My remedies were worth nothing at the exact moment I needed them

I wanted income without a second job, and preferred equity in a conversion looked like the version of this room I could actually own. 11 percent current, 4 percent accrued, one asset, a nine story office building in a secondary Sun Belt CBD going to 132 units. I was part of a $4.1m pref tranche behind a $52m construction loan. Cash flowed for eleven months on schedule.

Then the job went long. Not catastrophically, about seven months, mostly permits and a mechanical redesign after they found the existing riser cores were undersized for residential fixture counts. Current pay switched off and started accruing under a clause I had read and taken to be temporary.

My misread was about my own position. My remedies on a payment default were a bump in accrued rate to 16 percent and a right to remove the manager. Both were subject to an intercreditor agreement with the senior lender that I had seen but had not traced. That agreement standstilled the pref for as long as the senior loan was in balance, and the senior was in balance because the sponsor's guarantor funded a $3.9m equity cure. So the sponsor was in default to me and in good standing with the bank at the same time, and my only lever was frozen.

Eighteen months later the sponsor recapped with a new institutional partner. The recap paid the senior down and restructured the equity. My pref was offered a choice: take 62 cents on the dollar of face plus accrued, or convert into a subordinate common position behind a new $18m preferred return. The tranche took the 62 cents because nobody wanted to be the last dollar in a building that had already surprised everyone twice. On $300k of face plus about $71k accrued I got back roughly $230k.

So I turned an 11 percent current position into a negative return over four years, in a deal where the building got built and is now leased.

What I'd do differently: read the intercreditor first and the pref term sheet second, and price the pref off what my remedies are actually worth during a senior standstill rather than off the coupon. I'd also want the recap consent threshold to require something better than a majority of a tranche I don't control.

Answer

1samantha_ruizAU4APRO6

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.

2 replies

1mikeoconnell7SP2APRO6

The recap consent point is the one I'd carry forward. You got outvoted by people in your own tranche who had different holding periods and different tax positions than you, and there was no mechanism that made their reasons visible to you before the vote. Sixty two cents is a fine outcome for someone who needs the cash back and a terrible one for someone who could have waited on a leased building.

@keystone's outside date on the standstill is the thing I'd fight hardest for, because it's the only item on that list that changes the sponsor's behavior in month twelve rather than in year four.

My remedies were worth nothing at the exact moment I needed them

2 replies