Wednesday, October 27, 2010

Defies Belief
United Development Fund III, LP, (UDF III) is a limited partnership that raised capital to originate and service land and development loans to home builders, both third party and affiliated, that are based in Texas.  It raised its capital starting in late 2006 and finished in early 2009.  At the end of the second quarter, approximately a third of UDF III's assets are affiliated transactions.  On October 22, UDF III released its required per unit valuation in an 8-K that states that the value per unit is $20, the same value that the units were originally issued.

The 8-K lists a variety of valuation methodologies (income, market and asset) and resulting valuations.  Valuations were determined by the general partner and by a third party.  The valuations ranged from a low of $18.05 per unit to a high of $26.19.   The general partner determined the low-end valuation, and the high value was determined by the third party valuation firm.  The passage below discusses the general partner's value reconciliation process and how it arrived at the $20 per unit value:
In determining the Partnership’s estimated unit value, the General Partner considered the independent firm’s range of estimated values per unit of between $18.80 pursuant to an asset approach methodology and $26.19 pursuant to one of the valuation analyses used in the market approach methodology, as well as the lack of marketability discount discussed above. The General Partner also considered its own determination of the Partnership’s assets, less liabilities, of $18.05 per unit, as well as the General Partner’s estimates and projections regarding the execution of the Partnership’s business model set forth in the prospectus regarding the Partnership’s initial public offering of its limited partnership units and the General Partner’s expectation that a public trading market for the Partnership’s units is not likely to develop. The General Partner then determined the estimated value per unit of the Partnership’s limited partnership interests to be $20.00 per unit, which is within the range of values provided by the independent firm.
We are to believe that an original $20 unit price, which paid approximately $2.80 per unit (14%) in offering costs and netted approximately $17.20 per share in net investable proceeds with which to make loans, is still worth $20 per unit?  Well, I don't and here is why.  In general, UDF III took that $17.20 and made loans, and the loans pay interest and principal.  Fine, but the loans don't appreciate, they're generally repaid at par, and some loans don't even pay current interest as is common in the construction industry, principal and accrued interest are due at maturity.

Here is an example:  let's say the fund made a $1 million loan with a twelve-month term and 12% interest.  At the end of a year the fund would get its $1 million back, plus $120,000 in interest.  From that interest the fund needs to pay investors a 9% distribution on the original $20 per unit price, which is approximately $104,650 of the $120,000 the loan earned in interest.  The balance would be applied to the initial 14% load recovery, which only reduces the load by a small amount, so to fully recover the load, the money would have to be recycled 10 times!   Below is the transaction example described above using a $20.00 unit price and fully investing the net proceeds.  It shows that an excess $.26 that could be applied to the initial $2.80 load:

Initial Value:    $20.00
Load:                 $2.80
Net Proceeds:  $17.80

Loan $17.20 @ 12% for one year
Interest:          $2.06

Pay 9% on $20.00 per unit
Distribution:   $1.80

Excess proceeds  $.26 per unit

An astute reader may wonder what happens to loan origination fees and servicing fees.  I believe the bulk of these fees are are paid to the general partner and affiliates and don't stay at the fund.  UDF III's general partner does not have to use the small amount of excess interest to paydown the load, it can use to as part of a new loan or for other partnership purposes. 

I don't see how the independent valuation firm could possibly derive a value of $26.16 per unit.  (Actually, I suspect loan income was somehow capped at a low cap rate with little regard to the actual underlying asset.)   Behringer Harvard and Inland need to find this valuation firm and call it immediately.

This post is not questioning UDF III's business model.  That is a subject for another post or posts, because UDF III's affiliated dealings are worth analyzing.   This post is asking how a mortgage fund with a 14% load is able to publish a value that overcomes its load (and in one valuation significantly exceed the offering valuation) when a portfolio of mortgages does not grow and the fund does not keep origination fees.


Personal and Corporate Sales Coaching said...

I've been concerned with UDF and it's on going practice of simply lending money to affiliates for which they own, as noted in one of your post.

I've tried to redeem, completed the paper work however they claim a lack of liquidity to pay of current redemptions.

Who can I complain too or write too in order to get some help on this?

Rational Realist said...

I would start with the financial advisor that sold you the product. After seeing your comment I went back and read UDF III's third quarter 2010 10-Q. It states that the fund has stopped meeting redemption requests because there have been too many. Fund III's 10-K should be out in the next two weeks. Check the footnotes for an update on redemptions.

Anonymous said...

Interesting, as a rational realist, that you seem to have forgotten that Mortgages do have changing value. The change in value is based upon the "Coupon Rate" of the mortgage versus the interest rate environment. Also a factor is whether the notes pay interest only or principal and interest. Interest only mortgages will have a greater swing in value due to the fact that the principal amount remains the same until maturity or when the mortgage is paid off; just like a bond.

Not getting your facts straight is a huge dis-service to owners of this product. It makes me glad that I can count on a Licensed Professional for advice on matters such as these, instead of listening to someone like you with a limited knowledge of investments.

Rational Realist said...

Thanks for the anonymous comment. I didn't know this fund was now a mortgage trading fund where changing values would actually matter. I thought it just originated constuction/development mortgages (with the sponsor/gp, not the fund, getting all points and origination fees) and then held the mortgages until maturity, hoping the spread between the interest earned and distributions paid, would be enough to off-set the load. (Have your Licensed Professional check on the status whether this fund is reserving enough for its load recovery.) It's good to know it's now like a bond fund, albeit one with a big load, a third of its assets invested in affiliated dealings and where two borrowers account for 60% of the portfolio. You should also have your Licensed Professional check on how much of this fund's loans are now, or will soon be, in junior position to outside senior debt.

I see that this REIT recently received a market valuation of up to $27.61 per share (not to be confused with UDF's internal valuation of $18.41, but since you're an investment expert I don't need to explain the difference to you). You should recommend to your Licensed Professional that UDF try and sell the fund's assets at this price. If the UDF is able to get $27 per unit for a concentrated portfolio of construction loans for a fund that was offered on a loaded basis for $20, this is a trade UDF should make immediately. You should put down the Fabbozi and pickup the 10-Qs.

JCII said...

I too should have easily predicted these issues with UDF. They had substantial unfunded liabilities prior to going public and leading up to their taking IV public there are a substantially high number of redemption request that were cancelled. As one who is affected by this I'm angry at those who should've been responsible for reviewing their documentations prior to allowing them to go public. Even so slightly more angry at not being notified about them having been under investigation since mid 2014. It is sad that while many of us will lose large amounts of money others who listened to UDF preach how great things were and bought into their "peter to paul" dynamics will find themselves also held responsible. I firm believe after reviewing their cancelled redemption request on UDF III leading prior to UDF IV going public that they ultimately convinced their representatives to persuade the limited partners into cancelling their redemption requests with the upside of making a few extra dollars when III was rolled into IV as a publicly traded REIT. As a matter of fact I'm not really convinced, I'm more sure than anything. How else to they get 90% of those who wanted out to cancel their request and remain in the fund? And the audacity of them to say some blogger put something on the internet and that is the reason they're not able to pay distributions any more? Crazy, a blogger posting something on the internet? Yeah right. How about the truth like what really happened "the FBI raided the offices and...."

I'm a hair furious with the leaders of UDF they knew exactly what they were doing. Making loans to themselves charging outrageous fees and using those fees to keep them afloat. Where is the SEC in not identifying them for what they were before letting them go public? We have for far to long allowed the status, wealth and educational backgrounds of people to act as credibility and this virtue or public perception needs to stop. They used our funds and money to have a high class lifestyle affording them and others like Madoff to appear as honest and trust worthy individuals.

The gates of hell will welcome them all in due time, them being those who openly knew they were misleading investors and benefiting at the expense of others.