I signed a pref doc that let the sponsor put money in ahead of me and then he did

$900k into a pref position on a suburban office-to-flex conversion, 12% accruing, no current pay for the first eighteen months, 1.35x minimum multiple at redemption. I read the whole operating agreement. I flagged four things. I did not flag the one that mattered.

Buried in the additional capital section: if the company needed capital to cure a default under the senior loan, the manager could admit new preferred interests ranking senior to or pari passu with existing preferred without consent of the existing preferred members. I read that as a protective clause. It protects the deal, sure. It doesn't protect me.

Month twenty the senior lender called a covenant breach on the debt yield test. Sponsor brought in $1.6m of rescue capital at 15% with a hard first position in the distribution waterfall ahead of my 12%. Entirely permitted. My accrual kept accruing behind a bigger, faster-growing claim on the same cash.

We got out at a sale eleven months later. My 1.35x minimum multiple was a real contractual number and there simply wasn't enough proceeds behind the senior loan and the new pref to reach it. I received 1.08x on three years and one month. On paper that's a positive outcome and it's roughly half what a bank CD ladder would have felt like for the anxiety involved.

What I'd do differently: treat any language permitting new senior or pari passu preferred as a priming clause and price or refuse it accordingly. If a sponsor wants that flexibility, I'd want a consent right, or a cap on the dollar amount, or my multiple stepping up if it's used. Have counsel read the waterfall and the capital sections together, because each one looked reasonable alone.

Answer

1brandonlee36Passive

The version of this that got me was slightly different and worth naming, because the clause said pari passu and I assumed pari passu meant I was fine. It doesn't, arithmetically. New money at the same rank on a bigger balance dilutes every dollar of distributable cash you were counting on, and if the new money is at a higher rate it compounds away from you even while ranked equal.

wren, did your docs have any protection on the use of proceeds? Mine let the rescue capital pay down the senior, which at least reduced the claim ahead of both of us. A friend's deal let it fund operating shortfalls including the sponsor's own asset management fee, which is a different animal entirely.

The number I'd want next time is a hard dollar cap tied to the original pref balance. Fifteen or twenty percent, negotiated. Unlimited priming with a good reason attached is still unlimited priming.

4 replies

1priya_n21PO1C

1.08x over three years with a 1.35x minimum multiple in writing. That gap is the whole education right there.

1luis_carrera Get yours

I've been sitting on a pref allocation for five months partly because of threads like this, so thank you for posting it.

The thing I can't resolve is that every protection you'd want makes the deal less financeable, and sponsors know which investors ask for what. If I demand a consent right on new preferred, a hard cap, a reporting covenant with teeth and a recognition agreement from the senior lender, I've either priced myself out of the deals I can actually see or I'm being shown the deals nobody else wanted. wren, when you were negotiating, did you have any sense of how much room you actually had? Or was it a take-it list from the start?

2nataliehsuSO1BPRO7

I'm still working out where I fit, and the part that lands is that you read the document and still missed it. That's not a diligence effort problem.