AMERICAS NEWS: Bad boy bets

After six months of foreclosure proceedings, failed joint venture negotiations and a bankruptcy court hearing, Garrison Investment Group finally wins control of a Virginia office complex. But at what price? PERE magazine, May 2011 issue

It’s rare for PERE to report on debt refinancing, but Garrison Investment Group’s new senior loan on a portfolio of four office properties in Reston, Virginia, is an exception. In closing the $60 million first mortgage and $20 million credit line from Deutsche Bank last month, the firm brought to a close a rancorous clash with Normandy Real Estate Partners and a UBS securitisation trust over the future of the Virginia office complex.

The refinancing means Garrison can get on with the job of leasing up the 50 percent occupied development. However, it has come at a price for the New York-based firm following six months of foreclosure proceedings, failed joint venture negotiations and a bankruptcy court hearing that ruled against Garrison.

While it is no surprise that the transaction’s origins hailed from the overheated market of 2007, the battle between Garrison and Normandy was more than just an attempt to wrest control of an overleveraged deal. At its heart was a fight about the validity of “bad boy” guarantees, a battle that once again highlighted the inherent risks of conducting real estate deals through America’s court system.

As the mezzanine debt holder, Garrison was in prime position to take over the equity position of the borrower, Washington DC-based developer Penzance Partners, when the deal started to sour in 2009. Together with the UBS 2007-FL1 trust, which held the $67.5 million A note, and Normandy, which held the $39.5 million B piece, the trio had extended the loan for one year, but the debt fell into default when Penzance was still unable to refinance in 2010. And that is where the real story began.

As Garrison positioned itself for a mezzanine foreclosure, it also negotiated the possibility of a joint venture with Normandy, whereby the latter would either convert its B piece to equity or the senior lenders would refinance the A and B notes with new terms in return for Garrison’s injection of fresh equity. Those talks collapsed over terms, capital market and legal sources told PERE.

However, it was while Garrison was eyeing the foreclosure that it also signed a “bad boy” guarantee. The guarantee was a promise that, in return for the two senior lenders forgoing their own right to foreclose on the asset, Garrison wouldn’t throw the special-purpose entities that owned the Reston portfolio into bankruptcy. If it did, Garrison was required to repay the $107 million in full with the firm’s hedge fund, Garrison Special Opportunities Fund, placed as collateral.

What Garrison didn’t expect was Normandy filing for foreclosure on the senior mortgage so shortly after it had foreclosed on the equity interests of the properties from Penzance in November. Normandy’s actions as the controlling class for the senior lenders resulted in Garrison filing for voluntary bankruptcy in New York on 15 December, before it had found refinancing for the deal. And as the judge in the case, Judge Melvin Schweitzer, said in his final ruling: “[Garrison] made a decision to take a calculated risk that it could arrange a refinancing of the properties before being forced by an aggressive lender to initiate a bankruptcy proceeding to protects its economic interests.”

The risk didn’t pan out and, on 20 December, Normandy and the UBS trust demanded repayment of the $107 million senior loan, together with default interest, in full. A failure to pay could have seen Normandy and the UBS trust appoint receivers to the Special Opportunities Fund and begin a liquidation of the assets.

In challenging the guarantee and using the bankruptcy court system, Garrison opened itself up to a binding ruling from a legal professional, affecting the future of its fund and also the uncertainty of how slowly – or in this case, how quickly – the matter would be dealt with. Seasoned debt investors have told PERE they also would have employed the use of a “bad boy” guarantee in this situation. However, in making his ruling in just 78 days – a very quick time for most bankruptcy courts in the US – Judge Schweitzer put the pressure on Garrison to secure a refinancing in a short space of time.

Now, as the dust settles on the Reston portfolio, industry professionals take note of the “sharp elbows” displayed by both Garrison and Normandy as they fought to protect their investment. In the end, Garrison took full control of the asset, but only after paying down the senior debt at par plus default interest accrued. And, of course, there was a price to pay for taking control of the Reston portfolio: the need for Garrison to inject an extra $40 million of fresh equity into the deal.