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What is Preferred Equity?

In the context of this article, Preferred Equity simply means a particular investor who will receive different or priority returns than other investors. Preferred Equity typically comes from Family Offices, Insurance Companies, Hedge Funds, other Funds, and even certain Institutional Investors that will take a fixed return or equity position in your real estate deal. We have assisted many clients with their Preferred Equity transactions.

If you are considering using Preferred Equity in your deal, read this article first so you understand what you are getting into. You will need experienced attorneys to represent you in the transaction and we recommend you hire us as soon as you get a draft Term Sheet from the Preferred Equity Investor. We can help you negotiate the Term Sheet and the Operating Agreement(s) detailing the terms between you and the Preferred Equity Investor. Your Preferred Equity Investor will have expert legal representation, and you should, too.

Why Use Preferred Equity?

Before you pursue Preferred Equity for your real estate transactions, you should do the following analysis to see if it even makes sense:

The first question is, why do you want to take Preferred Equity in your deal? You need to make sure you are clear on your objectives to determine whether it makes sense. What is your reason?

  1. The primary reason to accept Preferred Equity is that you can’t raise all of the money yourself. If this is true, go for it! It’s better to own part of something than nothing of nothing.
  2. Another reason to do it is that the Preferred Equity Investor wants a lower return than you would have to pay your own private investors (this rarely happens). If it saves you money or results in a higher return for you or your investors, that’s a great reason to do it.
  3. If none of those reasons apply, is there something else you are trying to achieve? If so, will it help you purchase this property or further your syndication business in the long run?

Why NOT Use Preferred Equity?

Most of our clients who use Preferred Equity do so with the idea that they will get rid of it as quickly as possible, because the Preferred Equity Investor will likely place restrictions or additional burdens on you that you would not otherwise have with private investors. Here are some typical risks and burdens associated with accepting Preferred Equity in your real estate transactions:

  1. Most Preferred Equity companies will require that you produce a list of periodic reports (some may be monthly, others may be quarterly or annual), which is more reporting than you would typically do with private investors. This will cost you time and money, as you may have to hire someone to keep up with their demands. Additionally, they will usually want a lot of upfront paperwork that you will need an experienced attorney to draft for you.
  2. Most Preferred Equity companies will require that you meet certain performance parameters, in addition to the payments you owe them, for things such as minimum occupancy levels, debt service coverage ratios, reserves, budget compliance, etc., and if you don’t meet these parameters, they may consider it a “default” and begin the takeover process or force a sale at an inopportune time. If you also have your own investors in the deal, they are at risk, as the Preferred Equity firm will only care about making themselves whole and may completely disregard your investors by selling the property at a price that doesn’t yield enough to pay your investors — often selling it to an affiliate of theirs at the price they are owed so they can strip your investors’ equity.
  3. Some Preferred Equity companies are actually predatory and may try to force you into a technical “default” so they can take over and own the property themselves. I have seen mid-six-figure litigation between a Syndicator and Preferred Equity Investor on more than one occasion. In one case the takeover was initiated by the Preferred Equity Investor even after the technical default had been cured.
  4. Some Preferred Equity Companies may string you along and then pull out at the last minute, leaving you stuck with all of the pre-closing expenses and no investors to close the deal.
  5. Most Preferred Equity Companies will require that you pay their legal fees in addition to your own, which could double or triple your upfront legal expenses.

How Can You Include Private Equity in Your Offerings With Other Investors?

  1. Use a Side Letter. A side letter gives a Preferred Equity Investor some of the earnings retained by the management class (or Class B), without affecting other investors. No Lender underwriting required as no additional voting or takeover rights are granted. We can draft this for you, or the Preferred Equity Investor’s counsel may do so. This is the least expensive option.
  2. Create a separate Preferred Equity Class for a Preferred Equity Investor within a Syndicate. You can do this in a Class A/B structure by creating subclasses of Class A, such as Class A-1, Class A-2, etc. This option will typically require the Preferred Equity Investor to be underwritten by a first-position lender unless they have no voting or takeover rights (but could force a sale). We can do this for you. This is a moderately priced option, and your costs will depend on whether you incorporate the multi-class option into your corporate structure from the start or have to add it later.
  3. Create a Joint Venture between your Syndicate and a Private Equity Investor. This option will typically require the Preferred Equity Investor to be underwritten by a first-position lender, as they will have voting and takeover rights. This option requires a separate joint venture entity and agreement. The Private Equity Investor will usually provide the joint venture agreement but if they do, you’ll want to have it reviewed by us, or we can draft it for you.

Conclusion

Joint Ventures and Co-Investments by Private Equity Investors can help you grow your real estate investment or syndication business, as long as you understand what you are getting into, and you comply with the Private Equity Investor’s terms and requirements. This is not a decision to be entered into lightly or without sound legal advice, so make sure you engage us to help you with your Private Equity and Joint Venture transactions — preferably before you finalize terms.

For additional information, see these Articles in the Library at www.SyndicationAttorneys.com:

  1. “Joint Ventures & Co-Investments”
  2. “Whale Investors can Krill your Offering”

If you still want to do a deal with a Preferred Equity Investor, we are here to help. We have assisted many clients with their Preferred Equity transactions. Please schedule an appointment today for your free consultation.

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