Preferred Equity: Everything You Need to KnowStartup Law ResourcesVenture Capital, Financing
Preferred equity is a general term for any security (stock, limited liability units, limited partnership interests) that has priority over common equity. 5 min read
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Preferred Equity: What is it?
Preferred equity is a general term used to describe any class of securities (stock, limited liability units, limited partnership interests) that has higher priority for distributions of a company’s cash flow or profits than common equity. Typically, all cash flow/profits remaining after required payments to a company's lenders are distributed to the preferred equity investors until they receive the full amount of a previously agreed upon return, commonly stated as a fixed percentage annual rate.
Preferred equity can also be thought of as form of equity measurement that takes into account the company’s preferred shareholder equity and disregards common shareholder equity. Another way to put it is that preferred equity equals total shareholder equity less common shareholder equity.
As with common equity, preferred equity represents an ownership interest in the company. That interest, however, is unsecured and does not provide its holders with direct recourse to company assets, as is the case with secure debt holders.
Preferred equity investment can be complicated and should not be considered without the advice of competent legal and financial counselling.
Preferred Equity and Real Estate
Preferred equity is widely used to describe a specific type of investment in commercial real estate projects. Investors buy a direct ownership interest (“equity”) in a limited partnership (LP) or limited liability company (LLC) that owns real property. In return, the investors get the right to receive a fixed rate of return on their investment (typically 12-16% per year) that is paid before other ownership interests in the LP or LLC. Preferred equity investors are repaid the original amount of their investments either at a set date (the “maturity date”) or when the property is sold.
The company owning the subject real property will usually have different classes of investors and tiers of lenders. Preferred equity holders rank senior to investors who own common equity, but rank junior to the holders of the loans (or bonds) used to finance the real estate project. In other words, when the property generates income from rent-paying tenants, or profits when the property is sold, preferred equity holders are paid after the lenders (or bond holders), but before common equity holders.
Why is Preferred Equity important in Real Estate?
Using preferred equity in real estate projects allows the project sponsors to contribute less of their own money, while providing preferred equity investors a higher-yielding investment that generates consistent cash flow when interest payments are made. Preferred equity investments are less risky than common equity investments because preferred equity investors get paid before common equity investors. Because the rate of return is fixed, however, the returns of preferred equity investors are capped (unlike the riskier investment of common equity investors) and do not have the same upside potential as common equity investments.
Project sponsors like to use preferred equity because it is more flexible than other sources of financing. Preferred equity agreements can be designed up to function more like bank debt, or more like preferred stock in a corporation.
Types of Preferred Equity
There are two types of preferred equity:
Debt (or “hard”) preferred equity. Debt preferred equity requires the LP or LLC to make regular monthly interest payments (at higher interest rates, if those payments are late) to preferred equity investors, while additionally providing those investors with remedies similar to those of lenders (banks) if the investment is not repaid by the maturity date. For example, failure by sponsors to make timely payments to debt preferred equity holders may result in the sponsors’ loss of project ownership or management control to the debt preferred equity holders.
Equity (or “soft”) preferred equity. With soft preferred equity, interest payments are made to soft preferred equity investors only when a project is generating sufficient cash flow (enough to pay lenders and operating expenses.) Soft preferred equity agreements often do not have a fixed maturity date or absolute payment obligation, or come with the harsher remedies provided to hard preferred equity holders.
Reasons to consider using Preferred Equity.
- Conventional senior and mezzanine financing is unavailable or insufficient for the project.
- The project’s sponsors want to leverage the property by more than 80% of the property’s value, that is, beyond typical mortgage investment amounts.
- The sponsors wish to avoid investing more of their own money if lenders refuse to fund the project in the desired amount.
- Preferred equity investors are often not required to sign an intercreditor or subordination agreement with the project’s lenders. This can simplify the transaction and permit an earlier closing date.
Reasons to consider not using Preferred Equity.
- Traditional forms of financing are available in the amounts required by the project’s sponsors.
- Senior lenders may decide to treat preferred equity just like subordinate debt, with a lengthy due diligence and underwriting process, and require an intercreditor agreement.
- Preferred equity investing may not be possible if lenders won’t allow for preferred equity investors to possess effective default remedies.
- Not finalizing the preferred equity structure with investors with enough time to allow the lenders to do the research and underwriting they wish to do (this can cause a delay in the project’s closing.)
- Not anticipating that senior lenders may require a full underwriting process before agreeing to the preferred equity financing.
- Not understanding that senior loan agreements prohibit preferred equity investors from exercising many potential default remedies.
Mistakes in preferred equity investment can result in significant financial losses and legal entanglement. Seeking the advice of legal and financial professionals is strongly advised before agreeing to any form of preferred equity investment.
Frequently Asked Questions
- How is preferred equity different from mezzanine financing?
Mezzanine financing refers to a hybrid form of debt and equity financing in which the investor has the right to convert his investment into an ownership or equity interest in the company in the event of default, following payment to senior lenders. Additionally, interest payments are often deferred until the mezzanine loan maturity date, when all interest and principal is required to be repaid in a single “balloon” payment.
In regard to real estate, mezzanine financing and preferred equity are similar in that, in both cases, payments on investments are subordinate to those made to lenders, but senior to payments made to common equity investors. Mezzanine financing and preferred equity, however, differ in that mezzanine financing is structured as a loan secured by a lien on the subject property, while preferred equity is an investment in the entity that owns the subject property itself. In addition, in the event of default, mezzanine lenders exercise remedies through the Uniform Commercial Code’s sometimes complicated and time consuming foreclosure process. Preferred equity, on the other hand, is structured as an ownership interest in the entity that owns the project, with investor remedies contained in the the language of the entity’s operating agreement, thus avoiding the difficulties of the UCC foreclosure process.
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