Real estate credit markets are in a funk. Higher interest rates, nervous banks and shaky asset valuations are combining to drive loan activity to the lowest levels in recent memory. But developers still have good ideas and need money to implement them. How to bridge the gap? One option is preferred equity.
Preferred equity broadens the base of potential funding sources by allowing for an a la carte selection of characteristics of the applicable investment. Want your preferred equity investment to look almost exactly like a mezzanine loan (including by receiving a pledge of the sponsor's shares in the joint venture)? No problem. Or perhaps you would like to structure the investment to look like a typical joint venture except that the sponsor's return is subordinated to your own? Consider it done. The flexibility of this type of investment allows for an easy matchmaking process between those looking to raise money and those looking to deploy it.
How recognition agreements support preferred equity
Preferred equity sits in the capital stack below mortgage and mezzanine debt but above common equity. As such, the interaction between the investor's rights and remedies and a senior lender's interests can create some friction. For example, an investor would almost always have the right to remove and replace the sponsor if the sponsor defaulted in its obligations under the joint venture. The senior lender, however, will often require that the sponsor maintain control and a minimum hold in the venture given their importance to the execution of the business plan. These tensions are often addressed through a "recognition agreement" between the lender and investor.
Recognition agreements increasingly look like intercreditor agreements between a senior and mezzanine lender because the issues they seek to solve are similar (i.e., how to make sure everyone with a claim on the underlying collateral plays nice in the sandbox).
What to include in a recognition agreement
The basic list of rights that the preferred equity investor should look to include in a recognition agreement are as follows:
- Right to remove/replace. The investor will want to ensure that its ability to remove the sponsor and seize their equity is expressly carved out as a "permitted transfer" under the loan documents. This extends to removal and replacement of affiliates of the sponsor that are providing services to the venture (e.g., property management). Lenders will often agree to this with conditions on (i) delivery of replacement guaranties from affiliates of the investor in the same form as the original guaranties provided by the sponsor and (ii) lender's approval over the identity of the replacement or specific objective criteria that a replacement must meet (such as a specific net worth or a certain number/square footage of owned assets in the same class).
- Right to notice/cure. The investor should require that the lender provide simultaneous notices directly to the investor of any defaults under the loan agreement. Further, the investor should be granted the ability to cure the default on behalf of the borrower/venture to preserve its position in the capital stack (often, investors will ask for an additional amount of time to do this following the time period to cure in the loan documents). If the default is not capable of cure by the payment of money, the investor should require the lender to withhold on enforcing its rights under the loan agreement so long as the investor is proceeding to enforce its own rights to remove the sponsor and take control of the borrower. Often lenders will put an outer limit on this amount of time, given that the process of taking control (if contentious) could be lengthy.
- Right to force sale. To the extent that the terms of the investment allow for the investor to force a sale of the property following a default of the sponsor, the investor should have the lender agree to standstill its enforcement of any defaults under the loan documents during the process of marketing and selling the property so long as the proceeds of such sale are used to pay off the senior lender. The cloud of an enforcement proceeding could significantly impact the marketability of the asset.
- Right to transfer preferred shares. If syndication is a potential path to liquidity for the preferred investor, it should look to pre-approve a sale of preferred shares without violating any of the terms of the loan agreement. Often lenders will require that the original investor maintain at least 50% and control of the preferred shares.
There are a number of other provisions an investor may want to include in a recognition agreement, especially those relating to deal-specific matters; however, the above list should give dealmakers a head start on making sure that the preferred investment can slide into the capital stack seamlessly and to protect themselves in a downside scenario.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
