Commercial bank lending is expected to continue to drop with EMEA bearing a disproportionately large share of that reduction. The reasons are well known: increased regulation particularly Basel III, expectations on the part of lenders of deteriorating loan performance, a perceived "lag" in non-prime real estate workouts and continuing uncertainty related to the European sovereign debt crisis. We have seen that this has led to a "flight to quality" by lenders looking for increased exposure to secured lending on prime real estate. The increased focus on prime real estate by both lenders and investors has lead to increased competition for the best properties; with prime property finding itself keenly priced non-prime real estate assets will become an increasing target class for the investor base. In EMEA mezzanine finance and institutional debt will to an extent plug this shortfall in senior debt; mezzanine lenders in 2012 were on average seen lending at maximum LTVs of around 82% - although some mezzanine provides lent at significantly above that, depending on the deal. Of course, lack of transaction volumes caused by the contraction of the senior debt market has hampered the number of mezzanine transactions but one would expect those volumes to increase in the coming year.
This article is written from the perspective of the investor and adopts an assumed structure set out below. Of course the structure finally adopted will be influenced by a range of factors from tax structuring to the requirements of the senior lender in the deal. However, the issues outlined below will probably arise in one form or another in any senior/mezz real estate finance structure and so are worth consideration. Accordingly, set out below are some of the key security and intercreditor issues that an investor may have to consider when obtaining and negotiating mezzanine finance in a capital structure.
The lending and security structure
- For the purposes of this article we will assume the following structurally subordinated capital structure.
Senior Security. The senior debt is lent to the real estate holding SPV (the "Senior Borrower") which will also enter into the hedging. The Senior Borrower grants security over the property, all bank accounts, leases and any other assets that it owns. The Senior Borrower's SPV parent ("MiddleCo") makes a subordinated shareholder loan to the Senior Borrower representing the proceeds of the mezzanine loan and possibly also the equity investment from the ultimate investor (the "PropCo Loan"). It grants a share charge over the shares in the Senior Borrower, a charge over the PropCo Loan and a floating charge over all of its other assets to secure the senior debt and any hedging liabilities. The senior security is the strongest as it is taken over and close to the underlying assets and income streams. In this structure the senior lender is not sharing its security package with the mezzanine lender but this may differ on a deal by deal basis.
Mezzanine Security. MiddleCo's SPV parent (the "Mezzanine Borrower") draws the Mezzanine Loan and downstreams it by way of subordinated loan to MiddleCo (the "MiddleCo Loan"). The Mezzanine Borrower's parent ("TopCo") will grant security over the Mezzanine Borrower's shares, and the Mezzanine Borrower will grant security over MiddleCo's shares to the mezzanine lender. This key point to note about the Mezzanine security package is that, given the asset level security of the senior lenders, the value of the mezzanine security in an enforcement scenario may be zero. The strategic value of the mezzanine security is significant as it provides the senior lender with a further exit if the transaction goes into default and gives the mezzanine lender a means of selling the group, with the senior lender's consent, to a vehicle controlled by it. As this disenfranchises the investor and lessens the likelihood of an investor/senior workout, an investor should consider the scope of any permitted mezzanine enforcement rights carefully.
Some key intercreditor issues
- Payment blockage. If a senior default occurs the senior lender may have the right to issue a notice preventing the Senior Borrower from making any upstream payments. As this will not only prevent repatriation of funds to the investor it will almost certainly give rise to enforcement rights on the part of the mezzanine lender. Precisely which senior defaults will give rise to this right to block upstream payments and when the blockage will end will be a matter of negotiation the investor will need to be involved in.
- Mezzanine cure rights. If a senior default occurs the mezzanine lenders may want the right to cure and will want a timeframe within which to do so. Where cure payments are made by the mezzanine lender these will form part of the mezzanine debt and the investor will need to agree with the mezzanine lender how any such further cash injections will be treated: for example the mezzanine lender may want a higher rate of return for any such cure loans or an adjustment to any exit waterfall agreed with the investor.
- Permitted mezzanine enforcement rights. The mezzanine lender will want the right to be able to enforce the mezzanine security and transfer the Mezzanine Borrower's shares to a permitted transferee entity that the senior lenders have pre-approved. This enables the mezzanine to take control of the group and leave the equity in the cold. This solution may be preferable for a senior lender than a senior enforcement and sale and so the investor should ensure that it understands and is comfortable with the circumstances in which the mezzanine lender can exercise this right.
The above is by no means a template for all such transactions and nor is it intended to be an exhaustive list of issues in any deal and we will no doubt see patterns emerge as the mezzanine real estate finance market develop. Given the complexity of the issues in such a structure an investor would be well advised to consider its position at term sheet stage.