Equity comes in many shapes and sizes. When it comes to preferred equity, there are many ways to structure it. Flexibility is a very valuable tool when determining how the members of the joint venture are compensated, but it can lead to complexity as well. Within the senior lending world, the difference is boiled down to one of two forms, ‘hard preferred equity’ or ‘soft preferred equity’. The key attribute defining the two preferred equity structures is if a ‘performance hurdle’ exists.
Performance Hurdle
A Performance Hurdle is driven by the idea that there is a specific measurement related to the collateral, its performance, or its underlying cash flow that has the potential to trigger a default of the preferred equity investment. A few common types of Performance Hurdles include:
- Required Distribution – a portion of the preferred return as a percentage of the total preferred equity investment is required to be distributed on monthly basis
- Effective Revenue Threshold – the underlying collateral for the investment must achieve a specific performance target on the effective revenue of the collateral
- NOI Threshold – the underlying collateral for the investment must achieve a specific performance target on the net operating income of the collateral
In each case, failure to meet the requirement of the Performance Hurdle typically leads to a default in the preferred equity investment, in which case the preferred equity investor has the right to take over the management of the real estate entity. The change in management, which is certainly allowable in senior loans, is what senior lenders scrutinize.
Preferred Equity
In both Hard Preferred Equity and Soft Preferred Equity, the cash flow distributed to the preferred equity investor is derived from the available cash flow after operating expenses, inclusive of senior lender obligations. In the case of Soft Preferred Equity, a lack of a performance metric leaves cases where the preferred equity investor may receive no cashflow during the investment term because of under-performance of the underlying real estate collateral. In essence, A completely possible outcome is the preferred equity investor does not receive a distribution until the exit of the investment.
Hard Preferred Equity
In Hard Preferred Equity, most senior lenders prefer to have a Required Distribution as the measurement for determining the Performance Hurdle and have debt service coverage constraint covenants as well as loan to value constraint covenants to limit the total investment of a preferred equity investor. Additionally, any transfer of control rights to the preferred equity investor requires that the preferred equity investor be underwritten by the senior lender.
Soft Preferred Equity
In Soft Preferred Equity, more senior lenders are open to the preferred equity position because there is not a specific Performance Hurdle driving a change in control of the real estate entity. A common practice in soft preferred equity is to have a form of a sell right, similar to a joint venture equity deal, which allows the preferred equity investor to exit the deal. This right only provides the preferred equity investor an exit and does not allow the preferred equity investor the ability to change control of the real estate entity.
Underwriting
In either case, Hard Preferred Equity or Soft Preferred Equity, advising the senior lender early in the underwriting process is valuable so that there are no surprises in the underwriting process. Some senior lenders go as far as to require surveys be filled out in order to fully assess the type of equity that is entering a transaction. Understanding how to properly structure the preferred equity investment ensures a smoother overall underwriting process for all parties involved.
