Lenders point to new wrinkle in capital stack: Participating preferred equity 

Participating preferred equity is emerging as an alternative for lenders and borrowers as sourcing traditional joint equity has become more difficult amid market volatility. 

Cody Kirkpatrick, a managing director and founding member of Berkadia’s JV equity and structured capital, explained participating preferred equity is a hybrid structure that has features of preferred equity and joint venture equity.  

While traditional preferred equity sits lower in the capital stacks and focuses on achieving a target internal income return or equity multiple, with all upside going to the sponsor, participating preferred equity takes a priority return, but also participates in the upside after a catch-up to the sponsors, said Kirkpatrick.  

In other words, participating preferred equity allows holders to receive returns beyond their minimum required return, a benefit similar to joint venture equity’s uncapped profit potential, Kirkpatrick added. 

Filling the gap 

In a broader sense, preferred equity is more frequently filling in the gap as joint venture equity is harder to raise in today’s market. 

“Groups that traditionally have been offering JV equity, [at] where the market is today, they’re just more comfortable in a preferred equity position,” said Noam Franklin, managing director at Berkadia JV equity and structured capital. 

He continued: “The biggest challenge right now is that it’s hard to make deals pencil [out]. When we actually underwrite the deal, take out the developers’ assumptions and put in more institutional conservative assumptions, most deals aren’t penciling for a multitude of reasons.” 

Kirkpatrick believes the broader interest in preferred equity stems from today’s unusual market conditions, noting the firm had long worked with sponsors who did not consider preferred equity as an option. 

“The question that people are discussing internally is when it makes sense to take equity risk versus preferred or downside-protected investment risk,” said Kirkpatrick. “I think many of these groups [that] are able to achieve the returns [are] targeting in a credit profile, meaning preferred equity, or mezzanine versus common equity risk in today’s volatile environment.”  

Berkadia also is seeing pricing widen for preferred equity on multifamily development deals. Kirkpatrick cited the pricing of a secondary-market preferred equity deal at 10 percent last year could rise to around 12-13 percent now. “That’s just where we’ve come in 12 months, probably 250 [to] 300 basis points wide net, if not more,” Kirkpatrick said.   

Having said that, the structure could be a challenge for new preferred equity providers going behind agency debt and potentially adding “certainty of execution” risk to a sponsor’s deal. “There could be a steep learning curve, and it could potentially jeopardize your deal from an efficiency and execution standpoint, if [investors] can’t hit the key milestones within a contract time period,” said Kirkpatrick.