Navigating Mezz, Equity Refis

Investors in distressed debt these days are rather like whalers of old, riding the stormy seas of today's market, looking through the fog and rain for an opportunity to harpoon. Oft en there's little certainty in the fog. You might find a whale of a deal or a handful of little fish. However, no matter how bad visibility gets, there is a great big school of refinancing needs swarming up from all the underwater properties: estimates suggest more than $900 billion in commercial real estate loans will need to be refinanced through 2012 due to maturity dates (either original or extended).

Unfortunately for the borrowers, underlying property values oft en have dropped significantly. Loans cast with a comfortable loan-to-value ratio may have marginal (or worse) equity value now. Some that are far underwater will sink. But another large group may still hold promise: many income properties that secure distressed loans still work on a cash-flow basis, if not at the originally required loan-to-value ratio. Others are weaker, only barely covering loan payments. This need for cash creates an opportunity for investors to provide rescue financing, typically through a mezzanine loan or an infusion of equity. The basic pros and cons of such alternative rescues are outlined below.

Mezzanine Loans. Traditionally, mezzanine loans filled the gap between the cash contributed by the borrower and the cash lent by the senior mortgage lender. In a mezzanine loan, the lender provides debt financing, which is not secured by the real estate itself, so it does not impair a senior lender's mortgage, but instead is secured by a pledge of the property-holding company's equity. Senior lenders historically have been willing to accept mezz financing because it supports the property's value with new money while avoiding an additional junior lien on the collateral. Foreclosure of a mezzanine loan is typically handled quickly under the Uniform Commercial Code (UCC), leaving the senior bank holding a good mortgage lien against a borrower controlled by new and, hopefully, more solvent ownership.

Traditional Equity Funding. Investors also can invest cash as pure equity, contributing funds into the holding company at the same level where the principal holds ownership. That equity can take the form of pari passu (same priority) equity that dilutes the principal's interest percentage, or a preferred, superior-priority equity paid out in any liquidation ahead of the principal. The default and control terms of these deals are usually negotiated; they can give the investor some contractual control sharing rights, a right to take over or the ability to redeem and get paid early.

Hybrid or Preferred-Plus Deals. Recently, we have discussed proposals for a hybrid preferred-plus arrangement, where the new investor takes a preferred equity position but with its redemption rights secured by a pledge of the holding company's equity. This structure does not seem to be in wide use yet, but it should be plausible under UCC rules: a conversion or redemption right triggered by time, or covenant defaults, can be secured by a pledge, just like loan-repayment rights. The pledge should provide a faster ability to enforce since its foreclosure can be much quicker than enforcement of contractual rights through litigation.

Bankruptcy Risks. Any rescue investment risks some delay or loss if the property-holding company is forced into bankruptcy. Any junior investment is vulnerable to a valuation finding that the property has no value in excess of the senior-loan balance. Once in bankruptcy, any creditor, or the original principal, can attempt to have the rescue investor's rights equitably subordinated. But rescue investors may gain some protection from well-designed pre-bankruptcy strategies, including redemption, equity foreclosure, or other control-change provisions upon default; covenants and representations that make it harder for the principal to later claim unforeseen conditions; and the extra leverage of a preferred-plus lien. Thoughtful design of any rescue infusion is always wise. In the current uncertain economic weather, it's essential to protect the upside in any new investment in a distressed property.

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