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...