What happens when strategy comes up short and a promising formula needs a re-write.

By Roberta Maynard

It was 1991 -- not a very good year for builders in most places, particularly in California. A recession had taken hold. Banks and savings and loans -- the primary sources of home building capital -- had been wiped out.

Yet in the S&L ruins, two businessmen saw promise. James Pugash, who had worked in the commercial sector, and Richard Werner, who had been running a large thrift program, saw an opportunity to provide financing to builders for residential projects. Benefiting from the 1989 thrift "bailout bill," which shifted billions of dollars of capital from thrifts to pension funds, the two founded an institutional investment company called Hearthstone Advisors.

Werner was a CPA with extensive builder connections and know-how, and Pugash brought Ivy League credentials, including a degree in economics from Yale and a law degree from Harvard. Pugash was to be the fundraiser and Werner the operations guy.

"Rich was the best person to be my partner," says Pugash, recalling the early days of the San Francisco–based firm. "At that time, no one else could have filled that role. He had the credibility and the contacts."

Money to Lend

All the partners needed were investors to fund home building projects. After 600 cold calls and monthly visits to some companies' board meetings, Pugash got a commitment from CalPERS, the huge California Public Employees' Retirement System, for $75 million to create Hearthstone's first fund.

It was January 1992, and home building capital remained hard to come by. As the partners expected, cash-tight builders were eager to do business with Hearthstone. In time, the firm started a second fund, then another after that, each time expanding and diversifying its investor base.

Seven years later, though, the firm was struggling. Many Hearthstone builders were not performing adequately, and the partners were at odds with each other over corporate strategy and how to run the operation.

"You had to make sure you weren't caught between the two," remarks a former Hearthstone builder who asked not to be named. The partners' conflicting visions for the firm led to litigation and an eventual buyout of Werner.

But before that came disaster.

In 1999, with the home building industry in thundering overdrive, producing record volume and revenue, Hearthstone took a huge loss in the form of a $50 million write-down. Pugash still winces when recalling the event he soberly describes as "extremely painful."

As for what went wrong, time and reflection have provided insight for Pugash, whose rise to CEO in 1999 coincided with Werner's retirement.

Hard Times

It was a classic case of market timing making an unworkable plan briefly workable. The strength of the market had produced enough successes, particularly in California, to hide the fundamental problems, says Tom Bruin, Hearthstone's COO. It wouldn't be the first time, he says, that good market timing was mistaken for a brilliant strategy.

That was clearly the case, says Pugash. "Our original model was flawed. It worked for a few years because builders were so desperate for capital." The model was to give small companies as much as 100 percent equity financing and for Hearthstone to guard its investment by zealously managing the project's finances.

The first fund had been a great success, but during the second, serious problems arose. Some projects had significant cost overruns. Most were performing, but not according to plan, and crises were frequent. "We'd constantly be getting negative surprises [from our builders]. I had a feeling that our business was harder than it should have been," recalls Pugash. "Even prior to 1998, I thought there must be a better way of doing this."

When the asset write-down turned push into shove, the company took a long look at its operation. One of the first aspects to come under examination was its builders. These were primarily small, local companies that got from Hearthstone nearly all, if not all, of the capital needed to buy land.

"In a lot of cases, the smaller companies didn't have the organizational strength or capacity to execute the projects they were bringing to us," explains Bruin, who came to Hearthstone in 1999 from Town & Country Homes in Chicago. "They tended to have shoestring budgets … . They saw Hearthstone as a last resort. And we were doing deals we never should have done."

Fixing a Hole

Hearthstone had a reputation in those days for inflexibility. Werner and Pugash had reasoned that their typical builders needed help, structure, and discipline. The company kept a tight rein on the finances, requiring builders to create project budgets using Hearthstone's chart of accounts and to use Hearthstone's F.A.S.T. system. All payments to vendors were made by Hearthstone.

More often than not, the result was an overlay that didn't fit the small business' operating structure and that bogged things down. Pugash recalls that the firm required builders to use a voucher system for payments that involved sending Hearthstone copies of every invoice. "For every two projects they did with Hearthstone, they had to hire someone to handle the paperwork," he says.

"Under our old philosophy, we'd have a tough deal structure and documents and controls to protect ourselves … . Maybe because controls were so tight, we were reluctant to use them. It's like having only a nuclear weapon in your arsenal. You're reluctant to use it, but you don't have anything short of that." In truth, says Pugash of the old system, the builder wasn't on the hook for anything. "When you don't have money at stake, you make decisions differently."

For the sake of its survival, Hearthstone made some decisions of its own, and the result was a corporate metamorphosis. "We didn't fix the old system," explains Pugash. "We threw it out."

New Sights

One of management's first moves was to shift to larger, better-managed builders, including Kimball Hill Homes and Crosswinds Communities, and to require builders to make larger investments in their projects. The record painfully showed that working with small, cash-hungry builders meant Hearthstone attracted those with the fewest finance options.

"Small builders were outclassed in the market," says Bruin. "We just said this is crazy. We have to find a different model." Put another way, Pugash says, "We don't want to do business with builders who need our help ... . It used to be that we didn't discriminate between $1 million and $25 million deals. Now we don't want small deals. They're uneconomic."

As the company reconfigured itself, Pugash cut the number of builders from 40 to 20, seeking fewer, but better relationships. A few years ago, Hearthstone did no business with public builders. Now, it does a half billion with the likes of Beazer, KB Home, Sares-Regis, Western Pacific, and Meritage.

For those builders, Hearthstone offers what Bruin calls balance sheet treatment. Its non-recourse arrangements leave builders' debt-to-equity ratios unaffected and allow them to do a deal when they've hit the limits on other types of debt or when division presidents have already used their allocation of money for land.

Similarly, well-managed private companies can act on an opportune deal when their regular finance streams are already committed elsewhere, explains Bernie Glieberman, CEO of Crosswinds Communities in Novi, Mich. "The best deals will come at the same time," he says. "That's the way the world works." In addition, he adds, Hearthstone's deal structure offers builders valuable capital gains treatment on land.

"This type of financing augments," says David Hill, CEO of Kimball Hill Homes in Rolling Meadows, Ill. "Instead of five lenders, we have another, unregulated one capable of providing a different type of deal."

Given its new clientele, Hearthstone loosened its infamous financial controls and put its effort into extraordinarily strong due diligence--what Bruin calls a full-blown, bank-type review--and better customer service. It threw out its $1 million investment in a computer and accounting system, and the old voucher system went by the wayside, replaced by draws accessed via the Internet. "Now we pick good people and trust the people rather than the documents," Pugash says.

In the old days, larger private builders had avoided working with Hearthstone, complaining of the expense. The company made changes in that arena as well. "It's not that the cost of capital was out of line in relation to the risk we took," says Bruin. "But it was a structure many good builders were not willing to accept because they had the ability to mitigate many of the risks we were trying to get paid to take … . The ‘old' type of builder we did business with would put up with these terms just to get the money to finance their projects," he says. "What has changed is our willingness to be more flexible on pricing commensurate with the size, complexity, and duration of the projects, and the builder's financial strength and willingness to protect our downside when things other than the market go bad."

There were other changes as well. For example, the old Hearthstone didn't jump on problems quickly enough. Now, it's very aggressive at the first hint of trouble, says Pugash. "It's a merciless business in the sense that if you let problems fester the time and money will eat you alive. Your competitors will eat you alive."

Operations were restructured. It used to be that the regional people who monitored the builder relationships were also charged with getting new business, making them both buyer and seller. They were under pressure to endorse deals to meet quotas rather than evaluate the viability of the project. Moreover, as former builders, they tended to befriend builders rather than be the cynics they needed to be. In 1999, Bruin and Pugash divided those two functions and built a wall between them.

"There are a lot of things we could have done better," says Pugash. "We learned that we should never make changes without first asking our builders how it affects them. They're going to save us from doing something stupid."

And management learned to deal with nervous investors. When Pugash grasped the severity of the firm's situation in 1999, he chartered a jet and visited every investor to break the news in person that Hearthstone's forecasts and reality were far out of sync. "We told them right away and in person and met with them every three months for the next year. We had an open book."

"There's a good lesson in this," he says. "People will forgive you if you're honest and sincere. They'll root for you. Our investors could have really crucified us. Instead they supported us." And not one jumped ship.

For the better part of a decade, it was a rocky ride, but one with a happy ending. Hearthstone's current and fifth fund, which closes in 2004, is valued at $494 million, more than twice the value of any of its previous funds. The company realized record profits in 2001 with revenues of $817 million on nearly 5,000 home and lot sales in 275 communities. Its $700 million in commitments in residential projects marked an 8 percent increase over the previous year. Where the company had written down its assets, all but one project performed as projected. These days, investors' return on capital is stronger than ever, says Pugash.

At its worst, he says, Hearthstone was a C- company. Now, he rates it a B+. "I hope by the end of the year, we'll be an A."

Added Value: Using its initial CalPERS association as a launch pad, Hearthstone expanded and diversified its source of investors. The company will begin raising money for its sixth fund in 2003, and, this year, will fund 90 home building projects in 20 states. Its average investment of $10 to $15 million finances part or all of a 100 to 200 home development with a 34-month life.


Fund Date started Value
1st Fund* 1991 $75 million
2nd Fund* 1994 $60 millions
3rd Fund 1994 $135 million
4th Fund 1997 $120 million
5th Fund 1999 $494 million

*CalPERS only

Cash Source

Public Investors: 65%

Private Investors: 35%

Hearthstone's public investors include CalPERS (California Public Employees' Retirement System), State of Washington Investment Board, City of Boston Pension Fund, Dallas Fire and Police Pension Fund, State of North Dakota, County of San Diego, four universities, and GMAC. Confidentiality agreements, says Hearthstone, prohibit release of some of these investors as well as the names of private investors.

Hearthstone's Team

  • James Pugash, CEO
  • Thomas G. Bruin, president and COO
  • Mark A. Porath, senior vice president and CFO
  • James K. Griffin, senior vice president, eastern United States
  • Anthony I. Botte, senior vice president, western United States
  • Tracy T. Carver, general counsel and senior vice president
  • Robert Meltz, chief technology officer