Kramer Levin Naftalis Frankel
What trends are you seeing in mezzanine lending and preferred investing from the deals you’ve worked on this year? Are you seeing more of one than the other?
The biggest volume of deals that we’re doing are preferred equity deals, and what I’m finding is that the capital stack in what some view as a typical real estate deal has become as complex as any corporate finance deal, even on single assets. The choice of whether somebody puts out money as a mezzanine lender or a preferred equity investor is influenced by how the remedies get exercised, as well as the desired risk profile.
Mezzanine debt is secured by the ownership interests in the entity, so, in terms of exercising remedies, if there is a default the lender will commence a UCC foreclosure proceeding, which goes much faster than the remedies for a regular mortgage loan. At the successful conclusion of that proceeding, the mezzanine lender will stand in the shoes of the owner of the property. A preferred equity holder, who may take on more risk than a mezzanine lender, doesn’t have to go through a lengthy court proceeding for standard foreclosure or even a faster UCC foreclosure. What do they do? They send a letter to the developer that says, “You’re out as the operating partner.” That could also mean that the developer’s interest is diluted, or it could mean that the developer gets his or her money out last, among a variety of other possibilities.
What legal points are most heavily negotiated in preferred equity and mezzanine deals?
Since so many of the deals we work on involve preferred equity, there are a lot of nuances to the questions involved, such as how major decisions are made, under what circumstances can the operating partner be removed, who’s money comes out first, who’s money gets a return on it first, if there are fees for the owner or developer, when do those fees get paid and, finally, once there’s a profit, how does the profit get distributed? Does it get shared pro rata, does it go to the financial partner who is the provider of preferred equity first until that partner gets a specific return? Those all become negotiations.
What sorts of challenges do deals involving mezzanine or preferred equity financing present from a legal standpoint?
There are plenty of deals that we’ve worked on or that I see where it’s not clear how the mezzanine loan will get sized and how the preferred equity will get sized, because their rights are different. I could also show you deals that started out as mezzanine loans and for one reason or another were changed to be preferred equity. It was the same deal—the documents just changed.
In that sense, there’s a lot more legal work. The legal work has also become a lot more sensitive to business issues. Now when you look at a real estate deal, you’re not only looking at what the intrinsic value and potential value of the real estate is, but you’re looking at where you are in this more and more complex capital structure. One of the many considerations and concerns is transfer taxes. It also becomes a challenge to say to a preferred equity provider, “you’re calling yourself equity, but you don’t want the responsibilities of a principal.” Lawyers spend a lot of time in some instances trying to blend the attributes of preferred equity and loans.
Can you discuss any examples where this became a real issue?
There was a very big transaction in 2008 or 2009 where there was a major office building that was teetering on a potential bankruptcy filing, pitting a preferred equity holder against a mezzanine lender. Had there been a bankruptcy filing, I anticipated a very interesting fight over whether the preferred equity provider could claim that they were a lender and be treated as a creditor.
Interview by Damian Ghigliotty