Preferred Equity for Development Projects

This example illustrates the effect of mezzanine financing on a development project in which repayment of the senior debt is associated with incoming cash flows earned from property sales.

A development project which provides for an initial stage involving negative operating cash flows (purchase of the land and construction), followed by a stage involving positive cash flows from property sales will be analysed.

The project is financed using senior debt at 55% LTC with a yearly cost of 7%, the drawdown of which occurs on the basis of a WIP report in proportion with operating cash flows, whilst repayment is made at the level of the entire operating cash flow when positive. Financial charges are paid during the relevant period. For the sake of simplicity, transaction costs and taxes are not presented.

Furthennore, the possibility of using preferred equity for part of overall financing needs at 15% LTC is also considered, subject to the following privileges:

• priority repayment before equity for the full amount of available cash flow after senior debtors have been paid;

• preferred share of profits up to the target IRR of 13%.

A summary of financing conditions is shown in Figure 7.9.

This contractual scheme may be obtained simply by using a vehicle with two different classes of shares (e.g. real estate fund with different classes of units):

• Class A: priority in remuneration and repayment, with a limit on return (mezzanine);

• Class B: residual remuneration and repayment, but without a limit on return (equity).

The operating cash flows for the project are illustrated in Figure 7.10; post senior financing effects are illustrated in Figure 7.11. Residual financing needs, after the senior debt has been drawn down, will be covered initially out of preferred equity and thereafter with equity.

FIGURE 7.10 Operating profitability and levered cash flows

FIGURE 7.11 Cash flows with preferred equity

FIGURE 7.12 Cash flow distribution over time

It is noted that available cash flows after the debt has been serviced are allocated in full to investors in preferred equity until the target return has been achieved. For the purposes of that calculation, all cash flows of preferred equity, both negative and positive, must be capitalized until the end of the project at the preferred equity target rate of return (13%): the total sum, as an absolute value, represents the cash flow enabling the target return to be achieved.

The use of mezzanine financing means that the investment can be carried out with a reduced amount of equity and an increase in profits for shareholders.

Investors in preferred equity obtain a higher return compared to senior debt lenders, although this corresponds to a higher risk; it should be pointed out that this return is in any case limited by a Cap, although it is preferred over equity, which will only achieve a return after the minimum guaranteed return on preferred equity has been paid out. For the sake of simplicity, the structure presented in the example provides for only one threshold; in practice, however, it is commonplace for various levels to be stipulated, with the result that preferred equity is allocated a different quota depending on the different target returns achieved, thus enabling genuine participation in risk and profits.^[1]

Figure 7.12 shows the cash flow distribution for different investors in euros and as a percentage.

FIGURE 7.13 Effects of change in the conditions applicable to preferred equity

Finally, Figure 7.13 simulates the effect on ROE of a contractual change in preferred equity as a function of equity capital invested and of the minimum target return.

• [1] On the risk and profits split refer also to paragraph 7.5.