A preferred equity remedy is only worth what an intercreditor agreement lets it be worth

This is a structure worth studying closely, because the coupon on paper and the remedy in practice can be two different things entirely. Say an investor takes preferred equity in an adaptive reuse deal, 11 percent current, 4 percent accrued, one asset, a nine story office building converting to 132 units in a secondary Sun Belt CBD. A $4.1m pref tranche sits behind a $52m construction loan. Cash flows on schedule for eleven months. Then the job runs long, say seven months, mostly permits and a mechanical redesign after undersized riser cores turn up for residential fixture counts. Current pay switches off and starts accruing under a clause that reads temporary but isn't. The real risk sits in the remedies themselves. A payment default typically bumps the accrued rate, say to 16 percent, and gives a right to remove the manager. Both are commonly subject to an intercreditor agreement with the senior lender, one that standstills the pref for as long as the senior loan stays in balance. A sponsor's guarantor funding an equity cure, say $3.9m, can keep the senior in balance while the sponsor sits in default to the pref holder at the same time. The pref's only lever freezes exactly when it's needed. Eighteen months later a recap with a new institutional partner can pay the senior down and restructure the equity, offering the pref a choice: take a discount, say 62 cents on the dollar of face plus accrued, or convert into a subordinate common position behind a new preferred return the pref holder doesn't control. Most tranches take the discount, because nobody wants to be last dollar in a building that has already surprised everyone twice. On $300k of face plus roughly $71k accrued, that's about $230k back. An 11 percent current position can turn into a negative return over four years in a deal where the building still gets built and leases up fine. The lesson is to read the intercreditor agreement before the pref term sheet, price the pref off what the remedies are actually worth during a senior standstill rather than off the coupon, and push for a recap consent threshold that requires more than a majority of a tranche the pref holder doesn't control.

Answer

samantha_ruizPassivePRO

You named it yourself in the fourth paragraph and I want to make the mechanism explicit because it catches people repeatedly.

Pref equity in a construction deal is priced as if it sits directly under the senior. In practice it sits under the senior plus the intercreditor plus the guarantor's willingness to cure. A guarantor who can write a $3.9m check keeps the senior loan in balance indefinitely, and every standstill I have read runs off the senior's status rather than off yours. So the sponsor can be paying you nothing, for years, while never triggering the condition that lets you act. Your 16 percent default accrual was real. It was also just a bigger number on a claim you couldn't enforce, and it got haircut to 62 cents along with everything else.

The things I'd have wanted in that document, and I've only ever gotten two of the four in one deal:

A standstill with an outside date, so the freeze expires whether or not the senior is happy. Even 18 months changes the negotiation.

A cash trap that runs to the pref, not just a rate bump. Accrual is a promise. Trapped cash is money.

Consent rights over a recap at the individual holder level, or at least a drag threshold above 66 and two thirds with an appraisal-based floor.

A hard cap on how much the guarantor can cure before your standstill lifts. Unlimited cure rights and a limited standstill are incompatible and most documents pretend otherwise.

The riser sizing thing is the ordinary version of this. Residential fixture counts against an office core is a design question that gets answered in permit review, and permit review is where conversion schedules go to die. If I'm pricing pref on a conversion now, I assume a nine to twelve month schedule slip as the base case, not the downside, and I ask what happens to my current pay in month nine. If the answer is that it accrues and I wait, then I'm holding a zero-coupon instrument at a construction risk level and I should be paid like it.

Whether a given standstill provision actually bars a specific remedy is a question for a lawyer reading your specific documents, and it varies with how the agreement is drafted.

samantha_ruizPassivePRO

2 replies

mikeoconnell7 SO3CPRO 12

The recap consent point is the one worth carrying forward. In cases like this, one tranche can get outvoted by holders with different holding periods and different tax positions, and there is often no mechanism that makes their reasons visible before the vote. Sixty two cents is a fine outcome for someone who needs the cash back and a poor one for someone who could have waited on a leased building. @samantha_ruiz's outside date on the standstill is the item worth fighting hardest for, because it is the one that changes the sponsor's behavior in month twelve rather than in year four.

mikeoconnell7 SO3CPRO 12

A preferred equity remedy is only worth what an intercreditor agreement lets it be worth

2 replies