A mezzanine loss case study: what happens when a senior loan default forces a cure decision

This is the question I would have been embarrassed to ask and now I'm glad someone answered it before I had to. So the mezz position is only as strong as the syndicate's ability to write a second check that nobody told them about in advance. That seems like it should be on page one of every offering document rather than buried in an intercreditor most investors never see.

Near miss version of the same thing. I looked at a mezz syndication last year where the sponsor's answer to "what if the senior defaults" was that they'd cure it. I asked with what money and he said the deal would generate it. The deal generating money was the thing we were worried about failing.

@tonyv88 I'm not sure the cure provision is really where this went wrong though. The renovation ran over and the deal missed its coverage test. If the value add underwriting had been right, the cure question never comes up. The document risk is real, but the deal risk showed up first.

@derekj19, both things were live at once and they compound. Underwriting failure is what triggered the event. The document structure is what determined that a partial recovery was impossible.

The mechanism worth naming for anyone reading: mezzanine debt is usually secured by a pledge of the ownership interest in the entity that owns the property rather than by a lien on the property itself. That's the defining structural feature of the product and it cuts both ways. Foreclosing on a pledge can be faster than a mortgage foreclosure, though the process and timing vary by state. It also means that if the senior forecloses on the real estate first, the pledged equity is a claim on an entity with no asset. There's no partial recovery from a building you don't have a lien on.

That's why the cure right is the part of an intercreditor that determines outcomes. A cure right you can't fund is a cure right you don't have. Before committing to a mezzanine position, the questions that matter are what the cure obligation could cost in dollars under a senior default, what the standstill period is, whether the vehicle can meet the senior's qualified transferee conditions if it does take the equity, and how additional capital gets called from the group. Those answers are in the intercreditor and the operating agreement of the lending vehicle, and they should be read by counsel who works on this product specifically.

@tonyv88, the point about reading the return and the term and assuming the pledge was protection is the one that generalizes. Mezzanine sits behind senior debt by design, and the elevated coupon is compensation for exactly the outcome you experienced.