Preferential Equity or “Pref Equity” is it a solution?

Preferential Equity or “Pref Equity” is it a solution?

It is common knowledge the Bank’s LVR’s have retreated a long way from pre GFC levels. Compounding this challenge to Property Developers has been the falling As Is Land Values and On Completion Values not to mention the higher levels of pre-commitments now required by the Banks.
We have all seen the result, thousands of mortgagee in possession site sales, Property Developers forced to sell development sites at heavy discounts to reduce debt and fund working capital.
Further frustrating Property Developers is the Banks requirement for significantly higher levels of equity in the form of cash to be contributed before they become Bankable.
Defining a well-known problem is one thing, developing a viable solution is really what matters.
In some cases Pre Equity maybe provide part of the solution. So what is it? How does it work? What are the upsides and downsides? How is it different to the old Mezzanine finance products?
Pref Equity is a form of hybrid of debt and equity financing which DFP to fill the gap between what the Bank will fund and what the client is ideally willing or able to contribute towards the Total Developments Costs (TDC) of a project.
Pref Equity financing is basically debt capital that gives the Pref Equity provider the rights to convert to an ownership and control position in the development company under certain circumstances. These may include the loan not being paid back in time and in full or there being a prolonged un-remedied event of default relative to any loan documentation including senior lender or the Pre Equity facility itself.
How is Pre Equity different to the old Mezzanine Finance? If structured correctly the main advantage of Pref Equity vs Mezzanine Debt is that Pre Equity does not require a registered 2nd mortgage or a deed of subordinated of debt to be negotiated by senior lenders such as banks.
DFP selectively uses Pref Equity to finance Property Developments however we have also used this innovative form of financing to “Sell Down” equity and or pay down and restructure existing debts secured by existing income producing commercial properties.
As the name suggests the DFP Pref Equity lenders capital and return is secured in priority to the developer and obviously behind the Bank. The pricing of the Pref Equity return is generally calculated upon a risk adjusted return on capital basis and must achieve a minimum or floor Internal Rate of Return (IRR).
So what are the key Upside’s?
(a) The borrower is able to generate a higher return on equity as their cash contribution is significantly reduced.
(b) Banks are more willing to provide senior debt with Pref. Equity as they are reluctant to consent to second mortgages for construction projects.
(c) Immediate access to illiquid equity lying dormant in brick and mortar assets.
(d) Ability to restructure debts and rectify potential or existing loan covenant defaults without suffering significant losses due to the forced sale of the asset.
(e) Ability to restructure ownership/equity/partners within existing property portfolios.
(f) The Pref equity participant provides additional experience, capability and strong management support to help manage risk and profitably complete the development.
(g) The reduced cash equity required by the borrower may allow them to take advantage of other opportunities which would not otherwise be possible.
(h) The Pref Equity’s returns are usually fixed, reducing the potential for conflict with respect to calculating the “Project Profit”. This gives the Property Developer the opportunity and the incentive to make additional profit if the project achieves profits beyond those originally forecasted.
(i) The borrower is able to bring the project to market faster and significantly reduce holding costs.
(j) By bringing the project to market faster the Property Developer realises development profits sooner.
(k) Pref equity provides the bank and Property Developer with an additional source of cash equity in the event of cost overruns beyond the existing contingency budget.
(l) If structured correctly the addition of the Pref Equity participant can make the project more Bankable from a senior lenders perspective.
Ok what about the key downsides?
(a) As you would expect Pref Equity is more expensive then traditional debt and as such it needs to be used wisely.
(b) In the event of a unremedied event of default the Pref Equity lender can enforce step in rights with respect to control of the development company to ensure the project is completed and their capital and return is preserved.
So there you go, now you are a Pref Equity expert.
Naturally if you or your clients would like to know more DFP’s Pref Equity product and how it can be applied to you or your clients needs please feel free to contact us at DFP to find out more.

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