Scotsman Guide - December 2018 Commercial Edition

eal estate developers and investors, often referred to as sponsors, may want or need to increase leverage above the amount that the sponsor can borrow from a senior lender. Sponsors can fill the gap between the senior debt and common equity by raising mezzanine or preferred equity financing.

Mezzanine financing is a hybrid of debt and equity in which the borrower retains ownership control over the property and its associated business activities. Preferred equity, by contrast, provides a secondary investor with an ownership and decisionmaking stake in the business.

Often, senior lenders may preclude the use of subordinate debt — such as mezzanine financing. In such a case, sponsors need to raise preferred equity to address a lender’s prohibition.

Deal structures

Preferred equity is raised through a sponsor’s ownership entity, such as a limited liability company (LLC), by issuing one or more classes of preferred equity membership interests. This type of financing can be structured in many ways to favor the sponsor by treating it as an equity-like investment, or to favor the preferred equity investor by treating it as a debt-like investment. Here is a sampling of the provisions that may be found in these deals.

Waterfall priority order. A preferred equity investor may prefer a senior/subordinate, or A/B structure, in which they receive their investment and preferred returns in full before the sponsor receives theirs. The sponsor, however, may want a “pari passu,” or equal-footing arrangement, in which the sponsor and equity investor receive their distributions at the same time based on the proportional amounts they’ve invested in the LLC.

Recourse. The equity investor may require the sponsor to pledge their membership interests in the LLC over the entirety of the investment term, or until the sponsor reaches certain designated project milestones — such as obtaining entitlements, a certificate of occupancy, a minimum occupancy rate or stabilization of the property. The sponsor, on the other hand, may seek nonrecourse provisions in which the preferred equity investor has limited contractual rights that are contained in the LLC’s operating agreement. In these cases, the sponsor will likely need to agree to “bad boy” carve-out provisions — focused on areas such as fraud, misappro-priation of funds, waste, bankruptcy or environmental liabilities — and provide a completion guaranty for a development project.

Repayment schedule. The LLC may make periodic payments for some or all of the equity investors’ returns, whether or not the LLC has generated the cash flow to make these payments. Any unpaid preferred returns accrue and are paid when cash flow is sufficient, or as a priority distribution once the property is sold or refinanced. But the sponsor may benefit if the preferred return is paid only from available cash flow after senior-debt payments, operating expenses and any amounts set aside as reserves, as agreed upon by the managers of the LLC. Again, any unpaid preferred returns accrue and are paid if and when funds are available — typically upon stabilization, refinance or sale of the property.

Control rights. The equity investor may seek exclusive authority to make certain decisions within the LLC — such as removing a manager, borrowing funds, selling the property and/or filing for bankruptcy — for an agreed-upon period of time. These rights also may be tied to any recourse provisions, such as the ones previously mentioned. The sponsor, however, may look to have any major decisions approved by the LLC’s managers, including a manager appointed by the sponsor.

Capital-shortfall requirements. A manager appointed by the preferred equity investor may determine if the sponsor will be required to cover any capital shortfalls by loaning funds to the LLC.

If the sponsor fails to make such a loan, the equity investor could have the right to purchase the sponsor’s common interests in the LLC — and, possibly, their preferred interests as well — for nominal consideration. A more favorable arrangement for the sponsor, however, may call for them and the equity investor to fund any capital shortfalls on a proportional basis, based on their respective ownership interests in the LLC.

Membership interests

At or before closing, the sponsor and preferred equity investor will receive common membership interests by capitalizing the LLC for a nominal amount of money — $100, for example. Further, the sponsor and equity investor then receive preferred membership interests for their respective investments in the LLC. These membership interests provide for preferred returns at rates and terms negotiated by the parties.

The equity investor and sponsor, for example, could each purchase 50 percent of the common interests in the LLC. The equity investor may then contribute, say, 80 percent of the project equity and receive what is known as Class A preferred interest, with the sponsor investing 20 percent of the project equity and receiving the first-loss Class B preferred interest.