Pref Equity: How institutional sponsors lower their cost of capital

Sexy debt? Or boring equity?

It depends on how you view preferred equity, an underappreciated portion of the capital stack.

Preferred equity is a hybrid product issued by sponsors, typically at the institutional level. It’s a tool to substantially increase general partner upside, and capture a higher percentage of total proceeds.

Characteristics of Preferred Equity

• It has a fixed cash flow component (like debt).
• The market rate for preferred equity varies due to interest rates, credit risk, and inflation (like debt).
• Preferred equity pays out ahead of common equity in a liquidation (like subordinate debt).
• “Pref” investors are written into the deal’s operating agreement, allowing them to take control of a distressed asset without a public foreclosure process (like equity).
• It’s a perpetual instrument. Payout takes place over the entire life of a deal (like equity).
• Preferred equity breaks down into two components: current pay and accrual. Current pay is the cash returned to the preferred investor throughout the life of a a deal (from cash flow). Accrual is paid out when the preferred equity is “called” or the deal is refinanced / sold.

How it Looks in Practice

The majority of middle market syndications we see are underwritten with a vanilla capital stack. There are three portions: A senior debt, limited partner equity, and general partner equity.

Contribution Type% of Contribution to DealCost of Capital (Return to Investor)Equity MultipleBlendedN/A20%2.11xGeneral Partner Equity2.5%34.6%3.65xLimited Partner Equity22.5%17.8%1.94xSenior Debt (excl. equity pay-down and tax advantage) 75%5%N/A

**This deal includes the following assumptions:

• 20% IRR (5 year hold)
• pari passu up to 8% return, 70% | 30% LP vs GP split after 8% (single promote)
• Senior debt at 5% interest (30 / 360), 30 year Am, 10 year term, 36% tax rate
• Assumes no deal fees

Many newer syndicators have gone through similar training regiments with a standardized template for doing business (and that’s completely fine). But as the market matures, and competition increases, the best sponsors will exploit more efficient capital structures, and the mediocre ones will fail to evolve.

Here’s an example of a capital stack with preferred equity. We value simplicity, but small optimizations like this can yield outsized results.

**This deal assumes an annual IRR of 20%, and a 5% loan at 75% LTV.

Contribution Type% of Contribution to DealCost of Capital (Return to investor)Equity MultipleBlended
N/A~30.6%~2.84xGeneral Partner Equity1%~51.4%+

~5.99xLimited Partner Equity9%~27.0%~2.50xPreferred Equity15%9.0%

N/ASenior Debt  (excl. equity pay-down and tax advantage)75%5.0% (excl tax benefit + principal pay-down)N/A

The punchline… a preferred equity partner can reduce your traditional equity raise by more than 60%, at a 5% reduction in cost of capital (or more).

As a sponsor, you are essentially promoting yourself to higher GP returns by swapping common LP equity for preferred.

You’ll notice that LP returns went up in our second example, which provides the sponsor an opportunity to negotiate more favorable splits after hitting a higher return threshold. There’s a higher return on common equity (GP + LP) in the deal, which gives the sponsor more optionality (you can arrange to give as much / as little of that surplus return to your LP investors as you’d like). There’s more to go around for common equity holders.

Why Don’t More Deals Involve Preferred Equity?

There are a few reasons.

• Awareness: Many syndicators are comfortable with their traditional system for raising equity. If it isn’t broken, don’t try to fix it.
• Selectivity: Preferred equity groups demand a higher caliber deal with high quality partners. The character of your operating model, underwriting, and track record will need to meet the preferred group’s standards.
• Lack of Connections: Some sponsors have excellent equity sources, but they have not developed a rolodex of preferred equity investment groups. These investors are much like family offices… they don’t advertise and are part of word of mouth networks. “Friends & family” seldom step in as preferred investors in traditional “country club” deals.

The Anatomy of Preferred Equity in a Capital Stack

We are big believers in curating the capital stack with a focus on WACC, which is more typically used in corporate finance than in real estate. It’s essentially the blended rate you pay lenders and investors for the capital they provide you.

Your weighted average cost of capital dictates how much you get paid as a general partner, and the quality of opportunity you can say yes to.

Preferred equity cost of capital will range from 8% to 10% in today’s market. Compare that to the following alternatives (for a multi-family deal):

• Senior debt: 5%-7% + principal paydown
• Mezzanine (junior) debt: 10%-18% + principal paydown
• Common Equity: 12%+
• Co-Sponsor Equity: 25%+

If you can secure preferred financing on a deal, you you’re arbitraging your level of obligation and cost of capital substantially (reducing LP and GP equity).

Notice that common equity is actually cheaper than market cost of capital for mezzanine debt. Mezzanine financing is a valuable addition to many capital structures, particularly in a heavy value add deals. It’s more readily available (and a better fit) for certain transaction types, but consider the following:

• Preferred equity is often cheaper than mezzanine debt by 200 basis points or more.
• If a deal goes sideways, a true preferred investor (usually a skilled operator) will dilute LP / GP investors, but may save the deal from going into foreclosure (thus avoiding loss of the entire deal).
• Preferred equity can be taken out if enough total equity exists in the project, but they’re could be minimum equity multiples that are enforced if you attempt a take-out before the initial investment plan.
• Preferred equity (and subordinate debt) allows sponsors and LPs to capture the same depreciation benefit with a smaller capital injection… supercharging one of the key benefits of real estate ownership.
• Mezzanine debt are often quoted as a spread over a floating rate index (30 day LIBOR), making the property level cash flows less predictable (vs fixed payments to preferred investors).

To close, preferred equity takes the traditional syndication model to a new level, giving GPs the same ability to leverage / promote themselves into high returns on invested capital, but at a much lower hurdle rate.

Wishing you great success.

Kyle & Terry