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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].