Preferred Equity is a complex, nuanced investment that can make it challenging to properly vet and discern if it is the right and best investment option for you. However, it’s also one of the most secure and profitable investment forms, so it’s worthwhile to explore.
To make it easier to navigate, we’ve compiled a breakdown of the deal structure and a demonstration of why it is such a compelling investment
HOW PREFERRED EQUITY WORKS
The payment priority in the capital stack is ositioned ahead of common equity, which means it gets paid out after the Senior Debt, which is usually the bank, and before the Common Equity. This becomes a crucial safety net during uncertain times. This structure results in lower downside risk exposure compared to common equity.
For instance, if an asset value drops by 25%, the common equity could get wiped out, while the preferred equity and senior debt would be protected.
Preferred equity can sometimes also enjoy depreciation tax benefits, providing potential opportunities for investors to offset profits. This will be depending on the deal, but could be an extra perk on top of consistent returns. Negotiations may also lead to management control rights, offering a measure of control if performance metrics are not met.
For example, if the project is not done on time, if the rents go down, or if the operator isn’t hitting the DSCR, the preferred equity investors can potentially remove the operator in charge. It’s unlikely, and it does create the opportunity for more control.
Additionally, discussions around MOIC [see glossary below] further enhance returns if the preferred equity is paid off early.
However, this window of opportunity is only open for a limited time. Eventually, interest rates will drop, banks will resume lending at higher leverage, and demand for preferred equity will decrease. Increased institutional investment activity and raises in common equity capital will contribute to this shift.
In the realm of preferred equity, competition varies with check sizes. Smaller checks, in the $1 to $5 million range, present a unique advantage for investors due to limited competition, potentially resulting in higher coupon rates and favorable terms. Most of the more established players only deploy $10 million or more at a time.
WHY PREF EQUITY DEALS ARE RARE
While the allure of preferred equity is evident, individual investors may face challenges in accessing these deals due to concentration risks, experience requirements, and the need for a significant network. This is why only a few syndication groups offer these types of deals.
Common equity deals are more attainable for smaller syndication groups and private investors because the structure of preferred equity deals is so complex that legal fees usually cost $20,000 – $30,000.
WHY PREF EQUITY DEALS ARE SO VALUABLE
In the simplest terms, the key thing that is special about preferred equity is that it is as close to a guarantee as possible in an investment. It gets paid out before common equity, at the same requirement level as debt, just after repaying the bank loan.
LEARNING THE LANGUAGE OF PREFERRED EQUITY
Pref equity deals are also fraught with jargon. We’ve curated a comprehensive glossary tailored for our current and prospective investors to help you demystify this process and become familiar with the language.
- Lower Attachment Point: The LTV or LTC where debt ends and preferred equity begins.
- Upper Attachment Point (Detachment Point/Last Dollar Exposure): The LTV or LTC where preferred equity ends, initiating common equity.
- Coupon Rate: Cumulative projected return to Preferred equity.
- Current Pay Rate: Portion of the Coupon Rate paid from operations.
- Accrual (PIK – Payment in Kind): Accrued portion of the Coupon rate paid at a capital event.
- DSCR (Debt Service Coverage Ratio): Net Operating Income divided by Debt Service.
- Global DSCR: Net Operating Income divided by the sum of Debt Service and Pref Current Pay.
- Personal Guarantee: Contractual guarantee by the sponsor or Key Principal to cover Preferred equity in default.
- Major Decision Rights: Actions requiring approval of the Preferred equity Partner.
- Manager Removal & Replacement Rights: Preferred equity Partner’s right to replace the Sponsor as Manager in defaults.
- Forced-Sale Provision: Preferred equity Partner’s right to effect the marketing and sale of assets in case of default.
- Lender Recognition: Formal acknowledgment by the Senior Lender of the Preferred Equity Partner’s rights.
- Default Provisions: Conditions triggering control rights.
- Capital Improvement Reserves: Funds held by the Preferred equity Partner for capital improvements.
- MOIC Floor (Minimum Multiple): Minimum Multiple on Invested Capital is triggered if preferred equity is paid off before the multiple is achieved.
- Equity Kicker: Common equity shares are granted to the Preferred Equity Partner in addition to the Coupon Rate.
- Promote Participation: GP Promote shares granted to the Preferred equity Partner in addition to the Coupon Rate.
- Current Pay Reserve: The Preferred equity Partner controls a reserve account for Current Pay payments.
- Cash Flow Sweep: Preferred equity Partner’s right to all cash flow until covering Current Pay, achieving a predetermined Global DSCR, or completing pay off.
Disclaimer: This article is for educational purposes only and does not serve as the basis for entering into any transaction or making investment decisions. All investments involve risks, and past performance does not indicate future results.
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Ascent Equity Group remains committed to providing expert guidance and insights into the nuanced world of Preferred equity investing.