Navigating the Structured Finance Waterfall: Smooth Sailing or a Barrel Ride over the Falls?
Everyday business language is awash in references to water — “liquid” assets, “liquidity” events, cash “flow,” companies trying to “stay afloat” (perhaps because they tried to “boil the ocean”) and, of course, the “waterfall.” In real estate structured finance, waterfalls are the “plumbing” through which cash and control rights flow.
Most of the time, waterfalls work fine. However, in a restructuring, rocks sometimes lurk beneath the waterfall, and we discover that the plumbing — which looked great initially — connects differently than an investor thought it did or has developed a clog not even Drano® can fix. Some recent matters illustrate — and several important court cases are beginning to define — how the operative documents in structured finance transactions will be interpreted under certain circumstances; these cases,1 in turn, are influencing the initial and secondary market investment calculi and strategies of stakeholders involved in restructuring obligations held in CMBS and CDO structures.
Complicated piping can lead to unintended, or unexpected, consequences
Even the simplest waterfall can contain upwards of a dozen steps and reference at least that many defined terms (usually more). Intended to capture virtually all circumstances that might arise during the life of a credit, these provisions occasionally fail to adequately address some common restructuring outcomes.
Recently, a special servicer embroiled in a Chapter 11 case involving a large, securitized loan was negotiating with the debtor over plan provisions which contemplated extending the loan’s maturity date, payment of post-petition default interest and an increase in the post-confirmation interest rate (additional interest). The special servicer, contractually bound to maximize NPV for all certificate holders, sought to confirm how default and additional interest would flow through the waterfall. Surely, those millions of dollars would flow to the certificate holders put at risk by the default and bankruptcy, thus improving their collective NPV, right?
About the Authors
Senior Managing Director
Senior Managing Director, Co-Leader Real Estate & Infrastructure