In today’s commercial real estate debt markets, senior lenders often struggle to provide borrowers with the proceeds, and loan-to-value metrics borrowers need. More sponsors are considering subordinated debt structures as an alternative to raising more expensive equity capital. Subordinated debt options are often accretive to transactions, allowing sponsors to maintain ownership and control. It is not so commonly understood that subordinated debt has two subcategories – preferred equity and mezzanine loans. While each act like debt, and look like debt on the capital stack, there are several noteworthy differences between the two that sponsors and investors alike should be aware of.
Perhaps the most fundamental difference between preferred equity and mezzanine debt are the methods used by the capital sources to secure their investments. A preferred equity investment is written in the LLC operating agreement or LP agreement and is technically an unsecured investment as there is no collateral in the traditional sense.
However, a preferred equity investor owns preferred units in the LLC – commonly referred to as “class A units” – which have a priority on distributions ahead of common equity investors. This ensures that the preferred equity investor gets their principal back, and often interest, before the common equity investors receive their distributions. On the other hand, mezzanine lenders are almost always secured with a recorded lien on the equity interest in the entity that owns the underlying property. Additionally, a mezzanine lender may have a second mortgage on the property.
The two types of subordinated debt each have slightly different ways that they are repaid principal and interest. They are both usually contracted to be paid interest on a periodic basis (either monthly or quarterly). This is called the “current payment,” or “current return.” However, the total interest rate is not always paid through these current payments.
A lender often receives interest payments that are accrued and unpaid until the term of their investment matures. A preferred equity investor calls this accrued interest, while the mezzanine investor usually refers to this as paid-in-kind (or “PIK”) interest. The reason for this name, is because interest is paid “in kind” as an increase in the principal balance owed, instead of cash at the time it is owed. Both types of capital may participate in the upside of a project, in addition to interest payments. However, a mezzanine lender usually stipulates a percentage of participation in net profits. Meanwhile, a preferred equity investor’s upside participation is usually in the form of ownership in the common equity, as defined by the “distribution waterfall” in the operating agreement.
While many capital sources prefer mezzanine debt given the ability to place recorded liens on collateral, the senior lenders are often opposed to a mezzanine lender sitting behind them on the capital stack. This is mainly because an event of default may create a complicated workout process between both creditors. Furthermore, the first mortgage lender often gives up some control to the mezzanine lender to cure a default. For example, a cure period provides the mezzanine lender with a certain amount of time to pay off the first mortgage lender, and this is time that the senior lender does not have to start their foreclosure process.
Preferred equity offers senior lenders an often more attractive alternative structure to mezzanine debt, as the preferred equity investor is technically equity on the capital stack. Still, many lenders take issue with preferred equity investors’ control within the entity. Their ability to take over management in a default situation removes the sponsor and transfers control to the preferred equity investor. Many senior lenders, such as Fannie Mae and Freddie Mac agencies, do not allow preferred equity to stipulate any material events of default. For example, a “hard payment” requirement would allow the preferred equity investor to assume the management position in the LLC if the sponsor misses a distribution. Therefore, agency lenders only allow “soft payment” structures where the manager is not required to make any distributions until payoff of the senior loan.
Mezzanine lenders have the ability to file foreclosure on the equity pledge, which enables them to become 100% owner of the property-owning entity. Alternatively, a second mortgage allows them to force a sale of the property. Preferred equity investors do not always have the ability to simply take over the asset or force a sale. They must abide by the operating agreement which stipulates the contractual remedies of events of default, such as removing the sponsor as managing member.
The operating agreement is often negotiated heavily between the sponsor and preferred equity investor, and has many other negotiated consequences in events of default such as a loss of voting rights; ability to force a sale; ability to purchase the asset; sponsors’ economic incentives, etc. Simply put, the operating agreement is a more malleable document vs. more cut-and-dry mezzanine loan documents.
Unlike preferred equity investors, mezzanine lenders have potential for lender liability claims which can restrict their ability to become too involved in interfering with the borrower’s operations. However, approval rights for preferred equity investors can be substantial as they do not have the same lender liability concerns. These are usually negotiated on a deal-by-deal basis, but include oversight of major decisions such as purchases, financing activities, or other material decisions by the manager.
This is a general overview of the differences between the two capital structures. However, there are several other variables that could be covered in a more exhaustive essay, such as tax treatment, documentation, transfer rights, and bankruptcy risks. For a more in depth understanding, we recommend that you speak with your appropriate legal and tax counsel.
If you are thinking about whether subordinated debt is a fit for your project, contact us to be your guide.