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A new venture.

It was a different type of mortgage company buyout from the start. To begin with, the product itself was out of the ordinary. It was a 900-person mortgage banking operation that routinely posted $2 billion-plus origination years, but it was being sold with virtually no servicing to sweeten the deal.

And the majority investors in the buyout, well, that's where the differences really became apparent. They were a venture capital firm out of New York. Furthermore, their past investments had been in information-processing companies and health care firms. This was their first foray into mortgage banking--hardly an industry for novices or those looking for guaranteed returns. Yet, the deal got done and actually went to closing right as the California housing market was beginning its gentle slide into the Pacific.

What made this unusual deal work? What was it about the partners to this venture that allowed them to find comfort in each other to produce a true 1990s-style mortgage banking company?

It's a story about management talent, a quality production track record, investment in a state-of-the-art, integrated computer system designed to allay risk and finally, capital in the hands of investors who could make big decisions and see opportunities after they did an incredible amount of homework.


The buyout in question was the purchase of American Residential Mortgage Corporation, La Jolla, California, by the New York investment firm of Welsh, Carson, Anderson and Stowe. American Residential's senior management team also owns a minority share in the new, privately held company. The mortgage banking company was being sold by First Nationwide Bank, the San Francisco-based thrift that is the flagship financial institution in Ford Motor Company's financial services division. The sale was announced on May 7, 1990.

In 1989, American Residential originated $3.2 billion in home loans. Last year, the mortgage company originated $2.3 billion, and this year the target is between $2 billion and $2.5 billion in originations. The California-based mortgage company was clearly an originating machine, and First Nationwide wanted to boost its portfolio originations resulting in its acquisition of the mortgage company in 1988 from Imperial Corporation of America. At the time Welsh Carson started looking at the deal, the mortgage company was servicing roughly $1.5 billion, and "much of that was being done on a subservicing basis for First Nationwide," according to Thomas E. McInerney, general partner with Welsh Carson. The parent thrift reclaimed virtually all of that servicing at the deal's closing.

"The company was being sold to us with virtually no servicing portfolio," McInerney said. The venture capital firm was drawn to mortgage banking because it saw good return opportunities from servicing, yet it was buying one of a very few big production machines that boasted negligible servicing assets. What gives here?

McInerney acknowledges that at first glance it seems a little strange to be interested in a mortgage banking company without any servicing. "Frankly, most people wouldn't buy it." But he goes on to explain that on the plus side, by starting without any servicing, it gives new management the opportunity to build the servicing portfolio from the ground up. McInerney says the strategy is to supplement American Residential's originating might with strategic purchases of servicing to fill out the considerable servicing system's capacity that went along with the purchase. He adds that because the mortgage company will not be dependent on purchases of servicing to build its portfolio, it "can be fairly selective about what we buy."

The deal was not only somewhat unusual by mortgage banking industry standards, it apparently also defied the norms of typical venture capital deals. "We bought a company that was guaranteed to burn through $20 million in the first year. It was not the typical venture capital transaction, where you put in $2 million or so and you expect a 30 percent return. This deal was virtually guaranteed to eat up a huge amount of cash, because no one makes money on originations. Until you build up your servicing function, you are guaranteed to lose money," McInerney observes.

Making the deal

So how did this venture capital firm with no previous experience investing in the mortgage banking business find the comfort level it needed to sink potentially $20 million in the first year into a mortgage company with no income being generated by a servicing portfolio? The answer emerges as you talk to McInerney and hear him describe how venture capitalists ply their trade. They underwrite a company's management team first, then they underwrite its plant and systems capability, and then they gauge its capacity to grow, and then sometime after all that is carefully assessed, they decide whether to take the plunge.

He says the existing management team pulled down top marks from others in the industry during the network checking that is a routine part of due diligence work done before any buyout. John M. Robbins, Jr., American Residential's president and CEO, and his management team were found to have "a strong reputation for the quality of the credit they originated." The book" on American Residential, which is the street term for the offering memorandum on any company for sale, was 70 to 80 pages long, and it showed that the purchaser would need to invest significant amounts of equity capital. Taking American Residential private would require setting up a new warehouse line, plus other needs would require startup capital.

Welsh Carson started looking at mortgage servicing as a potential investment in late 1989. Nothing in particular triggered the interest other than the turmoil in the thrift industry. Plus, Welsh Carson had three of its general partners with very strong backgrounds in the data processing industry. The company saw in servicing a functional operation that was very analogous to the data processing industry, in that it is clerical-intensive, has a repetitive revenue stream (in other words, an annuity-like feature) and retains the same customer base for long periods.

Also, McInerney adds that the servicing business typically using cutting-edge, state-of-the-art systems. He said that Welsh Carson would not be interested in investing in the type of business that requires "the fastest and latest microchip invention. We are interested in applied technology, not R&D technology."

In approximately late January 1990, a boutique investment banking firm, Putnam Lovell, Inc., brought the American Residential deal to Welsh Carson to see if it had any interest. It was the first mortgage company "we looked at seriously, others we took a fast look at. It was the first that got us past the tire-kicking stage," McInerney said. Welsh Carson spent essentially February, March and April "looking very seriously at the deal." During the month of April the buyers got down to "negotiating intensely" with First Nationwide Bank. On May 7 it was announced as a done deal, with Welsh Carson ending up with roughly 80 percent of the new company's stock.

Shopping for owners

But the process of shopping for a new owner for the mortgage company really started much earlier, according to American Residential's Robbins. He traces the start of the process back to August 1989. First Nationwide "provided us with the opportunity to do a buyout," Robbins said, because the Ford-owned thrift company wanted to concentrate on developing its internal thrift mortgage operation without running a duplicative and separate mortgage subsidiary. So, in late summer, American Residential's management team started making what turned out to be a significant number of trips to New York talking to various venture capital firms. It had been decided that they were looking for someone to be a "strategic buyer rather than a corporate buyer."

The management team deliberately lined up a small "boutique" investment banking firm to prevent getting the "little bitty fish in a big pond" treatment at the large investment banking firms that reserve their best efforts for the more sexy headline deals. As Robbins puts it: "We were pretty unsexy. We were small potatoes." In their search for the right investment banker, Don Putnam was recommended to Robbins. Putnam Lovell, with offices in California and New York, specializes in buyouts, but this was the firm's first encounter with a mortgage banking deal. Robbins recalls that another factor working against using a big investment banking firm at the time was "they were very negative about the [real estate] business because they are too close to it." But Robbins and his team were trying to find an equity partner with a longer-term horizon whom they could show that real opportunities existed in the real estate finance business and the very best time to jump in a was now, at the bottom of the cycle.

Robbins and his team decided that they needed a buyer willing to put equity capital in the company and to forgo a debt-financed purchased that would make future servicing growth take a back seat to debt service obligations. They also wanted a buyer who was not driven by GAAP earnings cycles, which also leads to selling servicing. "The venture capital ideal became the logical one," Robbins recalls. They are cash-flow-driven investors, and they have a long-term viewpoint in terms of return on their capital. He said venture capital investment funds are raised with a 8- to 10-year time-frame in mind.

After deciding on the venture capital route, Robbins said the most difficult part was finding an equity partner "who you wanted to do business with." The management styles had to mesh. Robbins says you typically think of venture capitalists as being "very cold and off of Wall Street with no management experience." But he says Welsh Carson proved "just the opposite;" they all had operating backgrounds, and they were interested in people.

Servicing systems

Robbins said the idea of accumulating servicing was a natural item for the venture capital firm to comprehend. Welsh Carson's partners knew about the cash flow idea behind the servicing asset. He said they were able to see that this was a time in the servicing cycle when prices were very low and there were good returns available for those with the capital to invest. The returns ranged from as low as 15 percent to as high as 30 percent, depending on the package and how much due diligence you do.

As Robbins points out. "There's a lot of dollars looking at servicing, but there's probably not a lot of facilities that can handle it and do it correctly. Most of that money has to buy a servicing facility and not just a package from the RTC."

So Robbins and his team of top managers had to shop the idea around to a host of venture capitalists that this cash flow business of mortgage servicing was actually a very good business to be in, even though the housing slump was just starting to make some big headlines around the country.

But the people at Welsh Carson had already started looking into the servicing business on their own and found it appealing. Furthermore, they knew data processing systems, and they could assess the systems capability of a servicing shop and its ability to grow. When they went to California to look at American Residential's computer operation, they "saw a system that could handle from four to six times the amount of volume they were handling, without stressing the system in any way." McInerney and his team observed the physical plant aspects of American Residential's servicing shop when it was handling the roughly $1.5 billion it was servicing for First Nationwide. That meant that his team of systems experts found a company with the computer capacity to service as much as $9 billion or more without having to furhter invest in upgrading existing systems. That suited the investment strategy of Welsh Carson to a tee. McInerney says, "Our game plan in this business was we were going to buy this company with the idea of building a servicing portfolio." Indeed, numbers released to Mortgage Banking for this article show that American Residential has set a target this year of acquiring from $2 billion to $5 billion in servicing and subservicing. That follows a year when the mortgage company bought zero servicing and sold $1.3 billion in servicing.

It took Welsh Carson two months to do the extensive due diligence on American Residential's management team, the operation and its computer systems and on the mortgage banking industry as a whole. The data center that houses the computer system that supports the servicing shop and that is hooked into the production operation is part of Benchmark Information Group, a separate subsidiary of the thrift now run by the RTC. But the actual software and the applications developments that support American Residential's entire operation are owned by the mortgage company. McInerney's staff asked the operating people in the company, from an applications point of view, whether the system had enough features to do a good job with about $5 billion in servicing. The answer came back yes, no problem.

Clearing hurdles

Welsh Carson was proceeding to make steady progress in gaining the comfort level it needed to close this deal. The first hurdle had been to assess the management team. The team included Robbins, who in 1983 was picked to develop a national mortgage banking subsidiary for the large thrift, Imperial Corporation of America. The subsidiary originated $4.2 billion in home loans in 1986, a boom year by most everyone's standards. But Robbins led the company to impressive volume in subsequent years with $2.6 billion in 1987, $3.7 billion in 1988 and $3.2 billion in 1989. The other members of the team include James Gilcrest, executive vice president of national production and Jay Fuller, executive vice president and chief administrative officer. All three senior executives have been with the mortgage company since its creation in 1983.

So while the management team passed muster with the venture capital firm, the mortgage banking business itself needed to prove it was one of manageable risks. As McInerney says, "Credit risks and interest rate risks were very strong negatives to us. If we couldn't see us reducing those to an acceptable level, we probably wouldn't have gone on with the transaction. That was very important to us."

Technology decisions

Here, again, the state-of-the-art systems in place at American Residential helped paved the way for the deal getting done. "The same computer installation supports the origination side as supports the servicing side. I cannot [overstate] the importance of this. Pipeline tracking and risk management are all controlled by on-line terminals in the branches," McInerney says. The system gives American Residential's executives the ability to do on-line edits of applications for information that changes in the process or was entered wrong. It allows for automatic lock-ins of rates and commitments. More important, it gives an up-to-the-minute, accurate picture of what is in the pipeline, and it gives management the ability to instantly lock out the branches from entering further commitments at old rates if the market takes a sudden turn for the worse.

Fuller says they initially started developing the computer system for a secondary marketing point of view. They took that approach "purely out of self-defense, because the pipeline kills you." They developed a system with on and off switches so the secondary marketing team can turn a switch and close the branches off from getting commitments. "Think of sitting in a jet fighter with a bunch of switches in front of you. That's what our secondary marketing staff has," Fuller says.

The on-line system gives extensive information about all loans coming through the pipeline. As a result, "we know our fallout down to a tenth of a percent," Fuller adds. The system also has extensive automated edits built in, so that by the time the loan enters servicing, there are very few loan set-up errors.

The commitment to technology as a fundamental support to the business is well ingrained in the culture at American Residential, according to McInerney. Welsh Carson found clear evidence that the most senior managers at the company were completely familiar with the system's role in their operation. "The culture was all the way up at the top of the company."

As far as the due diligence the venture firm did on the industry itself, the results showed clearly that there would be a lot of servicing coming to the market in the near future. McInerney found out what many in the industry have long known--even healthy thrifts would be selling servicing to meet their capital rules. that meant there would be a healthy supply for sale.

The big picture

What kind of returns is Welsh Carson looking for from their new mortgage banking acquisition? McInerney said they would not looking at any investment that would not promise "30 percent per year over a five-year period at a compounded internal rate of return." He added they tend to be very long-term investors.

How big are their ambitions for the servicing portfolio? McInerney says the plan is to grow the portfolio to somewhere between $6 billion and 10 billion over time. They are explicitly looking for acquisitions of servicing and are talking to both the RTC and other prospective sellers. In late January, American Residential was "seriously looking at one very substantial purchase from the RTC." Robbins says the servicing acquisitions they are looking for will be high-quality loans that are seasoned so they have some payment experience that can be reviewed. He says they will probably be buying predominantly fixed-rate loan servicing, with ARMs only if they are fairly standard, plain vanilla variety. American Residential's CFO Judith Field added that they particularly like "high-balance conventional" loan servicing that comes from strong originators with good tract records. She added that prepayments are the major driver of the value of servicing, "that's what gets you those returns." So in the current market, with refinancings on the rise, prepayments are making servicing returns more difficult to count on.

Where will the capital come from to purchae major blocks of servicing? McInerney says if it's a large purchase, the venture capital firm would help American Residential do a financing and raise funds that way.

But Welsh Carson is not the only source of equity capital finding its way to the glimmer of potential servicing returns. Furthermore, when considerable capital finally connects with the available servicing on the market, it is liklely to trigger a new dynamic. As Field noted, that dynamic will produce a price jump for servicing, making returns less attractive to capital investors. Robbins said he believes there will be a one- to two-year window of opportunity before servicing prices start to substantially climb.

Robbins estimated last October that his servicing operation could handle roughly $10 billion to 12 billion more before it would bump up against its current systems capacity. At the time, he said American Residential's servicing portfolio had been built up to roughly $2 billion.

For a management team so fired up about building its servicing portfolio, it seems somewhat odd that the company sold $930 million in servicing in 1990 and bought zero. What held the company back last year from moving on its goal to aggressively build servicing, particularly if Robbins and the others felt so strongly there is only a short window before prices start to climb and big returns vanish?

The principle that applies here is the one about having to walk before you can run. Any company that wrenches itself out from under a major thrift parent organization to set up shop as an independent, privately held, mortgage banking operation that also wants to continue posting big origination numbers has to take care of a few details first.

As McInerney says, "We did the deal in May, and the company spent the first three months [after that] getting its sea legs."

Among the things that had to be wrestled with were the task of finding an outside counsel and an auditing firm, as well as internal administrative set-up chores, such as establishing stock options for managers.

On top of that, McInerney adds, the new independent mortgage company during its first four to five months "spent a good deal of time negotiating a warehouse line."

Timing is everything

In the midst of one of the worst credit crunches in recent history, in the midst of a significant housing slump, there probably could not have been a tougher time to be a new, independent, mortgage banking company looking for a warehouse line. Most people in the business will acknowledge it as somewhat of a coup that this management team and its track record could convince a syndicate of six of the country's largest banks to extend a warehouse line of $270 million in the current environment. For some established, independent, mortgage banking companies, the squeeze hurting warehouse line availability has been a severe problem. But on November 13, 1990, American Residential announced that six banks had established the short-term credit facility to fund originations. The banks included: First National Bank of Chicago and the Bank of New York, as co-lead banks, along with Bankers Trust Company, Chemical Bank, Security Pacific National Bank and First Bank.

McInerney says it was not until November, after the warehouse line hurdle had been cleared, that the new company actually started "getting serious about bidding for servicing."

The timing of this deal is just one more thing that marks the transaction as one to remember. One of the few things that was a clear positive about the mortgage market when this deal was being put togetheer was that certain types of quality servicing were going relatively cheap. But the origination markets, particularly in California and New England, were in a well-documented slump, and consumer confidence was sagging badly. So badly, in fact, it was clear that production volume in 1990 was hardly going to produce any headlines. The fact that American Residential could find venture capitalits willing to take the leap in this environment, let alone banks to provide a warehouse line, is noteworthy.

McInerney says it was clear even as the deal was closing in May that the California housing market "had started slowing a bit." The venture capitalist said that the regional slumps that were apparent in the housing market did not unnerve his company from proceeding because of its confidence in the mortgage company's ability to control production expenses. Numbers on American Residential's performance in 1990 show relatively low production costs for the large origination operation. Performance data released to Mortgage Banking shows that "the average cost of originations is less than 1 percent fully loaded with corporate and secondary market expenses." Production is split betwee two sources; 50 percent comes from retail originations, and 50 percent comes from a wholesale operation.

The compensation system for loan officers "Has significant incentives for the achievement of profitability and disincentives for the lack of quality," Robbins says. So not only are expenses controlled but incentives are built in at the ground level to help achieve corporate profitability. CFO Field says that loan officers are penalized directly for loans that do not come in at the scheduled price. She added that the revenue stream of the loan drives the compensation.

Even so, McInerney says that coincidental with the slide in the housing market, American Residential had furhter tigthened expenses in the branches.

The mortgage company had build up a strong government origination business in the past, but around the time of the buyout, the decision had been made to shift the emphasis toward conventional lending. Welsh Carson took comfort in the fact that American Residential is a national lender with presence in many geographic markets around the country. With roughly 40 branches in 14 states, some of the company's markets were bound to be thriving, even if regional economic downturns were hurting other markets where it lends.

Staking claims

American Residential state a claim at being "a leader in product innovation," according to a fact sheet of company "milestones." Robbins says that American Residential was the first company to put loans of more that $1 million into rated pools to be sold as securities. Another development the company touts on its list of innovations included being the "first to offer no income verification with 20 percent 25 percent down payment, commonly known as the PRO loand." That particular distinction, considering the current fligh way from low docs because of housing depreciation trends in some markets, may or may not survive on the list of "milestones" othe company circulates in the future. But being ahead of the park in introducing that product does demonstrate that the company was an aggressive innovator in its past. Whether current management wants to stay that aggressive on the product side in the current market environment will depend on how good Robbins and his team is at convincing its venture capitalist management partner to take some calculated risks.

Robbins himself admits it makes a difference when your own money is on the line. "Being an owner has changed our decision making." He adds that no matter how cost effectively you thought you ran your company, when you own it directly, you do not approach things anywhere near the same way when you have your own money at risk. He say, "There is no huge amount of capital protecting you from risks. It's your capital and it's sitting on the table. It tends to make decision making probably more conservative. Discretionary expenses are not discretionary anymore."

It is clear that Welsh Carson is deferring to its team of veteran mortgage bankers to call the shots in running the company. McInerney describes the relationship between Robbins, as CEO, and Welsh Carson, as majority investor, in making management decisions. "He deals with us the same way any CEO deals with his board. He runs the company. We are not telling him he ought to look at this, or that expenses need to be cut. He and his managers are running the company." Welsh Carson meets with Robbins and his managers once a month to review number such as operating expenses and the like. McInerney adds, "Unless there's a major investment decision to be made, you pick a good CEO and the he runs the company. I frequently go a week or two without talking to him. I know he has more latitude now than as a subsidiary of First Nationwide."

If this kind of relative management freedom sounds appealing, consider these words of counsel from McInerney. He says there are two things that you don't want to say to venture capitalists who have expressed investment interest in your operation. Number one, you don't say you want to be the biggest, and number two, you don't even hint at a desire to speculate or take undue risks. If you want to successfully court a venture capitalist, this is what you say, and this is the message that John Robbins and his people gave to Welsh Carson: "We have no interest in speculating on the future of interest rates. And we have no interest in being the largest. We are most interested in being the most profitable."

Janet Reilley Hewitt is editor in chief of Mortgage Banking magazine
COPYRIGHT 1991 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:mortgage banking
Author:Hewitt, Janet Reilley
Publication:Mortgage Banking
Article Type:Cover Story
Date:May 1, 1991
Previous Article:Boardroom view.
Next Article:Under new management.

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