It is common knowledge throughout the world that Bank’s LVR’s have retreated a long way from pre GFC levels due to the capital controls imposed by the Basel Committee through central Banks.

Compounding this challenge to Property Developers have been the changing As Is and Resource Consent/Building Consent approved Land Values due to construction cost escalation - not to mention the higher levels of qualifying pre-commitments and personal guarantees now required by the Banks credit policies. 

Further frustrating Property Developers is the Banks requirement for significantly higher levels of equity in the form of cash to be contributed before the Project becomes Bankable.

Defining a well-known problem is one thing - developing a funding solution is really what matters.

In some cases Preferential Equity may provide part of the solution.   So what is it?  How does it work? 

What are the positives and negatives?  How is it different to the old Mezzanine Finance products?

Pref Equity is a form of hybrid debt and equity financing to fill the gap between what the Bank will fund and what the client is ideally willing or able to contribute towards the Total Project Cost (TPC) of an otherwise bankable property development.  It can extend to much higher gearing ratios than second mortgage lending can.

For example, when a developer has 5% of the TPC in equity and requires 95% in external funding  Property Development Partners Limited would arrange a structured facility incorporating senior bank debt, mezzanine finance and preferential equity. Or just senior bank debt and preferential equity.

So What Are The Key Positives ?

(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 development margins 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 Negatives ?

(a) As you would expect Pref Equity is more expensive than traditional debt and as such it needs to be used wisely.

(b) In the event of an unremedied event of default the Pref Equity lender can enforce steps within its rights with respect to control of the development company to ensure the project is completed and their capital and return is preserved.   

How Preferential Equity Is Different To The Old Mezzanine Finance Second Mortgage Products:        

If structured correctly the main advantage of Preferential Equity vs Mezzanine Debt is that Pref Equity does not require a registered 2nd mortgage or a deed of subordination of debt to be negotiated with the senior lenders such as banks and their legal advisors. This saves time and cost.

Property Development Partners Limited Director of Project Finance – Fergus McMahon - has selectively used Preferential Equity to finance Property Developments however he has 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 to maintain bankable LVRs enabling clients to refinance/rollover facilities.

As the name suggests the Pref Equity lenders capital and return is secured in priority to the developer and obviously behind the Bank. 

Preferential Equity consists of company stock with dividends that are paid to the pref eq shareholders before ordinary share dividends are paid out. Preference shares typically pay a fixed dividend, whereas ordinary shares  do not. The pricing of the Preferential Equity is generally calculated upon a risk adjusted return on capital basis and must achieve a minimum Internal Rate of Return (“IRR”).

In the event of a company bankruptcy, preferential equity shareholders have a right to be paid company assets first. 

Pref Equity financing is basically debt capital that gives the Pref Equity provider the rights to convert to an ownership control position in the development company under certain circumstances. 

These generally include a negative credit event such as the loan not being paid back in time and in full or there being a prolonged un-remedied default relative to any loan documentation including the senior Banker or the Pref Equity facility itself.