structuring preferred equity investments in real estate

Structuring Preferred Equity Investments in

Real Estate Ventures: Impact of True Equity vs.

"Debt-Like" EquityNegotiating Deal Terms, Investor Return, Change in Control Provisions; Assessing Remedies, Tax, Bankruptcy Issues

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THURSDAY, NOVEMBER 5, 2020

Presenting a live 90-minute webinar with interactive Q&A

Michael J. Fritz, Partner, Shipman & Goodwin LLP, Hartford, CT

Kathleen M. Mylod, Partner, Shipman & Goodwin LLP, Hartford, CT

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Structuring Preferred Equity Investments in Real Estate Ventures: Impact of True Equity vs. “Debt-Like” Equity

Kathleen M. Mylod

Michael J. Fritz

Shipman & Goodwin LLP November 5, 2020


Hypothetical capital stack

Mortgage Financing$65MM

Mezzanine Financing$20MM

Common Equity$7.5MM

Property

Preferred Equity$7.5MM

• $100,000,000 capital stack with debt and equity financing

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Comparison of structures of mezzanine debt and preferred equity

Mezzanine Structure Preferred Equity Structure

Mezzanine Borrower

Mortgage Borrower

Property

Sponsor

Mortgage Lender

MezzanineLender

Mezz Loan ($)

Mortgage Loan ($)

100%

100%

Joint Venture Entity

Mortgage Borrower

Property

Sponsor

Mortgage Lender

Preferred Investor

Mortgage Loan ($)

100%

Investment:Contribution/Commitment

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Documentation matters

Mezzanine Loans Preferred Equity Investments

Note Purchase/Contribution Agreement

Loan Agreement Limited Liability Company Agreement

Pledge Agreement No analogous agreement

Guaranties (bad-boy, completion, etc.) Guaranties (bad-boy, completion, etc.)

Cash Management Agreement No analogous agreement

Intercreditor Agreement Recognition Agreement (either separate document

or in mortgage loan agreement)

• A comparison of material documents

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What is preferred equity?

• Preferred equity is an alternate form of financing

• Unsecured equity investment with enhanced rights and economics, including a higher return on capital to compensate for higher risk than secured lending

• Structurally subordinate to any mortgage or mezzanine financing, but senior to common equity

• “Sponsor” - the common equity holder, usually with management/development expertise (akin to the borrower)

• “Preferred Investor” - provider of the preferred equity funds (akin to the lender)

• Key difference - no collateral and no statutory framework (such as UCC Article 9) for enforcement of Preferred Investor rights; all rights are derived from contract, i.e. the preferred equity investment agreement/joint venture agreement

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When and where is preferred equity used

• To add more leverage to the capital stack

• If a senior lender does not permit additional debt, whether from an underwriting perspective or otherwise (Freddie Mac, etc.)

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Structuring the preferred equity deal

• Contribution agreement or purchase agreement

• Joint venture agreement

• Guaranties and other indemnities for the benefit of the Preferred Investor

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• Joint venture agreement

◆ Usually LLC agreement (possibly LP agreement)

➢ Sponsor would be the managing member or the general partner

➢ Preferred Investor would be the passive member/limited partner

◆ Preferably a newly formed entity to house the new preferred equity investment

◆ May hold the real property directly, or form a subsidiary to hold the real property

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• Key components of the joint venture agreement

◆ Representations from Sponsor

◆ Management and major decisions

◆ Capital matters (commitments vs. contributions)

◆ Distribution waterfalls (regular and capital events)

◆ Reporting requirements

◆ Performance targets and covenants

◆ Defaults and remedies

◆ Transfer rights

◆ “Key person” provisions

◆ Non-compete provisions

◆ Indemnity and fiduciary duty matters

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• Guaranties and other indemnities for the benefit of Preferred Investor

◆ Non-recourse carve-outs

◆ Completion

◆ Environmental

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Preferred equity economics

• Types of distribution waterfalls

◆ Operating cash

◆ Capital events

◆ Post-material default

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• Primary waterfall characteristics

◆ Preferred rate of return; default rate

◆ Make-whole/minimum equity multiple

◆ Hard pay vs. accrual (PIK)

◆ Timing of operating cash waterfall (monthly, quarterly)

◆ Future funding - Sponsor obligations vs. Preferred Investor obligations

◆ Capital commitments vs. protective advances

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• Sample text of waterfall provisionsDistributions of Operating Cash Flow. Prior to the dissolution of the Company and the commencement of the liquidation of its assets and winding up of its affairs, the Manager, on the first day following the end of each Calendar Quarter and at such other times as the Manager may deem appropriate or as required by any approved Annual Budget, shall determine and distribute the Operating Cash Flow to the Members in accordance with the following priorities:

(i) First, one hundred percent (100%) to Preferred Investor until all Preferred Investor Loans and accrued interest thereon are paid in full;

(ii) Second, one hundred percent (100%) to Preferred Investor until Preferred Investor has received an amount equal to the aggregate Minimum Dividend Shortfall for all prior Calendar Quarters;

(iii) Third, one hundred percent (100%) to Preferred Investor and Sponsor on a pro rata basis, based on each Member’s respective Interest; provided, however, that in no event will distributions to Preferred Investor under this provision in any given quarter exceed [_]% per annum; and

(iv) Thereafter, in Manager’s discretion, one hundred percent (100%) to Preferred Investor on account of any accrued but unpaid Preferred Investor Return.

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• Sample text of waterfall provisionsDistributions of Capital Proceeds. Prior to the dissolution of the Company and the commencement of the liquidation of its assets and winding up of its affairs, the Manager, promptly following any Capital Event, shall determine and distribute the Company’s Capital Proceeds to the Members in accordance with the following priorities:

(i) First, one hundred percent (100%) to Preferred Investor until all Preferred Investor Loans and accrued interest thereon are paid in full;

(ii) Second, one hundred percent (100%) to Preferred Investor until the Preferred Investor Equity Account has been reduced to zero dollars ($0);

(iii) Third, one hundred percent (100%) to Preferred Investor to the extent of the Make-Whole Amount, if applicable, and any other amounts due to Preferred Investor under this Agreement; and

(iv) Thereafter, one hundred percent (100%) to Sponsor.

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• Sample text of waterfall provisionsDistributions after Material Default. All Available Cash and proceeds of all Reserves, from and after the occurrence of a Material Default, shall be distributed as follows:

(i) First, to pay amounts due and owing under the Senior Loan, including debt service and reserves required thereunder;

(ii) Second, to Preferred Investor, until Preferred Investor has received an amount equal to all Additional Contributions made by Preferred Investor and any accrued Preferred Investor Additional Contribution Return thereon to the extent not previously repaid to Preferred Investor;

(iii) Third, to Preferred Investor, for all other amounts, if any, then due and owing to Preferred Investor under this Agreement, other than the Early Capital Return Fee, if any;

(iv) Fourth, to Preferred Investor until Preferred Investor has received a return of the Net Equity Investment;

(v) Fifth, to Preferred Investor in the amount of the Early Capital Return Fee, if applicable; and

(vi) Sixth, the balance, to Sponsor.

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Management of preferred equity investment vehicle

• Day to day management is typically vested in the Sponsor

• While major decisions are granted to thePreferred Investor

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Management of preferred equity investment vehicle• Examples of certain major decisions• Acquisition by the Company or Property Owner of any direct or indirect interest in land or other real property or interest therein other than the

Equity and the Property;

• Approval of any Annual Budget, Leasing Plan or CapEx Plan, or any material amendment or modification of any Annual Budget, Leasing Plan or CapEx Plan;

• Entering into or causing Property Owner to enter into a Mortgage Loan or incurring or causing Property Owner to incur any debt or obligation;

• Any amendment of the Mortgage Loan or the Mortgage Loan Documents;

• Any prepayment of the Mortgage Loan, extension of the Mortgage Loan, or payment deferral, forbearance, standstill or other workout agreement with respect to the Mortgage Loan;

• Any request for a future disbursement or other additional funds from a Mortgage Loan unless such proceeds will be used to redeem all of the Preferred Investor pursuant to the terms of this Agreement;

• Commencing any capital improvements, entering into any contracts for the construction of capital improvements, or entering into any contracts for matters;

• Directly or indirectly selling, exchanging, encumbering, or otherwise disposing of the Property or the Equity or any portion or interest therein, or entering into any purchase option or agreement to sell, exchange, or otherwise dispose of the Property or the Equity or any portion or interest therein, or entering into or causing Property Owner to enter into an assignment/assumption agreement for the Mortgage Loan;

• Lending money to, or guaranteeing the debts or other obligations, of a Member or any other Person, or causing Property Owner to do so;

• Making any tax elections and any other decisions affecting the tax treatment of Preferred Investor or its constituent members, including any such elections or decisions after the date that Preferred Investor's Interest has been fully redeemed and that relate to the period of time that Preferred Investor held an interest in the Company; this Major Decision of Preferred Member shall survive the redemption in full of Preferred Investor's Interest;

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Management of preferred equity investment vehicle• Examples of certain major decisions (continued)

• Commingling any Company monies with monies of any Member or maintaining any Company funds in other than an account in the Company’s name;

• Entering into or amending any contract, including any lease, between the Company or Property Owner and a Member or an Affiliate of a Member or the Manager;

• Causing the Property Owner to enter into (other than the Property Management Agreement) or amend any property management, asset management agreement or leasing agreement with respect to the Property;

• Dissolving, liquidating, and winding up the affairs of the Company or Property Owner, or taking any action or inaction that does, or with the passage of time would, make it impossible for the Company or Property Owner to carry on its business;

• Merging or consolidating the Company or Property Owner with or into any partnership, limited liability company, or other entity;

• Committing an act of Bankruptcy on behalf of the Company or Property Owner;

• Admission of any new Member or replacement of the Manager;

• Causing the Company or Property Owner to distribute Operating Cash Flow or Capital Proceeds to any Person other than the Members;

• Causing any modification, amendment or supplement to the operating agreement for Property Owner, including any designation, replacement or removal of a non-member manager or any officer of Property Owner; and

• Causing Property Owner to enter into any Major Lease.

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Sponsor defaults and Preferred Investor remedies• Defaults

◆ Breaches of the joint venture agreement

➢ Bad acts

➢ Failure to perform (including payment obligations)

➢ Deal specific breaches, e.g. ground lease obligations

➢ Failure to redeem if mandatory redemption

◆ Breaches under related management/development agreements

◆ Cross-default to senior debt

◆ Bankruptcy

• Cure rights/periods

◆ Sponsor’s right to cure

◆ Preferred Investor’s right to cure

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Sponsor defaults and Preferred Investor remedies• Remedies

◆ **All contract based remedies with no statutory backstop (i.e., UCC Article 9)

◆ Removal of Sponsor from management

◆ Increase return to Preferred Investor

◆ Ability to make protective advances

◆ Termination of Sponsor affiliated agreements

◆ Forced sale/refinance or put right

• Sponsor request for indemnity for acts by Preferred Investor after removal

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Sponsor defaults and Preferred Investor remedies

• Exercise of remedies - practical considerations

◆ Efficiency and efficacy

◆ Dispute resolution - arbitration and court proceedings

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Sponsor defaults and Preferred Investor remedies• Examples of remedies – removal eventRemoval of Manager. Preferred Investor may elect to remove Sponsor as Manager of the Company, install Preferred Investor or its designee as the new Manager of the Company and replace or terminate any non-member manager of the Property Owner. This election may be made by delivering written notice to the Sponsor, provided the election will not become effective if the Manager Default is cured to Preferred Investor’s reasonable satisfaction within ten (10) business days after Sponsor’s receipt of the notice. If not cured to Preferred Investor’s reasonable satisfaction within the ten (10) business day period, Preferred Investor or its designee will become the sole Manager of the Company and have all of the powers of the Manager under this Agreement, provided that Sections [_] and [_]concerning Major Decisions and Section [_] shall thereafter no longer apply, that is, Preferred Investor or its designee, as the new Manager, has the authority to take all actions that are Major Decisions without the consent of Sponsor or any other Members. If the Manager Default is not cured within ten (10) business days after delivery by Preferred Investor of written notice of a Manager Default to Sponsor, then Sponsor shall promptly execute and deliver to Preferred Investor, within five (5) business days of request by Preferred Investor, an addendum to this Agreement, a title affidavit, and/or any other certificate confirming that Preferred Investor or its designee has become the sole Manager of the Company, with authority to take any action on behalf of the Company contemplated in this Agreement. The change in management shall not affect any Member’s rights to distributions from the Company pursuant to Section [_]. Any costs or transfer fees payable to the Lender (or its servicer) and associated with removal of the Manager under this Section [_] shall be an expense of the Company. If Sponsor fails to grant power and authority to Preferred Investor as contemplated above, or to provide evidence to Preferred Investor of the grant of such power and authority promptly upon Preferred Investor’s request, such failure shall be deemed to be interference by Sponsor with Preferred Investor’s lawful exercise of rights under this Agreement pursuant to the terms of the Guaranty.

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Exit options

• Mandatory redemption

• Optional redemption and prepayment rights

• Sale of the property and exit strategy

• Put option/right

• Controlling interest transfer tax implications

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Senior lender recognition

• Separate recognition agreement, side letter or baked into loan documents

• Exercise of remedies

• Transfer rights

• Notice provisions

• Cure rights

• Conditions precedent - replacement guarantor

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Tax considerations

• Debt vs. equity treatment

◆ Fact and circumstance test

◆ Foreign lenders often seek to be treated as debt for the benefits of the portfolio interest exemption from withholding

◆ Recapitalization issues

• Tax allocations between sponsor and preferred investor (e.g. depreciation)

• Tax election decisions (pre- and post-redemption)

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Bankruptcy issues

• Bankruptcy related decisions and consent rights; bad boy guaranty backstop

• Standing of preferred investor in a bankruptcy of the joint venture, including in relation to senior secured/unsecured creditors

• Automatic stay considerations

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Questions?

These materials have been prepared by Shipman & Goodwin LLP for informational purposes only. They are not intended as advertising and should not be considered legal advice. This information is not intended to create, and receipt of it does not create, a lawyer-client relationship. Viewers should not act upon this information without seeking professional counsel.

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Thank You

Kathleen M. Mylod(860) [email protected]

Michael J. Fritz(860) [email protected]

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