We had the mezz cure right and couldn't afford to write the check

What was the actual trap trigger, senior-only DSCR or combined? I've seen both and the combined ones spring about six months earlier than sponsors model them.

The gap between having a cure right and being able to fund it is the structural feature of mezzanine that borrowers and junior lenders both tend to underestimate, and @ledger described it accurately.

Mezzanine debt sits between the first mortgage and common equity. It is usually secured by a pledge of the ownership interests in the entity that owns the property rather than by a lien on the property itself, so enforcement runs through Article 9 of the UCC as adopted in the relevant state rather than through a mortgage foreclosure. That is why the remedy is a sale of the equity interests. Whoever buys those interests owns a company that still owes the senior loan on its existing terms, assuming the intercreditor and senior loan documents permit the transfer at all. The economics of exercising therefore include the outstanding senior balance, any arrears and reserve shortfalls the intercreditor requires you to cure, and whatever capital the asset needs to reach the value that justified the position in the first place.

Two mechanics compound this. Interest that converts from current pay to accrual increases the balance without producing cash, so the position gets larger while the borrower's ability to service it gets smaller. And a senior cash management trap can route all property cash to the senior lender before any junior payment is made, which is a common structure and one you should read in the specific documents rather than assume.

Pricing at 10 to 15 percent reflects the subordinate position and the risk that comes with it. It does not by itself fund the cost of control. Sizing a reserve against that cost is a modeling decision, and how the intercreditor and the state's UCC provisions apply to any particular structure is a question for counsel on that deal.

Two questions before I try to learn anything from this. What level was the DSCR test set at, and was it tested on trailing three or trailing twelve? I've been told the trailing period is worth as much as the level and I've never seen anyone put a number on that.

$14/sf of TI on a 1980s suburban office at 62% leased was never going to be enough. I've priced that work. Second generation office space in a building that age wants demo, ceiling grid, HVAC boxes that haven't run in years, and by the time you're done with a full-floor tenant you're at $45 to $70/sf in most markets before commissions. Whatever the cash trap did, the business plan was underfunded from day one and the mezz was funding a gap that would have reopened even with full occupancy.

What does PIK mean here? I gather you stopped getting paid but the number kept going up.

What did the legal cost across the whole thing? Original docs plus the workout. I ask because when I model my own deals I put a flat number for legal and I suspect flat is the wrong shape.

The part I'd want to sit with is the 61%. You bought a minority piece of a tranche and the decision that determined your outcome was made by someone else's investment committee. That reads to me like the actual purchase was a vote you didn't have, and the coupon was just what you paid for it.

I've hit a smaller version of this on the borrower side. My mezz lender had a cure right they didn't want to use either, and for about four months nobody was willing to be the one who spent money. The asset just sat there getting worse while two sets of lawyers wrote letters.

Every time I read one of these I feel better about eight units and a fixed rate.

What was the exit assumption on the office? If it was a cap rate on stabilized NOI in a market that was already giving back space, I'd want to know what your downside case looked like at close, not in month 11.

@ledger to put a number on my earlier point, on a 190,000 sf building going from 62 to 82 you're leasing about 38,000 sf. At $50/sf of TI plus commissions at say 5% of a ten year lease, you're north of $2.4m before you touch the base building. The $14/sf line only works if you're renewing sitting tenants who don't move a wall.

@ledger the reserve idea is what I want to steal. How would you have sized it in practice? Full senior balance is obviously absurd for a minority participant. Something like arrears plus twelve months of senior debt service plus the leasing capital, expressed as a multiple of your check, so you either hold it or you know at close you're a seller in trouble?

Who else was in the tranche and how did you find out? When I look at participations the sponsor of the paper is happy to tell me the coupon and much less happy to tell me the names on the other 60%, and I've started treating that reluctance as the answer.

I'd put the cause somewhere different from where you put it. The TI number was thin and the trap was aggressive, but neither of those cost you the recovery. The participation agreement did. A 61% holder with the right to direct enforcement and to sell the strip means every other right in the intercreditor belonged to them and not to you. You bought an economic interest that was described as a lending position. I read those agreements first now for exactly two things, who directs remedies and whether a non-controlling holder has any purchase option when the controlling holder decides to sell.

Sorry for the basic one. When the tranche sold the strip at 22 cents, who buys that? Is there a standing market for distressed mezz paper or is it a phone call to four people who all know each other?

@fathom I'll take most of that. The 61% holder decided the outcome and I signed a document that let them. Where I push back slightly is that I don't think I'd have made a better decision with control. If I'd held the pen I'd have needed $3.1m of cure plus leasing capital against a $2.5m position, and the fund didn't have it. Control without capital gets you a slower version of the same result.

@meridian your formulation is close to what I use now. Arrears plus twelve months senior debt service plus the remaining business plan capital, divided by my check size. On this deal that ratio came out around 2.8x. I would not have written it at 2.8x if I'd computed it.

@flint senior-only, tested trailing three, set at 1.20x. Trailing three is what made it spring so fast.

@tally about $190k across the life of it, and roughly two thirds of that was the workout, not the closing.

I'm still slow on the collateral part. Is mezz basically a second mortgage that got a new name? If the sale of the equity gives you the building anyway I don't see why the pledge structure matters.

@vellum it matters a lot. A second mortgage is a lien on the real property and you foreclose it under that state's real property procedure, which in judicial states can run a long time. Mezz is a pledge of the membership or partnership interests in the entity that owns the property. You foreclose it under Article 9 as adopted in the governing state, which is generally a commercially reasonable sale after notice and moves faster. What you get at the end is the company, and the company still owes the senior loan. So you inherit the debt rather than wiping it out. Whether that transfer is even permitted usually depends on transfer conditions in the senior loan and the intercreditor, which is a document question for a lawyer on the specific deal.

@ledger thanks for the 2.8x. That single ratio is more useful to me than the whole rest of the thread, and I can compute it from a term sheet before I ask anyone for anything.

@tender that lands. So the recorded document people would find at the county isn't the mezz at all?

@vellum right. The mortgage or deed of trust for the senior gets recorded in the county land records. The mezz pledge is typically perfected by a UCC-1 filed with a state office, usually the secretary of state of the state where the borrower entity is organized, and the exact filing office and practice vary by state. Someone pulling only the county records on a property can miss the mezz entirely. That is one reason mezz balances are harder to see from the outside than mortgage balances, and in a dozen or so states you can't even see the sale price publicly to begin with.

@girder is right about the TI and I'd add the part that always gets me, timing. Even if the $14/sf had been $50/sf, second gen office fitouts run six to nine months from lease signature to rent commencement once you're through permits. So your cash trap sprang while the money you did spend was sitting in half-built suites producing nothing. The trap tests don't care that the rent is coming.

On price. 13% all-in for a subordinate pledge behind a floating senior on a 62% leased office repositioning strikes me as thin for the risk that was actually there, whatever the general range for these positions is. The coupon has to cover the chance you end up needing multiples of your check to protect it. If the reserve math @ledger described comes out at 2.8x, that's information about pricing, not only about sizing.

How does someone even see one of these? I've never been shown a mezz anything and I'm not sure whether that's because I'm new or because they don't circulate.

The test I run before I look at a coupon is break-even occupancy at combined debt service, using the senior's stressed rate rather than the current one, and using in-place rents rather than the sponsor's mark to market. On the shape @ledger described I'd guess break-even sat somewhere in the mid 70s while the building was at 62 and falling. If the trap trigger sits above break-even occupancy, the trap is not a warning system, it's a schedule. You know roughly when it fires the day you close.

@ledger did the intercreditor let cure payments you made count against the senior balance, or were they gone? I've read drafts both ways and the difference changes the whole calculus of whether you cure at all. Some versions treat mezz cure advances as an add-on to your own loan against the borrower, which is worth something if the equity ever comes back, and some treat them as payments to the senior with no credit to you anywhere.

Adding two lines to my checklist from this. Ask for the participation agreement before the intercreditor, and ask for the ratio @ledger described in writing from whoever is offering me the piece. If they can't produce arrears plus twelve months of senior service plus remaining business plan capital over my check size, they haven't done the work, and I'd rather find that out over email than in month 31.