Q: Is there a rule of thumb for when to incorporate a related entity that is not wholly-owned into the global cashflow? If a related business (not a borrower or guarantor) is 30%, 50%, 66% owned by guarantors (or any other percentage), are there guidelines as to the best way to handle both cashflow and debt from that entity in determining the global cashflow?

A: There are two fundamental considerations in selecting the parties for computing global cash flow - control and commitment.

With respect to control, the lender must identify the party that controls the borrower as well as identify all other business organizations controlled by this party.

With respect to commitment, the lender must be assured that the controlling party is committed to using its own financial resources in support of the borrower's debt service.

To see how this plays out, recall the proposed Shadelands Glen apartment complex acquisition by Sequoia Properties from the Credit College Course on Commercial Real Estate Underwriting. Sequoia Properties is a general partnership with two partners. Each partner - Fritz Schumacher and Luis Castillo - has a 50% ownership share of the partnership.

The first step in the global cash flow compilation process is to identity which of the two partners controls the partnership's finances since they have equal ownership. The Credit Narrative identifies Schumacher as the managing general partner, the one who controls the company and its finances. The Statement of Changes in Partners' Capital reports that partnership net income is split evenly but that Schumacher receives the distributions and provides the partnership capital. Given this information, it is clear that Schumacher is the controlling party. This, in turn, requires us to identify all other business organizations controlled by Schumacher since such organizations are included in the global cash flow computations. The Credit Narrative reports three additional business organizations fall into this category.

The guidance to draw from these set of events is that control of a business organization is generally determined by ownership of 50% or greater. But 50% ownership is no assurance of control as evident by the role Luis Castillo plays in the partnership with an equivalent 50% ownership. Had we mistakenly identified him as the controlling party, the resulting global cash flow would be quite different and quite incorrect.

The second step in the global cash flow computation process is to determine if the controlling party is committed to repayment of the underlying loan used by the borrower to acquire the property. That commitment takes the form of a personal and continuing guarantee. If the controlling party provides such a guarantee, then its financial support is included in the global cash flow computation. In this instance, the Credit Narrative reports that Fritz Schumacher guarantees the proposed $3,450,000 term loan.

In the absence of such a guarantee, there is far less assurance that the controlling party will use its financial resources to support the loan in question should the borrower encounter cash flow problems or face bankruptcy at some point over the loan repayment period. There are far too many instances in which controlling parties, which have not provided a continuing guarantee, simply walk away from a failed transaction and leave the property in the hands of the lender. From the controlling party's point of view, it is less costly to give up the property than provide a guarantee that might cost it far more if the controlling party were compelled to honor the guarantee in a crisis.

Therefore, exclude the controlling party from the global cash flow computations if it does not provide a continuing guarantee.

Q: If someone has 15 businesses owned 50%, would 50% of the cashflow and debt for each be applied to the global cashflow? 100? Does it depend on majority ownership?

A: With respect to the percentage of business cash flow and business debt for related business organizations that should be included in the global cash flow computations, use the full amount of business cash flow available and the full amount of business debt in the computations. The controlling party has access to the full amount of business cash flow, which it controls and must apply in meeting the full amount of debt service on the related party's outstanding debt. To use any lesser amount of either may underestimate the related party's ability to service its debt from its own business cash flow or it may not identify the additional cash flow support required by the related party to properly meet its full debt service.

Q: We have a lot of people who overlap in ownership of related businesses as well. If 3 guarantors own 75% of a related entity (not a borrower or guarantor), should that be included at 100% ownership? 75% of cashflow and debt?

A: If the three guarantors are, indeed, the controlling party, they determine the use of 100% of the company's business cash flow. Within the group, there is likely a partnership agreement or ownership agreement that identifies one of the group as the financial decision maker.

Course overview: Global Cash Flow