An MBA intern at Wildcat Capital Investors was tasked to come up with a financial model for the purchase of an office building in suburban Chicago. The intern must consider the real estate downturn and the possibility of outside investors taking up the challenge.
Harvard Business Review (KEL553-PDF-ENG)
January 20, 2011
Case questions answered:
- Re-create the base-case property proforma with debt. Using the rent roll numbers in the Excel template, the operating cash flows will differ from the case exhibits by $2-$6 (The reversion cash flow will differ by about $60 due to multiplier effects). Then, complete the waterfall shown in Exhibit 10 using the benchmark assumptions outlined in the case. (Skip to the last page of this document for instructions on filling out the waterfall.) Under these assumptions, calculate the expected return to Wildcat Capital Investors and its limited partners and compare those returns to the property-level return on Financial Commons if it is sold after three years. Returns to Wildcat should be calculated without including its management fee. Note that the waterfall to the equity partners doesn’t get paid until after the loan payments have been made/OLB paid back to the bank.
- For each of the following scenarios, recalculate spreadsheets for exhibits 9 and 10. With the exception of the changes noted below, keep the benchmark assumptions constant. Each scenario will be recalculated independently; that is, each scenario is to be treated as a distinct variation from the benchmark. Assume that outside investors will become partners with Wildcat only if they believe they will receive an IRR of at least 20 percent, and Wildcat will only close on the property if it believes it can earn a 50 percent IRR. Discuss whether or not the deal will proceed. Assume that any unpaid preferred return gets added to the equity contribution, and the following year’s preferred return gets calculated off of that larger balance. Finally, assume that if expenses exceed property income, both partners will make additional equity contributions in the same shares that they made their initial equity contributions to cover the shortfall.
a. North Shore Bank does not renew its lease at the end of year 3, and its space remains vacant in Year 4. A new tenant begins leasing the space in Year 5 at $18/sf on a net lease requiring $5/sf of expense reimbursement. The new lease does not contain any rent escalation clause. To make the space suitable, capital expenditures of $4/sf are required in Year 5 for tenant improvements. A leasing broker charges Wildcat 2 percent of the first year’s rent as a commission. As a result of this turnover, Wildcat holds the property for 5 years. [Accuracy check: reimbursements in year 4 are $138,197, and PGI in year 5 is $1,809,245]
b. All tenants renew according to the benchmark assumptions. However, due to continued weakness in commercial property demand, Wildcat holds the property for 5 years. During its hold period, Wildcat made capital expenditures of $500,000 in Year 2 for a new roof and $150,000 in Year 3 for a new parking lot.
c. After more careful underwriting, the life insurance company offers a reduced loan-to-value of 60 percent and an interest rate of 7 percent. Assume a 3-year holding period.
d. The outside investors are nervous about the economic climate. As a result, they demand the following investor-friendly changes to the waterfall structure. Assume a 3-year holding period and that all of the changes below are incorporated simultaneously.
i. Outside investors will provide only 90 percent of the required equity
ii. Outside investors will receive a 10 percent preferred return
iii. Outside investors will receive a 12 percent IRR preference. (This means that at reversion, after the invested capital has been returned to the outside investors and to Wildcat, the outside investors will receive additional cash until they achieve a 12 percent IRR over the lifetime of the investment. The remaining cash flow will then go through the promotion.)
iv. Cash flows in the promoted structure will be split 80/20 rather than 70/30
- Evaluate the benchmark assumptions Zaski made for reasonableness. Would you have made different assumptions? What do you think is the fair market price for Financial Commons? Explain why your answer does or does not differ from $10,400,000.
- If you were an outside investor being approached by Wildcat and were shown the financial projections outlined above, what additional information would you seek before investing?
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Wildcat Capital Investors: Real Estate Private Equity Case Answers
This case solution includes an Excel file with calculations.
Executive Summary – Wildcat Capital Investors
According to our data, we believe that Wildcat Equity Partners should not continue with the project. While we found that Wildcat Capital Investors does, in fact, earn a satisfactory return on their base case scenario, this scenario seems like more of a best-case scenario than anything else.
In other scenarios, such as revisions 2A and 2B, both investor and wildcat will not continue the deal as the return that they will receive will be lower than their required IRR.
Meanwhile, in revisions 2C and 2D, only one of them will earn satisfactory returns, so it would not be possible for them to continue the deal based on these scenarios.
As we will discuss in more detail later, Wildcat made a number of serious omissions that led to their base case number being a lot higher than any of the other hypothetical scenarios.
According to our analysis of 2009 market conditions, it would be much more reasonable to assume that something would go wrong, that someone would not renew their lease, or that extra demands would be made to compensate for the uncertain market. The deal is an appealing risk because there really isn’t much else to buy out there right now.
And it could be claimed that in five years, the markets will be growing again, and it might be a great time to sell. This is purely speculative, though, and as a developer, it doesn’t make a whole lot of sense to go against your numbers and act only on your belief that the market conditions will change within a relatively short hold period of three years or even five.
Additionally, this is a terrible time to be out in the market looking for a loan, as the credit crunch is only just loosening. While the loan provided in the base case is not terrible, it is probably a lot worse than what Wildcat could be getting in a healthier market.
All of these things considered, we feel that it would be an incredibly high-risk decision to go forward with this property and that Wildcat would be better off passing and waiting on a better opportunity than taking such a huge risk on one of their first development opportunities.
1. Re-create the base-case property proforma with debt. Using the rent roll numbers in the Excel template, the operating cash flows will differ from the case exhibits by $2-$6 (The reversion cash flow will differ by about $60 due to multiplier effects). Then, complete the waterfall shown in Exhibit 10 using the benchmark assumptions outlined in the case. Under these assumptions, calculate the expected return to Wildcat and its limited partners and compare those returns to the property-level return on Financial Commons if it is sold after three years. Returns to Wildcat should be calculated without including its management fee. Note that the waterfall to the equity partners doesn’t get paid until after the loan payments have been made/OLB paid back to the bank.
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