What is pref equity?
Tried looking this up and still feel like I have no clue what this is. Can anyone explain this to me like I’m an idiot (I am). Thanks to whoever helps!!
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It is more like debt than it is like equity
Do you know what mezz is?
It's equity, so subordinate to debt, that sits at the top of the priority stack for distributable free cash flow after debt service. It's essentially a 2nd mortgage / b note that is unsecured.
There's also the concept of "soft pay" vs "hard pay".
"Hard pay" pref will often require a minimum cash distribution each month, and may involve other strong armed provisions like managerial takeover rights, etc. This type of pref equity can be seen as problematic to lender's, as they don't want their borrower's to be obligated to distribute free cash flow in times of stress.
"Soft pay" is the opposite and allows for interest accrual, which is much more favorable to the senior note holder. Hypothetically, this additional repayment risk to the pref provider would mean that soft pay costs more than hard pay.
Disclaimer - I work on the debt side & have a basic conceptual understanding of all this. Our borrower's don't tend to use/require pref, but we've explored the option a number of times.
Is there upside as being the pref equity holder? If the spread larger than the other pieces of the stack? As a borrower, does the pref juice your returns, or does it have no effect?
The upside is that you get paid before all other equity & at a decent spread over debt.
AFAIK, pref is in the 9 -13% ish range right now so certainly not juicing any returns. It's used to fill a funding gap. A borrower's goal should be to retire the pref ASAP through either a 2nd mortgage, recap, or sale.
Pref is typically only utilized if the borrower needs more equity than they have themselves and/or they don’t get the financing they need and still have a financing gap. The cost of pref equity is higher than common equity, and therefore ends up being the most expensive capital in the stack. It’s common to see pref equity rates north of a 10%+, whereas common LP equity preferred returns fall in the 8-10% range. With this all said, I’ve worked with partners who will fund the debt proceeds as pref equity in a manner that mirrors a loan, so in other words same interest rate as a lender would charge but the capital is treated as pref equity vs debt. Understand the cost of capital and it will help you evaluate risk/reward.
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