The Starwood default and the story of subordinated equity.

Starwood defaulted. Yes, Barry Sternlicht Starwood. No, not the whole company, just a subsidiary called Starwood West limited owning seven malls in Ohio, Indiana, and California. It defaulted on a $254 million unsecured subordinated debt, raised as bonds in the Israeli exchange, early 2018. This default has a bigger story unfolding behind it, with Starwood just as a supporting character.

Starwood is one in a long line of (mainly) privately-held US real estate developers, which during 2015' - 2018' discovered the Israeli el-dorado, raising billions of dollars of subordinated equity in the form of low single-digit unsecured bonds.

Yes, subordinated equity. It's a new, one of a kind tranche of capital which doesn't (and shouldn't) exist anywhere else worldwide. It's legal, brilliant, and utilizing the conventions of the Israeli market to shift massive risk from the developer and senior creditors to unsuspecting investors. 

Israeli employees and employers are required by law for monthly provisions into different savings and retirement programs, generating permanent demand for publicly traded bonds. The Israeli investors are so yield thirsty, that a publicly real estate traded entity with an ok'ish FFO can relatively easy issue an unsecured subordinated corporate bond with low single-digit interest on top of senior secured loans.

The bondholders assume that, like the rest of the world, if a company can't pay it will settle with them, or they will take over it as shareholders to try and heal it, or take it apart. It's possible because the company is publicly-traded, senior lenders and partners deal directly with the company, and the identity of the shareholders doesn't matter.

This perception is precisely where the problems start. The US developers bundled a few assets with senior loans and other debt under a new entity and display a cashflow prediction from all assets that theoretically can pay the interest on all its debt, including the bonds (and that is a very loose theory in many cases). Then they issued debt in Israel, but their equity remained fully-owned as just another special purpose entity in a chain of LLC's, going from the underlying real-estate to the developer himself. The structure looks like that:

If you can't see the problem in this picture, let me point it out - the bonds are last in a line in any case of cashflow coming up from the assets. Other creditors get collateral, stronger covenants, paid higher yields, and are ahead of the bonds in any liquidation scenario. But the key to turning these bonds from just cheap equity to cheap subordinated equity is the fact that most senior loans, Mezz and preferred equity, have a change of control covenant, along with a personal guarantee of the company owner himself. Meaning, even if there is a problem with the bond payments, bondholders can't take over the company without risking a breach of every other loans' covenants and losing all the underlying assets, forcing them to settle with the developer, on his conditions. 

Who would say no to a very cheap subordinated equity, knowing that if something goes wrong, you pay almost nothing back?

No one obviously, leading over 30 American private developers to the Israeli stock exchange, raising close to 10$ billion. Although technically the companies aren't American, or Israeli, they are British Virgin Islands entities (BVI). That brings us to a few more things that make this a real sweet deal for the developer:

A British Virgin Islands entity reports in IFRS which, unlike USGAAP, allows easier revaluation of real-estate at fair value and recognizes capital gains as profit. Along with the British Virgin Islands 0% corporate tax, the company has an endless (on paper) equity printer, allowing it a seemingly low leverage ratio, and a big equity buffer.

Add to that the following: Every small-medium development company in the US is gigantic in Israeli standards; the credit rating difference between the US and Israel (BB+ in the US is A- in Israel); the general lack of familiarity of rating agencies with the new and unique legal structure; and what you get on paper is a big, strong, investment-grade REIT.

Money was flowing in, but in late 2018' the first company collapsed and the problematic structure revealed. In 2019' the weak corporate governance raised more questions, and the market was mostly closed for these entities.

Starwood was one of the biggest names that issued in Israel and the second to fail. Unfortunately for it and the LP that controls it and guarantees it's senior debts, the problems started with the senior loan at the assets level. The same happened with the first BVI entity that defaulted in Israel, resulting in the value of their bonds reduced to almost nothing, with bondholders realizing there is little to recover. Now that investors understand it was too good to be true, we hit the turning point. Almost all 30 companies trade at double digits yields and can't refinance. 

Some are good companies that have full intentions and capabilities to pay the bonds back. Others are reckless, taking a mountain of debt they can't handle in the first place, planing on refinancing it forever with more and more bonds. Furthermore, all kind of problematic stories arises as controversial stakeholders deals with the companies, questionable valuations that in some cases contradict other reports in the US, and even money that was 'accidentally' taken out of the company's accounts and into the owner's.

This Year is going to be unique for the subordinated equity trenches. Some companies have more to lose than others and will do what they can to pay back. Others can't or won't, and would prefer going head to head with the bondholders, knowing they have an advantage. Starwood won't be the last to default, and this is a playground for sophisticated active investors who are brave enough to play.

This article is for information purposes only and should not be regarded as an offer, solicitation, or recommendation to sell or purchase any security or other financial product.