A/B Note Structure
Can anybody explain how an A/B note structure works?
this is for multifamily bought in 2021-2022 and financed by debt fund. New capital offering to come in at loan amount and proposing A/B note structure. They way the new capital explained the waterfall structure was 1) their equity gets a xx% irr, 2) then B note gets repaid, 3) then a split between new capital and original sponsor (hope note).
if anybody here has experience w these structures would like to clarify understanding. Thanks in advance.
Don’t know much but will put in my 2 cents anyway. Based on what you described the original sponsor is pretty much losing the asset and will only see returns if a miracle occurs. Do you have more information about the deal?
What are your questions? You described a "workout" or "rescue financing" transaction pretty well.
My question is the b note just a portion of the original loan that the new sponsor is getting the lender to accept as subordinated to new sponsor pref? Is the purpose of it to reduce the new sponsors risk? Why would lender accept / not accept?
also, what is a typical IRR hurdle, and also split between new sponsor and old sponsor after IRR hurdle met and b note repaid? Does the b note still accrue interest at original loan rate?
sorry for the word vomit. Lots of questions as have never encountered this before. Also curious if there are other structures to resolve this type of issue (over leveraged borrower that needs rescue capital to avoid foreclosure). Thanks
A note - keeps interest rate and needs to keep being paid first.
B note - Keeps interest rate and likely doesn't need to be paid right now but all payments are tacked on to the loan principal.
In general this a bad structure. It is a hailmary play for the lender and a bad deal for anyone in the equity position. Lenders have bills to pay too, so it won't workout for them except in extremely rare cases.
The new sponsor is paying off the debt fund and becoming the new lender, right?
So they are essentially recapitlizing the deal at that debt level.
The hope note is essentially saying that the current equity is wiped, but if there is some upside, they might be able to get something back.
So total deal was 100mm. But loan is 75mm/25mm equity. The new equity partner is paying off the 75mm loan, and becoming the new lender (to give themselves a senior secured interest).
Say in 2 years, you sell the property for 95mm. 75mm is used to pay back the new "lender", they get their return (say 10mm) and then the remaining 10mm is split.
The only way this could be good for the existing sponsor is if they are released from all guarantees on the loan.
If the lender still has a hook in the original guarantors, they will ride out that guarantee until they bleed every last dollar. I am not saying they shouldn't do this. They agree to lend on the deal because of their first position and the borrower guarantees. Lenders are only concerned with getting their money. Any modification they propose is to increase their odds of getting paid back.
It is often better for the borrower to cut their losses and move on. Wasting years working out a deal that is never going to work out for the investor is bad for everyone except the lender. It is usually bad for the lender too becuase they waste their time grasping onto burning straws.
A little more color on the situation:
institutionally owned asset historically, consistent history of operating around 95% occ. syndicator bought at peak pricing in 21/22. Deal now 75% occupied from poor management. If you put a market cap rate on the impaired NOI today the deal is +/- worth the loan balance.
in the scenario I am seeing, the new sponsor is not paying down the existing debt. They would bring equity to the table for stabilization costs, capex as needed, etc.
my understanding is the original loan gets split into two notes: up to 80% ltv would be A note, and the remaining 20% (from 80% to 100% ltv) would be the B note. After paying off the A note, the new sponsor would earn 20% on any new equity injected into the deal. After that the B note would be paid off. Finally, if anything is left over, the remaining proceeds would be split 70/30 or 80/20 between new sponsor and old sponsor.
Understand comment above that this is usually not a profitable structure. At the same time, it does feel like there is pretty easy value add by just stabilizing operations. Even further upside if you have capacity to hold to more favorable capital markets environment.
why would each party do this?
old sponsor - pretty obvious. Take this deal with potential to reclaim some equity down the road, or turn the keys over to the bank and kiss 100% of equity goodbye. Relatively no risk going forward as they will be placed into passive position and not required to contribute go forward capital.
new sponsor - controlling the property at the loan balance. If able to operate effectively fairly low hanging fruit. Somewhat protected by having priority of repayment over the B note.
lender - not entirely sure why a lender would accept this structure. If they truly believe their loan is impaired, maybe they are willing to subordinate part of the loan to have a strong new sponsor come in. On the other hand if they have any ability to operate the asset themselves they would probably prefer to foreclose and retain all the upside to themselves.
thoughts?
A lender would only consider this if they didn't have a way to operate the property themselves, were worried about capital charges, or as you mentioned, thought they were impaired themselves.
A more common structure would be:
Original Deal: 100MM
Original Loan: 70MM
New Sponsor "buys" at 70MM, pays down the original loan to $56MM (80% loan to current value) and New Sponsor takes the b-not from 56MM-70MM; The new sponsor puts in money to get the property stabilized, gets their pref (including on additional dollars spent), and then splits anything above that with the old sponsor once the deal exits.
Maybe I’m understanding it incorrectly and the new sponsor is in fact paying down the existing loan to right size the ltv. You could be right. If that’s the case it makes a lot more sense from lender perspective by reducing their exposure. But I also think if new sponsor puts in that much equity up front earning a 20% pref that there is not a lot left for old sponsor on split.
That is why they call it a hope note. The old sponsor hopes to get something from it, but it isn't generally base case.
We've explored similar structures with lenders, not the existing operators.
There are a dozen ways to skin the cat but the primary objective it to "convert" the existing debt to more of a participating pref.
Sponsor Defaults on the loan, lender takes back the asset, new operators steps and provides equity to reach stabilization and a pref is paid on those dollars.
In terms of order of payment, 1. go forward equity w pref, 2. senior debt, 3. catch-up for lender (return similar to pref), 4. split 60/40 or 70/30 (depending).
What has been the reception from lenders?
A workout like this is most likely only available to you if the lender is a debt fund (or the loan is purchased by a fund/hedge fund). Agency most likely won't entertain and life companies/banks would most likely sell your loan before they agreed to a modification like this.
Mixed - the structure works best for a specific subset of lenders. Some lenders are motivated to do anything possible to avoid selling a loan for pennies on the dollar or write it down significantly. Solutions that align with those interests seem to resonate. Realistically, it just hasn't gotten bad enough yet. Our house view is '24 is "moving year" for lenders and GPs out of the equity.
No Agency - money center banks, regional banks, debt funds, etc.
What we are seeing is consistent with what you are describing in terms of when this all reaches a boiling point. Right now still feels like a stalemate — equity doesn’t think deals are worth the debt but lenders aren’t ready to recognize any impairment.
Does anyone of an excel model showing how this works?
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