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.
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.
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.
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by contrast, provides
a secondary investor
with an ownership
stake in the