Download The Capital Stack - Lancaster Pollard

FEATURE
The Capital Stack
W
hen thinking about how to fund the capital needs
of a business, two primary sources generally come
to mind: debt and equity. The debt is generally assumed
to be in the form of a senior secured term loan from a
commercial bank, bonds or notes, or government agency
or government-sponsored enterprise (GSE) financing. The
equity is typically derived from the personal liquidity of the
owner of the business.
However, there are a few other creative sources of capital
available that can augment or substitute for traditional
forms of equity. As illustrated below, the different sources
of capital include, ranging from the highest to the lowest
risk: equity, preferred equity, mezzanine debt, and senior
secured debt. This article will examine the different
layers of the capital stack and provide an overview of the
advantages and disadvantages of each.
Equity
96%-100%
Expected return 25%+, all
upside benefit but also all
downside risk, first loss
Preferred
Equity
91%-95%
Expected return 17% to 25%,
stated preferred return and
return of capital, equity upside (waterfall distribution)
Mezzanine
Debt
76%-90%
Expected return 12% to
17%, fixed P&I payments, no
equity upside, collateralized
by real estate and often
with operations
Senior
Secured
Debt
0%-75%
Expected return 4% to
7%, secured by mortgage
on real property, least
risk in capital stack
Senior Secured Debt
Senior secured debt is likely the most common form of
financing. It involves obtaining a loan (from a commercial
bank, bonds or notes, government agency or GSE
financing), which is typically secured by a first mortgage
on the real estate being purchased with the funds. Such
loans will typically feature a maximum loan-to-value (LTV)
of 75% to 80% with the remainder coming in the form of
equity from the buyer of the real estate. The strong LTV
significantly reduces the risk to the lending institution
which allows for lower interest rates (4% to 7% for first
mortgages).
If necessary, the subject property can be foreclosed through
the process governed by state regulated mortgage law. In
addition to the mortgage, personal or corporate guarantees
are usually a part of a senior secured loan. Should the
operations of the company be insufficient to cover the
debt service, the guarantors will need to support the cash
needs. The loan documents and underwriting are typically
standardized which can help streamline the execution but
also reduces the borrower’s ability to negotiate the terms
and reduces the flexibility to complete transactions that are
outside the box.
The loan documents will usually contain financial
covenants that allow the lender to execute its rights and
remedies in the event of a default. These are essentially a
way to monitor the performance throughout the life of the
loan. Without any default, the lender has no control of the
property. For real estate transactions, the terms can range
from five to 10 years with amortizations of 25 to 30 years.
Interest rate risk is a factor given the loan will need to be
refinanced after each term expires. When capital is needed
to purchase the project, senior secured debt will always be
a primary component of real estate transactions due to the
low cost of capital.
Mezzanine Debt
Next on the capital stack continuum is mezzanine debt, a
funding source that has grown in use over the past decade.
As lending standards have tightened, the gap between the
purchase price and the maximum loan amount has grown,
thus increasing equity contributions from borrowers. This is
especially true in cases where there is cash flow instability,
such as a turnaround, or when there is no in-place cash flow
whatsoever, such as new construction. Mezzanine debt has
become a tool to partially fill the gap between the maximum
LTV offered by senior secured debt and the total purchase
price. The process has become much more streamlined and
standardized in recent years due to its increased use and
popularity.
Mezzanine loans are similar to senior secured debt in that
the lenders do not have any managerial control or fiduciary
responsibilities. One of the primary differences is in the
source of collateral. Mezzanine lenders seek a second
mortgage on the real estate and a second lien on all other
assets of the borrower.
To outline the rights of both the senior mortgage lender
and the mezzanine lender, the two lenders enter into an
intercreditor agreement. These agreements typically discuss
the ability and timing of a mezzanine lender to exercise
default rights. Some mezzanine lenders also require a
priority lien on the equity of a borrower. Mezzanine loans
are more expensive than senior secured debt given they
assume more risk. Interest rates range from 12% to 17%
with a three to five year investment horizon. Mezzanine
loans fill a gap of some of the equity required by senior
lenders. Leverage can be as high as 90% LTV or the cost of
the project. Some mezzanine loans also include conversion
features that can enhance the future return of the loan
by taking warrants in a company’s stock. Advantages
include the fact that mezzanine loans are non-dilutive to
the owner’s equity, are pre-payable and are often much
less costly than raising outside equity. This can assist
companies that are growing and need to maintain their
short term capital.
Case in Point
Project: A multi-facility operator in North
Carolina sought financing to buy three assisted
living facilities to renovate and add a memory
care component.
Preferred Equity
The final element of the capital stack we will discuss is
preferred equity, which carries the most risk excluding
common equity. Preferred equity holders either enhance
or replace mezzanine loans. This product further leverages
the capital stack by providing up to 95% of the total cost
of a financing. It can either be used on top of mezzanine
and senior debt or it can replace the mezzanine debt if the
senior lender will not allow a secured second position.
Often the structure includes a preferred return to the private
equity investor, a return of the capital invested, and either a
payment to get to a stated internal rate of return (IRR) or a
split with the common equity holders.
The preferred payment typically accrues until paid and
comes out of dividend distributions. Sometimes this
instrument is redeemable. Cost of this instrument can range
from 17% to 25% plus IRR. Preferred equity investments
that are redeemable act similarly to mezzanine debt in
leveraging common equity returns and limiting the need to
raise dilutive equity. Typically there is a springing control
provision in place if the common equity owner defaults on
the underlying debt of the financing stack.
The investment horizon will vary depending on the specific
deal, but full redemption of the preferred equity holder’s
interest will be outlined in the agreement. Failure to fully
redeem the equity holder’s interest at the specified date is
considered a default and entitles the preferred equity holder
to pursue its rights and remedies.
Each form of capital has its strengths and weaknesses,
and the exact combination of funds used will depend on
a multitude of factors unique to each business. One factor
not contemplated in this article is the tax consequences,
which could have a dramatic impact on each funding
source. The implications are highly dependent upon the
exact circumstances of the business, but they should be
considered when evaluating options.
Total costs: $13.07 million
Senior debt: $9 million, 69% of costs
Mezzanine debt: $2.5 million, 20% of costs
Doug Korey is the president of Lancaster
Pollard Finance Co., LLC. He may be reached
at [email protected].
Preferred equity: $1.2 million
Sponsor equity: $370,000
Results:
• Three-month turnaround to profitability
• Renovations completed within nine months
• Real estate sold for $15.3 million, a
$2.3 million net increase in value over a
12-month time period.
Eric Sengpiel is an associate with Lancaster
Pollard in Columbus. He may be contacted at
[email protected].