What's in a Name: Mezzanine Debt versus Preferred Equity
Heller, J. Dean, Stanford Journal of Law, Business & Finance
Mezzanine loans and preferred equity interests are forms of investment in commercial properties; they are favored by investors, particularly institutional investors, who want a fixed, or at least floored, return and priority as to both their return on and return of investment. In its most common form, a mezzanine loan is secured by the investment property, but only indirectly, by a pledge of the equity in the entity (usually a limited liability company or limited partnership) that owns the property. Preferred equity, on the other hand, usually takes the form of a direct equity investment in the property owner, with a fixed, preferential return that is paid prior to distributions to the "common" equity interests in the owner. Apart from this difference, mezzanine debt and preferred equity can - and often do - have similar terms and conditions. Nonetheless, most institutional and many other real estate investors appear to regard mezzanine debt as an intrinsically better form of investment than preferred equity.
This article postulates that capital markets may be giving undue deference to the notion that one is "debt" and the other "equity," and analyzes the purported legal advantages of mezzanine loans over preferred equity interests. While acknowledging that mezzanine debt may be the preferable form of investment for certain types of investors and properties, this article concludes that preferred equity generally provides an investment structure that works as well as - if not better than - mezzanine debt.
"What 's in a name? That which we call a rose by any other name would smell as sweet. "
-William Shakespeare, Romeo and Juliet, act 2, sc. 2.
Anyone familiar with modern marketing techniques knows that Shakespeare got it wrong. A Juliet's Heart(TM) Rose, promoted by an extensive advertising campaign featuring celebrity endorsements from the screen's currently reigning ingénue, will smell sweeter. At least, so it would seem to millions of less famous ingénues and their suitors, which is what matters in the market.
Lest we think "brand" labels operate to dissociate perception from reality only in retail markets, consider whether branding also helps explain how "mezzanine debt" came to dominate the market for real estate financing in the space between senior mortgage debt and "common" equity. Compared to preferred equity investments, commercial real estate mezzanine loans quickly became the popular choice for most institutional investors and, as a result, appear to have been priced more favorably for consumers of capital than preferred equity with a similar risk-to-reward profile. Yet from a purely contractual point of view, does mezzanine debt do anything that a preferred equity agreement cannot do as well or, in some cases, better?
The following chart matches the salient rights and remedies of a real estate mezzanine lender with those of an investor holding a preferred equity investment:
This comparison demonstrates that a mezzanine loan from the property owner's parent entity should not be more secure than an equity interest in the owner because a mezzanine lender's only connection to the property is through an indirect hold on the selfsame equity interest. If one accepts as axiomatic that the more complicated a contraption is, the more likely it is to malfunction, then a direct preferred equity interest in the property owner ought to outperform an essentially similar, but indirect, interest, regardless of whether the latter is labeled "debt."3
Why, then, do sophisticated institutions regard mezzanine loans as not merely the equivalent, but indeed the superior device for mezzanine-level investments in real estate? If the answer does not derive from the branding of mezzanine loans as "debt" rather than "equity," there should be some intrinsic or extrinsic advantage that these loans have over economically equivalent preferred equity investments. This article will identify the purported advantages of mezzanine debt and consider whether they justify the market bias toward mezzanine debt over preferred equity. …