The Riskiest Way To Structure A Deal

I love syndicators. I respect what they do. It takes guts to buy deals as an operator. They exhibit the ability to take responsibility, execute, and make money for their clients.

However, as investment capital becomes harder and harder to come by, some of the marketing that I’m seeing from syndicators is becoming troubling, to say the least.

It’s OK to hustle to raise capital. It’s fine to tout the selling points of a given transaction. But it is much more important to stick to factually accurate information. Misleading statements about the risk profile of a deal are not only inappropriate, they may be illegal.

Here’s one questionable piece of marketing material I saw recently:

“We are financing this deal conservatively. We are using bridge debt, but we are buying a rate cap, and we are using preferred equity to bridge the gap on proceeds.”

In this line, the sponsor claims that the deal is being financed conservatively. But frankly, that is not the case.

While the sponsor is buying a rate cap, which limits the interest rate risk on the deal, they are still using bridge debt. Which is by nature, shorter term. Shorter term debt is inherently more risky than long term debt, because the sponsor is forced to increases the value of the property fast enough to repay the debt which will be due… soon.

But that’s not why the statement is so misleading. It is the fact that they are using preferred equity, and still claim that they’re structuring the capital stack conservatively.

Preferred Equity does not make the deal more conservative. It makes the deal more risky! And that is because the preferred equity will expect their principal and their minimum return before the common equity.

Preferred equity gets its name for a reason. And that is because it is preferred in relation to the rest of the equity: aka the common equity. If the deal were to sell at a loss, the preferred equity would get all of their funds returned and their expected return, before the sponsor could take a nickle. That would mean that all losses will be born by the common equity holders. While the common equity would only lose a portion of their capital in a deal with NO preferred equity, the common equity stands to lose ALL of it in a deal with preferred equity.

Therefore, while preferred equity could greatly enhance the returns on a transaction (it is a cheap form of capital), it automatically adds a level of principal risk to a deal that was not there before.

All in all, the combination of bridge debt and preferred equity is possibly the most aggressive financing structure one could have on a deal. It is definitely not fair to describe this as conservative.

To all sponsors. Please be careful with what you put in a pitchdeck. The statements you make should represent real knowledge of how a capital stack works. And being overly rosy about expected returns may help in the short term, but could come back to bite in the long run.


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