As real estate values have fallen over the last few years and construction costs have increased, many sponsors and asset managers have been forced to look at creative ways to capitalise or recapitalise assets.
For many, an injection of fresh capital is needed to fund overruns in construction costs or to fund change of use or retrofit projects. Most typically, however, an injection of funds is simply needed to bring down LTV ratios to a level that will enable a refinance on viable terms. An “equity” like capital investment, which ranks after senior and mezzanine debt but ahead of common equity (ordinary share capital and shareholder loans), can be an attractive solution in these scenarios.
Real estate investment firms have a growing appetite to deploy capital in this manner. Preferred equity investments typically attract higher returns than traditional debt but, unlike common equity, will carry a minimum or threshold level of return on capital invested. Factors that distinguish these investments from traditional debt include the lack of asset security, similar to common equity, and the potential absence of a hard maturity date (at least in the short term). Instead, exit protection (which is certainty for the investor on when its capital will be returned to it) may be achieved through other tools, including governance controls and a clear business plan and disposal strategy.
While preferred equity comes at a relatively high cost, sponsors benefit from the fact that they will likely retain all or a majority of the potential upside in the underlying asset through their existing common equity position. If the business plan envisages sufficient income or sale proceeds to repay all debt and deliver the preferred equity return to the new investor, inherent value should remain in the common equity.
William Fry has advised many new investors, existing sponsors, and asset managers on “preferred equity” investments over the past 18 months. However, these investments are not a one-size-fits-all, and they are invariably less straightforward to implement than they may seem at the outset. Every transaction is different, each presenting its own challenges and, if structured correctly, can create opportunities with upside potential for both the sponsor and new investor. The make-up of the existing structure (and the presence or absence of regulated funds within that structure), the domicile of the existing and preferred equity investors, the asset type and the business plan will all be significant factors in determining the most efficient way to structure the investment, as will the extent of exit protection and upside sharing agreed with the new investor.
At their most basic level, investors may achieve the preferred equity interest through a share class or limited partnership interest which carries preferred economic rights and ranks ahead of ordinary shares or limited partner interests. However, depending on the deal terms and tax, regulatory and security considerations involved, it may be appropriate to structure the “preferred equity” as debt at a structurally subordinate level or even a combination of both debt and equity.
In almost all circumstances, the new equity will require some form of remedy if the business plan fails as protection for its investment. There are several ways to achieve this, some of which may involve the assumption of control to force a sale. However, careful consideration is always needed as implementing and enforcing any such remedy can have unintended tax and regulatory consequences.
Given the competing factors involved, we believe it is critical to have real estate, finance, corporate, regulatory and tax specialists working together to determine the best structure for any proposed preferred equity investment. William Fry has extensive experience providing that advice.
One thing is clear, as market activity picks up and pricing stabilises, any potential gap in funding models will need to be quickly filled, and traditional capital structures do not always yield the answer. We believe preferential equity-type investments will continue to become more prevalent in Irish real estate.
Please reach out to William Fry for more information.
