Why are we in a limited window of opportunity for top preferred equity deals right now?
"Why are we in a limited window of opportunity for top preferred equity deals right now?"
As a reminder, preferred equity sits in the middle of the capital stack. It can provide debt-like repayments ahead of common equity, with additional upside to investors. It generally carries less risk than common equity but typically has a capped upside.
Preferred equity is more needed right now than usual, and with this supply and demand imbalance comes better terms and returns for groups like Wellings Capital.
Why is Preferred Equity Compelling in General?
⦁ Immediate cash flow, future upside, and shorter hold time
⦁ Payment priority ahead of common equity
⦁ Lower downside risk exposure than common equity
⦁ Preferred equity still receives depreciation tax benefits
⦁ Can negotiate control rights in case something goes wrong
⦁ Can negotiate a MOIC floor to juice returns if taken out early
Why is Preferred Equity a Compelling Investment Right Now?
⦁ Many lenders are pulling back on new deals compared to 12-18 months ago, drastically increasing the demand for preferred equity. We have all seen the news about lenders refusing to lend on deals. Many that do get funded end up closing with lower loan-to-cost ratios and stricter terms. This has created a gap, whereby sponsors scramble to close deals by employing preferred equity.
⦁ Shortfalls in common equity create gap-funding opportunities. This is a double-whammy for sponsors already coming up short on debt. With both equity and debt capital in limited supply, preferred equity or mezzanine debt is often the remedy.
⦁ Coupon rates/current pay are much higher than in the past. We are negotiating deals with higher coupon rates than we have seen in the past for $1-5 million check sizes. This capital crunch has hit smaller deals particularly hard. It is often not worth most preferred equity providers' time to evaluate these smaller deals. But these under-the-radar deals often provide the best safety and potential upside.
⦁ Sponsors with excellent assets are often caught with an unfortunate capital stack. Many excellent projects with upcoming loan maturities will not get refinanced as planned. Sometimes this has nothing to do with the sponsor or project. Injecting preferred equity is often the only way forward.
Why is Right Now a Limited Window for Preferred Equity?
⦁ Banks will start lending at higher leverage and relaxed terms when interest rates drop. As the credit cycle ebbs and flows, lenders will predictably change their underwriting standards and terms. High interest rates and tighter terms are creating an excellent opportunity for us right now, but it won’t last forever.
⦁ When interest rates drop, sponsors with floating-rate debt won’t need to recapitalize as much as they do now. The current conditions have wreaked havoc on sponsors with floating rate debt. Though we won’t typically invest in these deals, their ubiquity has created tremendous demand on a limited pool of preferred equity dollars. When interest rates drop, the pressure and demand will decrease significantly.
⦁ Institutional investment activity and common equity investments will likely increase when market uncertainty recedes. The issue here is not just the lower availability of debt. It also hinges on constrained equity availability. Part of the issue, in cases like institutional investors such as Blackstone and KKR, regards spooked investors cashing in their shares. The issue is not a lack of investible cash; at some point, the spigots will open again.
⦁ Potentially more competition coming for $1-5 million check sizes could drive down current pay and coupon rates that we’re seeing now. We’re not alone in spotting this opportunity, especially with the premium returns generated from small check sizes. We believe preferred equity competition in this sector will increase soon, hence our desire to place more preferred equity as soon as practical.