Using preferred equity for your next deal?

Most sponsors mistakenly pitch pref equity providers a deal in the same way that they would pitch limited partners.

Don’t make this mistake.

Here’s what you should keep in mind when presenting an investment opportunity to a pref equity provider.

What is Pref Equity?

Preferred equity is a type of equity that is given preferential treatment over common equity. In the event of a default or bankruptcy, preferred equity holders will be paid back after senior debt, but before common equity holders.

What Pref Equity Cares About:

Pref equity providers prefer to focus on downside risk rather than upside potential. These capital providers care about project level returns. Meaning you as the underwriter (or sponsor) would never send them limited partner returns as a result of your waterfall structure.

Since a pref equity provider gets paid (no matter what) before the common equity, the limited partner returns are completely meaningless to them.

We discussed the capital stack structure in a previous newsletter.

Other metrics pref equity providers will focus on:

• Yield On Cost = the rate of return of an investment based on taking the net operating income and dividing it by the total cost of the investment.

• Last Dollar Exposure = The total amount of deal financing when considering both senior debt and preferred equity.

• Development Spread = This will differ from one firm to another but let’s assume a rule of thumb of 200–300 basis points above the cap rate.

• Cap Rate - Year by year return.

They typically have a fixed rate of return, targeting between 12–17% per year over the hold period of the deal. Many preferred equity investments fall somewhere in between “hard” and “soft”. Learn more about the differences here.

I typically like to show pref equity providers a clean and simple layout of my proforma and basic assumptions in a 2 page summary. A well formatted presentation will provide your audience with a lot of confidence that you have a thoughtful analysis.

*Keep in mind that every deal is different and each pref equity provider will look at deals and structure their equity differently.

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