We have experience with foreigner investors investing both preferred equity or mezzanine debt. In most cases, our investors who have a short-term investment horizon will prefer mezzanine debt due to higher short-term return. On the other hand, the investors with longer-term goals will choose preferred equity. Each investments has its own risk and rewards, which really depends on how the LP/GP is structured. (Buyer's required IRR, ref return, holding period, equity buyback options, any tax shelter structure.) Without a better understanding of the investor's goal and the return/risk the project is being offered, it would be extremely difficult to advise on which of these options an investor should consider.
What should foreign institutional investors consider when weighing the options of preferred equity and mezzanine loans?
We are an institutional investor from China and are planning to invest in a real estate development project in Florida. We have the option to do the preferred equity or mezzanine position. What should we consider when choosing between these options?
This is a tough one, as a distinction between mezzanine loans and preferred equity isn't always clear. Mezzanine debt is generally a loan that is secured by a property and senior to any equity, but junior to the senior loan on the property. Preferred equity, on the other hand, is an equity investment in the property-owning entity. This is entirely subject to the appetite of your investment/lending criteria. If your institution is seeking to hold some form of equity, preferred equity is the way moving forward.
This is a good question. And I will give you a nuanced answer. A mezzanine loan gives the holder a security interest in the shares of an entity that has an ownership interest in the property. Even if the borrower (which may be the property owner or the owner of the property owner) files for bankruptcy, you can still enforce your interest in the owner. It is not a perfect world, as mortgages and liens encumbering the property are superior to the interests of the owner of the entity. Additionally, the party foreclosing takes title subject to any organizational issues in the owner entity. The position is still sought by lenders. Preferred equity gives you a direct ownership interest. It will likely have limitations on voting rights. Many lenders structure a combination of both. It requires careful structuring, but can be done.
They have different legal remedies and different legal relationships with senior lenders. A mezzanine lender would generally have an intercreditor agreement with the senior lender that would give it additional notice and cure periods to cure senior loan defaults, and ultimately the right to foreclose the equity and step in to take over the equity, subject to the senior loan. But if the senior loan remains in default, the mezzanine lender would need to pay the senior loan off in full in order to protect its position. In preferred equity, there is merely a recognition agreement with the senior lender where the senior would recognize the preferred equity holder's right to remove the sponsor/GP and take over control of the deal, but there is no foreclosure of the equity and the preferred must likewise keep the senior loan current in order to protect its position. Another difference is that in a mezzanine loan, if the sponsor defaults, you foreclose and take over all of their equity; in preferred equity there is a stripping of the GP's rights and perhaps a dilution of their equity but not taking over the equity of the sponsor. In some cases, senior lenders do not permit mezzanine loans and generally are more accepting of preferred equity junior to them than mezzanine, so many times you may not have the option to choose.