What exactly is Pref equity ?
New to RE and want to understand the terminology used in the industry.
I see the term Pref Eq floating around but I don’t actually understand it fully. I do understand the cap stack and what usually happens in an event of default. I also understand that sometimes Mezz is used to fill the capital stack when there’s the senior and equity in place.
But where does Pref equity sit? Why do people opt for it? Can someone break it down to me please using a RE example.
Thank you all
Preferred equity and pref are two different things and the terminology could really be improved. The distinction is as follows:
Preferred equity is a separate class of equity that has to be paid a set return before the common equity gets paid. This is usually filling a hole in the capital stack between senior debt and regular equity.
Preferred return or Pref shows up in waterfalls governing how the GP and LP divide returns over a certain threshold. This can occur in any transaction with a GP and LPs.
Here's a kicker, what's the difference between Pref Equity and Mezz Equity?
So my firm does both. They are effectively the same thing, but pref gets structured in a way that it is referred to as equity from an org standpoint and does not get the scrutiny mezz gets, especially from specific GSE lenders. With that said, they also get different tax treatment.
Generally mezz is considered debt and pref is considered equity. Everyone structures and refers to them differently but at my firm we generally consider the major differences below:
Mezz would be debt that is subordinate to the senior, i.e. it would have another type of collateral which is generally a pledge of equity from the sponsor, and an intercreditor agreement (ICA) with the senior. In a case of default, when the senior would try to foreclose on the asset itself, the mezz would be able to foreclose on the equity interest in the deal and take over the entity that owns the asset, the ICA would then be the agreement governing how the two entities (the mezz and senior) would work together, like a period to for the mezz provider to cure any defaults etc.
Pref generally doesn't have those similar rights and no real collateral, which is usually because the senior lender wouldn't allow it and wouldn't engage in an ICA. The pref then has other rights like forcing a sale to protect their interest, or taking management controls, etc.
Both of these pieces also sit in the same spot in the capital stack, where the equity is the lowest priority and the senior is the highest priority, these would sit somewhere in the middle, but if there were both (on a rare case) it would most likely be mezz being senior to pref.
Preferred equity and mezzanine act similarly, yet are different. Mezzanine financing has strict rights to foreclosure (through an affirmed court driven process) via UCC Article 9 and is unsecured. Preferred equity similarly may act like mezzanine debt; however, there is not typically a tried and true method of controlling the common equity (relative to mezzanine and UCC) and equity agreement stipulates terms (assignments, defaults, cures).
With that in mind, does Mezz Equity typically price lower than Pref Equity?
"Mezz Equity" is a misnomer and I think is unnecessarily confusing because no one uses this term. You can have either (i) a mezz loan (debt that sits behind the mortgage loan and is secured by an equity pledge - in a simple transaction, the pledge would be in the propco) or (ii) preferred equity investment (a special equity interest granted to the preferred equity investor in exchange for the preferred investment).
The reason for pref equity is that most mortgage loan docs have restrictions against mezz loans but are less clear on prohibiting preferred equity. If an asset is in trouble and a mezz loan is prohibited, then borrowers typically will look for a preferred equity investment to bridge the gap.
Preferred Equity investments typically have a guaranteed return (like interest paid on a loan) and a redemption date (like a maturity date for a loan). A downside of preferred equity is that things can get dicey if a removal event occurs (similar to an event of default for a loan) because any change of control/transfer of interests from the borrower to the investor may trigger a default under the mortgage loan. You can try to solve for this by getting a recognition agreement between the preferred investor and the mortgage lender but easier said than done - especially if you're not so sure that the preferred investment is permitted in the first place.
In my experience, you're better off making the preferred equity investment first, and then go talk to the mortgage lender about it after you close. If you ask the mortgage lender before you close, they'll take forever and you'll never close.
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