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the magic of creative financing
THE ONE THREAD that runs through every business I have attempted, whether it was a housing development, a vineyard, or a Broadway play, is finance. The financing of business—as opposed to the business of finance—can be a creative pursuit unto itself. How you put a deal or a business together will often determine how well it works and whether it survives. I learned this almost by default.
Actors who pay their dues in the theater tend to have a somewhat parsimonious view of money. So, when I went to Hollywood and first made a little money, unlike movie actors who often burst on the scene with publicity and flagrant salaries, I was financially conservative.
One of the first investments I made was the purchase of an apartment complex in Hollywood. It was a fifty-unit building called the Hollywood West, and it was in foreclosure at the time, meaning that it was owned by a bank. The bank, Home Savings and Loan, was asking $1.5 million for the building and wanted a substantial down payment. Acting alone, I did not have sufficient funds to make the purchase, so I went to some friends. With these friends, including the late Jack Webb of Dragnet, Peter Falk, who played Columbo in the TV series, and others, I put together a partnership for the purpose of acquiring the building. In the course of due diligence, I discovered the reason for the foreclosure: The building was primarily a transient building, and many occupants had not been paying their rent on time.
One day when I was at the building, I saw a car parked out front with diplomatic plates. I asked the manager who the man was. The manager said that he did not know the man, adding, “He’s visiting 304.” Apartment 304 was home to an absolutely stunning lady. This gave new meaning to the word “transient.” I then understood the reason that most of the rent was paid in cash. This meant that an extended period would be needed to turn the building around to make its cash-flow positive. The solution to the problem of how to provide for that time was found in the method of financing the purchase.
In many cases, examining the financial details from all sides is as critical as running a sound business. In those days, you could prepay the interest on a loan and take the deduction on your tax return in the year the tax was paid. The tax law said that you could prepay up to five years of interest! Since the lender wanted $500,000 as a down payment, I quickly calculated that five years of interest at 6¾ percent on the purchase price of $1.5 million got me to the required down payment of $500,000. That meant that all the partners could deduct their pro-rata share of that money in the first year on their tax return. We would still owe the bank the total of $1.5 million, but we would reduce our carrying costs by a little more than $100,000 per year for the first five years. This gave us the time to replace transient tenants with more permanent tenants and to increase the quality of the building and make its cash flow positive.
Why would the bank do this? At that time, the bank needed income, as opposed to capital, and, because we were paying interest and deducting it, the bank had to record that interest as income. Since the stock of the bank reflected the earnings in any given year, the bank was willing to accept the money. In addition, the bank was removing a nonpaying asset from its scheduled items and adding a paying asset, which made it look much better to the regulatory authorities. Best of all, it did not have to write the asset down but could hold it on its books at full value. This was one of my first lessons in creative financing. If the transaction is good for you, also make sure it works for everyone, and that includes the lender. This plan also served as a template for due diligence on the tax code. Tax implications can sometimes make or break a transaction, and they must always be factored into your decision making.
Because I had partners in the transaction who were relying on me, I was reluctant to retain an outside company to manage the building. If I was responsible for getting my partners to invest with me, then I had to be responsible for the operation. The manager lived on the premises in exchange for reduced rent, and I can still remember carrying furniture up and down three stories when tenants moved in and watching the office when he ran errands.
This first major investment of mine also underscored the importance of having good partners. Another lesson: Try to invest with people who not only risk their money but carry on with their continued responsibility, as well.
creative financing in real estate deals
Is the financing of real estate that different from a corporate transaction? It’s true that real estate is a comparatively simple business: It’s not as complicated as an operating business. Almost all real estate transactions have an asset that can produce a certain amount of income. You buy the asset, and you are looking for a rate of return. There are certain parameters that guide you as to what will work and will not work. If you don’t adhere to these parameters, you will not be successful.
However, within those somewhat rigid parameters, real estate can be approached in a creative fashion. One question you might ask is this: “Why does real estate have to be financed in a conventional manner?”
The answer you usually hear is that “everyone does it this way.” The banks say that. All those people who are doing the same thing tell me that. But hold on. Why can’t I do it a different way? For example, if it is a commercial project, why do I have to finance it as one entity?
Let’s say I am building a hotel with a parking garage in a city. Pretty straightforward, right? Yes, but why can’t I finance the garage separately from the hotel? Why can’t I find an alternative use for the garage? Perhaps I can design it to service more than just the hotel and to function as a public garage to create an additional revenue stream.
What else does that do for me? It allows me to go to the regulatory agencies—those people from whom I need clearance for the project—and say that I am providing a public service. As part of my project, I am creating more parking spaces for the entire area than I will need for my hotel. This, in turn, will help other businesses in the area and alleviate on-street parking congestion.
There is a point at which being opportunistic and being civic minded come together and work to the benefit of both the developer and the city. If you work within those parameters, it turns out best for everyone. Yes, you are doing the project for your own capitalistic reasons, but, at the same time, you are helping the city, which in turn helps you. By allowing you to build a profitable project, the city is increasing its own tax revenues. Everybody benefits.
The only snag typically occurs when the regulators become involved. With so many disparate interests at stake, winning approval for these projects can be like trying to push a bill through Congress. The process reminds me of Dustin Hoffman’s character in the movie Wag the Dog, which was written by Hilary Henkin and David Mamet, based on the book American Hero by Larry Beinhart. Dustin plays a movie producer named Stanley Motss who is brought in by a Washington spin doctor to help stage a war to divert the public’s attention from a sex scandal plaguing the president’s re-election bid. Every time someone talks with amazement about the war that he is creating, the producer tells them “this is nothing” and punches the line with illustrations of how much harder it is to make a movie. “This is nothing. D’you ever shoot in Italy? Try three Italian starlets on Benzedrine; this is a walk in the park.”
Usually, when developers try to build in an urban area, the city regulators complain about problems like added traffic or an over-burdened sewer system. You respond to those objections by building a larger parking structure, widening the streets, and enhancing the sewer lines. These changes contribute to the betterment of the area, but they also enhance the project to your benefit.
This type of give and take is common when you are developing a project. Always look for a way in which you can align your interest with those of the regulators and the public. This will open up possible financing alternatives.
A few years ago, we found an office building in Salt Lake City that was in foreclosure. Aetna Life insurance was stuck with the building, which was only 40 percent occupied, and it wanted to unload it. The developer who had built it had political connections and was able to finance the project with industrial revenue bonds, which are tax-free. Again, the tedious, boring, but useful tax code comes into play.
A normal approach would require new financing in a traditional mode: an amount equal to 70 percent of the building’s appraised value payable at a market interest rate over a twenty-year period. But such a requirement would make the transaction financially infeasible and therefore impossible to close.
I wanted to keep the existing financing because of its tax-free nature. However, because the building was more than half-empty, the lender imposed stricter credit requirements. In other words, the lender said the asset did not support the loan. If I could get the credit enhanced, I could keep the industrial revenue bond financing in place and retain the tax-free component of the loan.
Putting together a package of creative financing gave my partners and me time to fill the building. Three years later, we sold it to a Delta Airlines pension plan for a substantial profit. Again, the success of the project depended not solely on the building’s location but also on the structure of the transaction. Just think, I could have been Dustin Hoffman!
taking advantage of high interest rates
People in real estate always moan about high interest rates, but the truth is that high rates can create opportunities in residential real estate. When interest rates shot to 16 percent in 1974, the housing market went into a depression. This created a lot of stress among homebuyers, as well as distress among developers and lenders. A partner and I came up with a plan for how we could ease the buyers’ stress and capitalize on the developers’ distress.
We went into Las Vegas, which was overbuilt even at that time, and acquired several closeout land parcels from the banks. These were properties where developers had purchased fifty lots and built on thirty-five but defaulted on the last fifteen, resulting in bank foreclosures. We went around and acquired these remnants: a few lots here, a few lots there.
Once again, a distressed opportunity helped make the price right, because we were looking at a creative way to make the situation work for us.
We built houses in the area but designed them differently. If there were already thirty houses in a neighborhood and we were building another ten, we made our houses slightly smaller but configured them differently. We could obtain a cost differential just in the parameters of the design.
Then we went to the lenders and bought down the interest rate. The interest rates for residential financing were so high that Las Vegas developers were advertising new homes at what were then considered low rates—9 percent financing—as if it were the best deal in town since the all-you-can-eat buffet at Caesars Palace. So, we advertised even cheaper financing—6 to 7 percent, putting us two or three points lower than the competition.
How did we do that? We simply added that cost of the lower rate to the price of the house. Most people buying a house don’t think about overall cost when the price is competitive. What they think about is the carrying cost as it relates to their income. Can we afford to carry this house? Is it within our budget to make this monthly payment? That is more important than overall price because 90 percent of homebuyers don’t pay off their mortgage; they either sell or refinance.
Being aware of that general cycle of home ownership, we bought down the interest rate and tacked it on to the price of the house. Because it was a slow market, we built only three or four houses at a time, sold those, and then continued to build more until the project was complete. But it was the interest rate buy-down that made all of this succeed. This type of thinking is not specific to real estate. You should always look for a creative way to make your price more attractive than that of your competition.
bankrupt companies can pay off
Opportunity also exists in companies that have failed. Many public companies that fail file for bankruptcy, leaving few if any assets, yet continue to exist as a shell with the corporation intact as a legal entity.
Because these companies have no assets or operating businesses, their shares trade for pennies, if at all, so it is easy to acquire control of them. I’ve been involved in ventures of this sort and have learned that they can work well for an investor. In these cases, we’ve first undertaken all the administrative and legal functions necessary to rehabilitate the company as a viable public entity, meaning that we’ve filed all the necessary documents with the Securities and Exchange Commission (SEC), squared things with creditors and the Internal Revenue Service (IRS), and filed a legitimate audit that conforms to the law. Mind you, at this point this company does not have an active business; it’s just a shell.
What does all of this accomplish? It offers an opportunity for a small private company to become public at a very low cost. Our shell company is already public; therefore, the new business that we back into the shell does not have to go through the process and expense of an initial public offering (IPO). The term “shell company” has acquired a negative connotation because of a dishonest few, but the fact of the matter is that shell companies are a legal and valuable financial tool that can help you maneuver through our overregulated system. For the financier, using such a vehicle requires understanding all the rules. For the entrepreneur, it is a way to benefit from the system, rather than being ground down by it.
Years ago, our group took over a bankrupt company called Lazarus Medical. The company had been sitting dormant for many years. We bought control of Lazarus, had certified audits completed, restructured the company, and put $50,000 into its bank account. It was now an entity with no business, trading around 19 cents a share on the Over-the-Counter Bulletin Board (OTC BB).
Next, we began looking for a company with assets and revenues to back into this shell. In 2003, through an intermediary in Los Angeles, we were introduced to a Chinese entrepreneur who ran a powdered-milk company with $12 million in sales that he wanted to take public. The individual was very well connected with the Chinese government and consequently controlled the right to buy the dairy from the government. We did a reverse merger—in which a smaller company acquires a larger one—and a couple of private financings. The terms we negotiated gave us 5 percent of the new company, and the existing shareholders of the once-moribund Lazarus Medical got somewhere between 4 and 6 percent. The remaining 90 or so percent was retained by the Chinese company, which was renamed American Dairy.
What was the result? In 2003, our shell company started out as an OTC BB stock trading at 19 cents a share. In June 2009, as American Dairy, it was admitted to the New York Stock Exchange (NYSE) under the symbol ADY, and it traded at $25 a share and had $270 million in revenue.
There are other ways to do a creative financing transaction like this that benefit the entrepreneur who wants to go public and the group that gets him there quickly, cheaply, and efficiently. Let’s say you started a business that is doing $12 million in sales and earning a profit of $700,000 a year. With an injection of capital, you believe you can expand the business exponentially, so you go to an underwriter and say that you want to go public and raise the necessary money. The underwriter will probably say that you are too small and will advise you to do a private placement or some other alternative. Even if the underwriter is interested, it will tell you that it will be very expensive and that you will probably have to give up 40 percent or more of your company to the public for it to underwrite the transaction. Since that seems like a heavy cost, you look for alternatives. But a private placement might be even more expensive in fees and dilution. That brings you to the reverse merger.
By taking a company that is already public and merging it with your company, you can negotiate for as much as 80 to 85 percent of the company—and be publicly trading in sixty to ninety days. The negotiation is simplified because it is between the control group of the shell and the principal of the company that wants to go public. There is a company called AAON, Inc., that now trades on the NASDAQ exchange that went through this process.
the reverse merger that brought a 2,000 percent return
This transaction began when our group of investors created a company called Diamond Head Industries. In what was then called a blind-pool or blank-check offering, we first raised roughly $500,000 from about two hundred qualified investors to form the company, whose sole business was looking for a business to take public. The comparable set-up to this in today’s market is called a special acquisition corporation (SPAC, for short), which is governed by special rules set by the Securities and Exchange Commission. Through one of our investors, we found an air conditioning company called the John Zink Company, or JZC.
JZC was started in Tulsa, Oklahoma, in 1928 to produce equipment for the oil industry, and it eventually diversified into the residential heating and air conditioning business. Around 1968, JZC began making commercial modular rooftop air conditioners that could be expanded by plugging one unit into the next. In 1970, it began selling these units to McDonald’s; it started selling them to Wal-Mart the following year. When the founder died, in 1972, JZC was sold to the Sunbeam Corporation, which in 1981 was acquired by Allegheny International. In 1987, a company called Lone Star Industries bought JZC. Lone Star later filed for bankruptcy, leaving JZC, which was a going concern, dangling in the wind.
What made the John Zink Company unique? After all, HVAC—heating, ventilation, and air conditioning—is HVAC. Yes, but JZC had a special place in the market. JZC did not compete with Carrier in the large office market, nor did it try to compete with Lennox in the residential market. It concentrated on making the best equipment for the specialty, small-box retail market.
In addition, it had great management—the key ingredient in any transaction. The business was run by Norm Asbjornson, an engineer whose philosophy was to make money the old-fashioned way. He could manufacture a highly reliable air conditioning unit for less than the competition and sell it for more. We wanted to extract that business from Lone Star and make it a publicly traded company.
In 1988, we bought JZC from Lone Star Industries with a loan from the First National Bank of Tulsa. Then we backed it into our Diamond Head entity and renamed it AAON for advertising reasons—the double AA’s made the company the first listing in the phone book and the yellow pages. This transaction is called a reverse acquisition, and it made JZC instantly public. Our group received 20 percent of the stock, and the existing JZC shareholders got the other 80 percent.
Why would the JZC shareholders consent to this type of transaction rather than seek a traditional public offering? For several reasons. First, it is much easier to raise money through what is called a PIPE—a private investment in a public entity—than it is through an IPO. Our company had $500,000 in capital that JZC could immediately use. Second, doing an IPO would cost the company some 10 percent of the amount raised in the IPO in underwriting fees and expenses, as well as all the auditing fees that go along with becoming public, all before potential investors could know if the company would succeed. Finally, there is always the uncertainty of time. No one can ever predict the changes in the stock market on a given day, and that uncertainty can cause an underwriter to cancel the offering just when the company is counting on receiving the money.
With a reverse merger, the company was public in sixty days with cash in hand and did not have to go through all the bureaucracy to get there. Once public, the company could point to its market capitalization as validation for its value that could be used for bank loans and expansion.
And how did our group come out? Remember that our stock was acquired when the company was a shell. The insiders average cost was approximately 10 cents a share. Today that stock trades above $20 per share. That is a return of around 2,000 percent!
While this is not the usual way to take a company public and is not held in high esteem by the investment community, it is effective and has led to the creation of some very successful companies like AAON. However, you do have to be very careful about reverse mergers and make sure that you are following all the rules because the rules can change frequently.
why go public?
Let’s loop back. Why go public at all? The most common reason is that you need capital, and it can be a cheaper way to raise capital than by borrowing it. But there are ancillary reasons. Being public gives an entrepreneur an immediately quantifiable asset. The majority shareholders can say that they have public financial statements; they trade on an exchange, and therefore they are worth measurable dollars. That gives them leverage for borrowing or for stock-driven acquisitions. Such was the case with a Chinese medical company called China Sky One, which our group of partners backed into another existing company, called the Comet Corporation, an entity that had no business but that had a clean balance sheet and a public presence on the OTC exchange.
China Sky One is in the nutraceutical business. Nutraceutical products are extracts of natural foods and other things that have a beneficial effect on your health. The history of ancient Chinese medicine has evolved through the use of many extracts found in nature, including roots, herbs, and even discretionary animal parts.
China Sky wanted instant liquidity so that it could make acquisitions. At the time, the registration process in Hong Kong was difficult administratively. (Since that time, by the way, China has changed these laws and made it easier for companies. So again, you must keep up with the rules.) Without a creative financing strategy like the one we offered, it would have taken China Sky a year or more to go through the process of becoming publicly traded. We offered the entrepreneurs behind China Sky One an opportunity to get there much quicker.
Because it had three years of audited financial statements, we were able to take China Sky One public through a reverse acquisition, and in less than a year, China Sky One went from the OTC BB to the AMEX and then to the NASDAQ, where it trades today under the symbol CSKI.
creative transactions keep you on your toes
While all this may sound simple on the surface, much work goes into making it a success. Comet existed for many years before we found a business to merge into it. With Jack Gertino doing the leg-work, we had looked at more than two hundred possible companies as candidates for a transaction, thirty of which were in China.
The rules are also constantly changing. For example, SEC regulations now require that an entity must be an existing business to be listed on a public exchange, so, even if you have a registered shell corporation, it must be a going concern before you can undertake a reverse merger transaction.
As we do these creative transactions, we have a growing list of people who want to participate. It is a bit of a pied-piper world. If you do a good deal, everyone is happy. If you do another good deal, everyone is happier. But it is the nature of people to always remember the one that did not work. And this is what has happened to Greater China International Holdings (GCIH)—one that is not yet working.
GCIH is one of the largest non-state-owned real estate developers in northeast China. We did the private placement at $2 a share and the stock trades below 50 cents a share, so the investors are under water. The company has solid assets and earned more money than Citigroup in 2009, so its book value is about $8 a share. But we won’t see a return until the share price catches up to the real value or the founder sells the company.
I was recently asked if I was afraid of these Chinese deals. Why should I be? My partner traveled to Shenyang and toured the buildings owned by GCIH. In other words, he verified the assets. The Chinese economy is growing faster than ours, and GCIH operates under the same requirements for filing audited financial statements with the SEC as a company that owns a string of office buildings in Manhattan. Although the location of the real estate may be key to its profitability, if the management is corrupt, a company in Manhattan can cook the books just as easily as someone in China. Ask the people who invested with Bernard Madoff!
A twist of irony: When Jack Gertino and I were looking at GCIH, I asked the founder of China Sky One if Shenyang was a big city, since I was unfamiliar with it. “No, not really,” he replied. “There are only seven million people.” No wonder China is the new, new market for American companies.
Perhaps our next shell transaction will be in a small Chinese village of three million people. Perhaps it will be with another Midwestern family business. We currently have a corporation called Phoenix Acquisition Recovery Corporation, which, like its name, has risen from the ashes of the past and awaits rebirth as a viable entity. We have completed a private placement, and we are now looking for a business to complete a reverse merger using our creative, somewhat unconventional approach that will allow an entrepreneur to realize his dream in a regulatory and financial system that would otherwise push him around.