How To Select A Defeasance Advisor

You're ready to give notice to your loan servicer of your intent to defease your conduit loan. The only task remaining is selecting a defeasance advisor. You have solicited proposals and have a number of possible candidates. How do you evaluate a potential advisor without actually going through the defeasance process with them?

It is easy for a consultant to claim the necessary defeasance expertise in its written materials-quite another for that consultant to demonstrate that claimed expertise in the clutch when a defeasance issue threatens to derail your entire transaction. Even assuming the basic competence of the companies that you are evaluating, it can be difficult to compare the costs that they quote on an apples-to-apples basis. This article provides a framework for qualifying your consultants and evaluating their fee proposals and cost estimates.

Qualifying Potential Advisors

Like many fields of consulting, there are no schools or professional organizations licensing, regulating or credentialing defeasance advisors. Any company can set itself out as offering defeasance consulting services. That company may even have as its principals individuals with impressive experience, for example, in mortgage banking or loan servicing. Unfortunately, that type of experience does not necessarily translate to the required understanding of the defeasance process. If the principals do have solid experience in the field, you still risk signing a contract for the company's services and then having your transaction handed to a recent college graduate to close, with little or no further contact from senior personnel. We have great respect for recent college graduates, but our nation's universities are not yet offering course selections in CMBS Loan Defeasance; using an experienced advisor is the best insurance against unforeseen obstacles complicating your transaction. We suggest using the following guidelines to prequalify each of your consultants, before moving on to the next step of evaluating their proposals.

Advisors Who Are New to You

If you have not worked with a potential consultant before, the easiest and best way to gauge their expertise is to ask them questions about the process.

The qualitative difference between defeasance advisors lies in the advice and proactive guidance they provide during the defeasance process. An experienced consultant will be able to guide and educate transaction parties with no prior defeasance experience and anticipate problems before they arise. Use the opportunities that arise when you contact a potential defeasance advisor to obtain an estimate, and when they contact you to follow up, to establish their level of expertise.

In reviewing the defeasance provisions of your loan, numerous questions probably occurred to you. Ask the candidates whom you are evaluating these questions. A qualified consultant will be able to provide clear, easily understood answers to these questions and will make sure that you understand each step of the defeasance process.

Determine the identity and title of the person with whom you are discussing a proposal. If it is a principal of the firm, ask if they will be the contact for your transaction, or if the matter will be handed off to a junior staff member. If a staff member is the party trying to answer your questions, it is likely that they will also be your primary contact for the transaction itself. Observe if they can handle your questions on their own or if they need to speak to someone else and call you back with the answers.

Advisors from Earlier Transactions

If you have worked with a potential consultant before, review their past performance objectively.

How was your experience in hindsight? Did the process go smoothly? Was your consultant able to anticipate problems before they arose? Did they provide clear explanations of the process as it was taking place? Did you have easy access to the principals of the firm after you signed their contract, or did junior staffers handle your transaction?

Finally, did your consultant place your economic interests first? For example, there is usually an open prepayment period of one to six months at the end of every conduit loan term when the loan may be prepaid. Some forms of conduit loan documentation allow this prepayment to take place even after the loan has been defeased. If a loan is defeased to the earliest possible prepayment date, it can result in significant savings to the borrower. If a loan is defeased to the maturity date and the successor borrower retains the right to prepay the loan, the result is a potentially significant windfall profit to the successor borrower- sometimes on the order of a spread of two to three percent on the remaining principal balance the loan. Did your consultant advise you of this potential profit to their affiliate, the successor borrower?

Breaking Down the Numbers

Once you have narrowed your list of potential defeasance advisors to a prequalified group, you will be in a position to compare their estimates.

Most proposals will provide one bottom-line number for your transaction and a detailed breakdown of the components of that bottom-line number, which will include the fees of the defeasance advisor and related parties, the fees of parties unrelated to the defeasance advisor- such as the loan servicer or the rating agencies- and the cost of the securities in the defeasance portfolio.

Bottom-line numbers are not the best way to compare different estimates, because bottom-line estimates for defeasance transactions combine three completely different types of components: (1) fee quotations that should be firm and unchangeable, such as the advisor's fee, (2) estimates of fees of other parties over whom the advisor has no control, such as the rating agencies or the loan servicer, and (3) estimates of costs that are highly variable over time and are useful only as ballpark figures, i.e., the cost of the securities in the defeasance portfolio. Looking only at the bottom line, non-binding, highly variable components of the quote, such as securities costs, may mask those parts of the quote, such as the fees of the advisor and its professional network, that should be fixed and binding.

We suggest that you divide each of your estimates into the following categories for purposes of comparison.

Fees of the Advisor, its Affiliates and Unaffiliated Related Parties

This is the most important category for comparison purposes and includes the consultant's fees, fees that will be paid to its affiliated entities, such as the successor borrower, and fees that will be paid to unaffiliated parties with whom the advisor has a prenegotiated arrangement, such as the defeasance accountant and the securities intermediary. The quotes for these fees should be firm because they will be paid to parties the advisor controls or parties with whom the advisor has a negotiated agreement. Fees for some or all of the following services may appear on your estimate, and should be included in this category:

• Defeasance Manager, Advisor or Consultant
• Accountant, Defeasance Accountant or Verification Agent
• Successor Borrower and/or Successor Borrower's Counsel
• Securities Intermediary or Custodian

Careful review may be required to extract the defeasance advisory or consulting fee from certain estimates. An independent consultant will explicitly quote this advisory fee to you. Defeasance consultants affiliated with securities broker/dealers may build their fee into the price of the securities. If a potential consultant has built their fee in, or quoted their fee as a basis point spread on the price of the securities, ask them to break it out as a dollar amount-and confirm whether the quoted securities pricing is gross or net of this fee.

At Defeasance Management LLC, we will explicitly quote our advisory fee to you, and our quote for your transaction will not include any hidden fees.

Fees of Parties Unrelated to the Defeasance Advisor

This category includes fees of parties over whom the defeasance advisor has no control. The defeasance advisor may provide an estimate of these fees to you based on its prior experience, but these estimates are not binding on anyone, despite any representations a potential advisor may make. For example, one advisor may estimate the fees of the loan servicer's counsel to be $12,000, while another may estimate the fees of the same party to be $20,000. Neither consultant has any control whatsoever over what the loan servicer's counsel will charge for your transaction, and these estimates are only each consultant's best guess. For this reason, fees that fall into this category are useless for purposes of comparison and should be discarded from the analysis.

Fees for some or all of the following parties may appear on your estimate, and should be included in this category:

• Loan Servicer, Master Servicer and/or Special Servicer
• Servicer's Counsel
• Rating Agencies

Securities in Defeasance Portfolio

This category includes the cost of the securities comprising a model portfolio that will be sufficient to defease your loan, based on the projected defeasance closing date.

We suggest that you review the estimates of securities costs for informational purposes, but that you set these estimates of securities costs aside from your comparison analysis, and instead compare consultants based on two other factors related to securities pricing.

Why do we suggest abandoning a comparison of estimates of what is, by a huge margin, the largest cost component of a defeasance?

First, the market for the fixed income securities that make up a defeasance portfolio is one of the broadest, deepest and most competitive financial markets. Any defeasance consultant that you select will have relationships with more than one securities dealer, and will obtain your defeasance portfolio at the lowest possible price. No consultant has any advantage over another in this regard, because they are going to the same general group of dealers to obtain these securities.

Second, the optimal portfolio of securities to defease your loan may change between the date of the estimate and your defeasance date, as the yield curve changes shape and new securities become available in the marketplace.

And third, estimates of securities costs will always explicitly state that they are estimates only and are not binding. Prices for fixed income securities change daily, a defeasance estimate is usually prepared thirty days or more from the actual defeasance closing, and the securities are not purchased until the closing process has begun. The fact that securities cost estimates are not and cannot be binding unfortunately may create an incentive for some consultants to aggressively market their services by estimating securities costs at prices they know they will not be required to honor.

Rather than concentrating on variable and non-binding securities price quotes, we suggest that you look at two particular factors related to the securities portfolio.

An estimate should contain some assurance that your consultant receives no fees from the purchase of the securities other than fees that have been disclosed to you. Defeasance Management LLC, for example, is not a broker/dealer. We receive no fees from the purchase of the securities and we do not offer defeasance advisory services to drive deal flow to a fixed income trading desk.

Each estimate should also provide a schedule detailing the securities contained in the proposed defeasance portfolio. The maturity date of the security representing the balloon payment should be as close as possible to the maturity date of the defeased loan. This allows the defeasing borrower to obtain the maximum possible benefit from the interest accruing on that security. If a proposed portfolio includes securities for the balloon payment that convert to cash many months before the balloon payment is due- an undesirable situation because no interest that can be applied to the payment is earned on those funds for that period- check to see if the other estimates offer securities with better timing.

Selecting Your Advisor

After undertaking this analysis, the final decision on an advisor should be relatively simple. Dividing estimates of defeasance costs as suggested above will provide a basis for final discussions with each prospective consultant. Once you have engaged an advisor and your transaction is underway, understanding which cost components should be fixed, and which are variable, will allow you to determine whether any subsequent changes in those costs are appropriate.