Preferred Equity: the Preferred, Negotiable Financing

Preferred equity—like the name implies—is an equity investment into a joint venture that owns a 100 percent interest in a property. The investment is typically made into a newly formed entity so that the equity investor does not need to conduct entity-level diligence or analyze any entity-level liabilities. If the asset is encumbered by senior debt, the preferred equity investor will conduct an analysis to ensure that the investment is made in compliance with the loan documents. One of the biggest misconceptions about preferred equity is that its legal structure is the same as a mezzanine loan. It is not a loan, and it is typically not secured.

Preferred Returns, Not Secured Creditor

The preferred equity investor is entitled to a “preferred return” on its investment, which can be structured to either accrue or to have periodic payments irrespective of cash flow. The payments to the preferred equity investor will be set forth in the distribution provisions of the joint venture in order to ensure that the preferred return is paid first. Any preferred equity investment will have an end date or a mandatory redemption date on which the equity investment is required to be redeemed. Extensions of the mandatory redemption date can be negotiated, but generally it is coterminous with the senior loan maturity date or, in some instances, it is a date that immediately follows the loan maturity.

To the surprise of many parties in this alternative lending space, preferred equity is typically not secured. Pledges of ownership interests are not unheard of, but they are not typical in the same way that they are for mezzanine loans. If there is no pledge, the concern, of course, is what remedies can be made available to the preferred equity investor if the investment, together with the preferred return, if a default occurs. Since there is no loan, pledge or loan agreement, all remedies available to the preferred equity investor are set forth in the joint venture agreement with the other partners. These remedies typically include a lockdown on cash flow.

‘Take over’ Right

The most important remedy available to the preferred equity investor is the ability to “take over” the deal, become the sole manager of the asset and make all property related decisions, including the determination of whether to sell the property and at what price. The investor will want to be in complete control with no interference from the other partners. To have control, there is no foreclosure action or Uniform Commercial Code process that the preferred equity investor has to commence and complete. The right to “take over” is contractual.

The other partners who now no longer have control of the deal will generally retain their economic interests in the deal, but they will be deeply subordinated in terms of payment. In more rare instances, the other partners completely forfeit rights and economic interests. Some deals are structured in a manner so that the other partners (or credit-worthy persons or entities acceptable to the preferred equity investor) indemnify the preferred equity investor against any claims or losses that the investor may suffer if the other partners interfere with this “take over.” This is akin to a “bad-boy” guaranty in the mezzanine loan space.

Like mezzanine loans, any remedies that investors may have negotiated in their joint venture agreement must take into consideration any senior loan restrictions or requirements. If the senior loan documents do not sufficiently allow the preferred equity investor to exercise its remedies in a timely manner, the investor will need to pursue certain amendments to the loan documents or negotiate a separate recognition agreement with the senior lender. The form and substance of recognition agreements are rapidly evolving.

Specialized Negotiation Needed

Preferred equity can be an effective alternative financing source, but investors need to be fully informed of all the concepts and protections that are necessary to include within a joint venture arrangement and understand that joint ventures are more specialized and highly negotiated than we typically encounter with loan documents.

Laurie A. Grasso (hunton.com/Laurie_Grasso) is a partner in the New York Real Estate Practice at Hunton & Williams LLP.