding of the actual risks or whether there’s a more pervasive rent seeking culture among the sponsor and affiliates.