As you head into the market for private placement deals, you’ll probably run into a few different offering types. Some will be riskier than others, but the equity offerings tend to fall into two buckets – preferred equity and common equity.
Common equity is the most prolific of private placements in a normal market. Still, there are plenty of reasons that a deal sponsor would pursue preferred equity. The differences may be subtle, so it’s worth reviewing what to look out for.
Common Equity
For a pint of reference, your holdings in most publicly traded companies are common equity.
This is the position at the top of the capital structure, which is the riskiest but also has the greatest upside potential. Essentially, you keep all cash flow that remains after paying capital sources below you, including debt and preferred equity.
You may have some rights over major decisions in this position, but don’t expect too much. Private placements are usually structured to put the investors in a passive position with rights only over decisions that would materially impact their position in the deal. Otherwise, the decision to refinance, sell, or reinvest in the venture lies solely with the deal sponsor.
Common equity is a great place to be if you believe the upside potential outweighs the downside risk.
The best way to look at this is by taking a realistic perspective on the real estate property value relative to the market, cash flow potential, and the sponsor’s ability to execute the business plan. These, among other considerations, will help determine whether the majority of your upside will come from cash flow or value appreciation.
Preferred Equity
Investors and deal sponsors like preferred equity for similar reasons. It acts like debt with the flexibility of equity.
A typical preferred equity opportunity comes with two repayment tranches.
The first level is a preferred return that is similar to that in a common equity position. The difference with common equity is that this preferred return is usually paid current as opposed to accruing. Therefore, it’s important to get comfortable with the sponsor’s ability to generate cash flow from the property.
The second tranche sets a higher return hurdle in which interest accrues if not paid from current cash flow. All cash flow in the first level goes to the preferred equity investor to reach the preferred return. However, cash flow may be split between the sponsor and the investor between the preferred rate and the hurdle rate.
Many preferred equity deals stop at this hurdle rate or some minimum return. That said, some deals may also offer a defined percentage of the upside created in the deal.
Preferred equity tends to be more expensive capital than mezzanine debt. However, it allows the deal sponsor and common equity investors to increase their leverage with clarity on what an investment decision means for their position in the deal. This has tremendous value when considering the alternative for diluting common equity investors without limiting the payout.
You may start to see more preferred equity offerings arise in trying times. This is because loan agreements allow you to sell a certain amount of equity, but they may restrict taking on additional debt. It’s important to evaluate the strength of the operator and her staying power when deciding to invest in the opportunity.