What are the primarily differences between mezzanine debt and preferred equity? They both seem to sit in the same place in the capital stack.
I understand mezzanine debt is a loan secured by the property while preferred equity is only secured by the common equity. Other than that, are there any major differences?
Why would someone go for mezzanine debt versus preferred equity and the other way around?
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Mezz is not secured by the property, but by the entity that owns the property. So if the owner defaults on the mezz loan, the mezz lender forcloses on the ownership entity, not the property itself.
Pref equity, I believe, is structured through ownership documents, LLC or partnership agreements, but can be written/structured to be debt-like or equity-like. I haven't worked on preferred equity, so I could be wrong.
Someone would choose one over the other based on what is offered and what is the better deal. If you are in a situation where you need subordinate debt, Mezz should offer a lower rate than pref equity and that would probably be your first choice. But if the deal doesn't fit for a mezz lender, for various reasons, it might fit for someone offering preferred equity, which could have a higher rate or other more onerous terms. From the perspective of someone lending or investing money, it's all based on how it's structured legally to protect your interest and getting repaid.
This.
There’s other reasons a senior lender may not want mezz debt in the deal. They may want to avoid negotiating a complex intercreditor agreement. Adding debt also increases the risk of other creditor claims during bankruptcy proceedings.
Pref is also (usually) quicker and easier to document than mezz debt. It’s essentially a different equity class within the borrower’s operating agreement instead of a debt instrument with an accompanying set of loan documents.
For the mezz lender/pref investor, sometimes taking control of the property is easier to achieve through pref than mezz in a downside scenario. To foreclosure your interests in the equity pledges as a mezz lender, you need to conduct a UCC sale (while lawyers will tell you it’s quick and easy, trust me when I say there’s PLENTY of ways for a bad actor to delay proceedings, depending on the state). As a pref investor, there are provisions within the operating agreement that allow you to take control of the entity (which may or may not actually be easy depending on how the operating agreement is structured).
So yes, they occupy a similar space in the cap stack, but they differ in how they’re secured.
My understanding is that mezz has recourse to the equity i.e. if the returns are not met they have a claim to the equity. Preferred equity does not have a claim over the equity, it only has a claim over the profit generated.
In the event that the cash-flows are insufficient to cover the mezz interest, the mezz loan holder has a claim to repossess the equity. However, in the event that the cash-flows are insufficient to meet the preferred equity rate, they do not have a claim over the equity. I.e. preferred equity is not “debt”, it is just senior in the profit payment hierarchy to equity.
Why would someone go for mezzanine debt over preferred equity? Because mezz debt is cheaper, but the price you pay for it being cheaper is that they have a more senior claim, being over your equity rather than over your profits.
Edit: May be wrong on this point, but another reason I believe is that senior lenders (real debt) may restrict additional debt in the structure due to a lack of skin in the game for the equity, and so if equity wishes to have more leverage in the structure, they can only leverage over the cash-flows rather than over the underlying asset / equity.
If the mezz is structurally subordinated i.e. holdco debt and not party to the common terms agreement then the senior debt lenders can only restrict the senior leverage and have no say about the total leverage.
In this case, senior lenders see the mezz as equity because they can take control of the OpCo under an enforcement procedure.
The other thing to note is interest deductibility. If at OpCo, mezz interests are probably deductible. If at HoldCo level, then it depends on whether pushdown accounting is allowed by the tax authorities.
Preferred equity probably doesn't have that feature but that depends again on the tax authorities (e.g. Luxembourg let you do it under certain conditions)
Great responses.
Is there usually "upside" to a preferred equity position? Let's say the preferred equity rate is 8%. If the property does well, does the preferred equity get any upside or only the 8%?
I understand you can structure any way you want. But what's most common for preferred equity, upside in the property, or just a fixed return?
That's how i always viewed it. Mezz equity is basically a debt piece, your returns are limited to your interest rate. Pref equity has upside potential, but typically not as much control rights at JV equity.
In practice, a lot of times this comes down to a simple PIK vs Cash distinction. If a Company is trying to call something that toes the line Pref Equity, then a senior Lender is going to require it to either be all or mostly PIK. That way cash flow is not going out of the business which is how the senior gets paid back obviously. In turn, the company doesn't have to count the Pref Equity as debt, which gives them more debt capacity from Senior and Mezz lenders.Mezz is usually soemthing like 10% Cash Pay, 2.0% PIK. Pref Equity is generally 10-14.0% PIK with either no or little cash pay.
Not in RE but Pref also tends to come with some Warrants to boost returns, sometimes there is say a 10% PIK interest and the Pref investors wants a 15% return, they may attach warrants to the Pref to give that extra 5% return.
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