Make sure you are familiar with the operational and structural considerations of mezzanine financing.
Mezzanine financing provides lenders an attractive opportunity to achieve higher returns than they would with a standard real estate loan. Before engaging in mezzanine financing, a lender should carefully evaluate the risks associated with a mezzanine loan. Part of this analysis involves understanding the typical intercreditor agreement (ICR) executed as part of a mezzanine financing.
Let’s review some of the key intercreditor agreement provisions that favor a mezzanine lender.
Bridging the Gap
Mezzanine debt, often referred to as “mezz debt” or “gap financing,” is a form of debt frequently used to bridge the gap between senior financing and pure equity. Employing mezzanine financing benefits a borrower by increasing leverage without resorting to equity, which dilutes a borrower’s ownership structure.
In a typical estate loan transaction, the senior lender’s maximum loan-to-value requirement, or LTV, will dictate the maximum loan amount. For example, if a lender’s maximum LTV is 65%, that means the lender will fund a loan not more than 65% of the value of the real property collateral. If a real property has a value of $1,000,000, this translates into a maximum loan of $650,000. The borrower must fund the $350,000 difference. If the borrower has $200,000 of its own funds, another $150,000 is still required to fully fund the project. This $150,000 is a gap that can be filled with mezzanine financing.
Loan Structure
A common mezzanine loan structure involves two separate loans. The first loan is a real estate loan a senior lender funds for a borrower who owns the real property collateral (the real property borrower). This loan is secured by a first priority lien on the real property.
The second loan is a subordinate mezzanine loan made to the owner of the real estate borrower (the mezz borrower) and is secured by the mezz borrower’s collateral pledge of 100% of the equity interest in the real estate borrower. This structure exposes the mezzanine lender to the risk of not having a direct lien on the real property collateral. Due to this, a mezzanine lender relies upon the real property having a value greater than the senior loan amount.
If a senior loan default results in a foreclosure of the real property collateral, the mezzanine lender can be left without any assets to support repayment of the mezzanine loan. This risk is addressed in an ICR executed between the senior lender and the mezzanine lender.
Key Intercreditor Agreement Provisions
The ICR is perhaps the most important document in a mezzanine transaction. Understanding the key provisions are vital to a mezzanine lender’s ability to underwrite the risks associated with a mezzanine loan.
An ICR is a legal agreement between a senior lender and a mezzanine lender that sets out their respective rights and remedies in relation to the senior loan and the mezzanine loan. The ICR provisions referenced below are often highly negotiated and vary from transaction to transaction.
Foreclosure on separate collateral. The provisions addressing when a mezzanine lender can foreclose on the equity pledge of the real estate borrower’s equity interests—generally known as the Separate Collateral—are critical to any ICR. A typical ICR will prohibit a mezzanine lender from foreclosing on the Separate Collateral unless the mezzanine lender:
- Agrees to acknowledge that the real property borrower remains subject to the senior real estate loan.
- Causes the real property borrower to reaffirm all the provisions of the senior loan and senior loan documents.
- Cures all defaults under the senior loan if they are capable of being cured.
- Provides a replacement guarantor in support of the senior loan. When a mezzanine lender realizes upon the Separate Collateral, it takes over ownership of the real estate borrower and will be required to comply with the terms of the senior loan. This requires a mezzanine lender to have a complete understanding of the senior loan and to have undertaken its own exhaustive underwriting of the senior loan transaction.
Modifications or amendments to loan documents. A typical exit strategy for a mezzanine lender is to be paid off upon the refinancing of the real property or upon the sale of the real property. Either way, the value of the real property is crucial to a mezzanine lender’s ability to be repaid. If the real property’s value is insufficient to pay off the senior loan, the mezzanine lender will bear the shortfall. Accordingly, a mezzanine lender has a vested interest in preserving the status quo of the senior loan amount. An ICR accomplishes this by prohibiting the senior lender from making certain amendments or modifications to the senior loan documents that, among other things, increase the principal balance of the senior loan or increase the interest rate applicable to the senior loan.
Subordination of mezzanine loan. A critical provision in each ICR is the subordination of the mezzanine loan to the senior loan. Under a typical ICR, the mezzanine lender subordinates its loan to the senior lender’s rights to payment under the senior loan. The mezzanine lender is prohibited from accepting or receiving any payments under the mezzanine loan until the senior loan is repaid in full.
The prohibition against payment generally applies only when the mezzanine lender receives notice of a default under the senior loan. Upon receipt of such notice, all payments the mezzanine lender receives are to be held in trust for the benefit of the senior lender. If a senior loan default is cured or waived by the senior lender, some ICRs permit the mezzanine lender to receive “catch up” payments of all missed payments that were prohibited during the continuance of a senior loan default. Mezzanine lenders should note the possibility of not receiving debt service payments and build that risk into their credit analysis.
Right to cure. A typical ICR evidences a mezzanine lender’s right to cure a senior loan default—both monetary and nonmonetary defaults. For obvious reasons, a mezzanine lender wants to avoid a foreclosure of the senior loan and preserve the real property collateral as a source of repayment.
To facilitate this right, the senior lender is required to provide the mezzanine lender written notice of any senior loan default and an opportunity to cure the default. The mezzanine lender is generally given the same cure period afforded the real estate borrower under the senior loan documents.
Some, but not all, ICRs will limit a mezzanine lender’s right to cure a monetary default to just three payment defaults. After the third monthly payment default, the mezzanine lender loses the right to cure the senior loan default and the senior lender is free to exercise remedies. In order to effectuate a cure, the mezzanine lender must remit to the senior lender full payment of all unpaid principal, interest, and fees.
Right to purchase the loan. Another critical protection afforded a mezzanine lender under a typical ICR is the right to purchase the senior loan. The purchase option is usually triggered by the senior lender’s acceleration of the senior loan or the senior lender’s commencement of enforcement actions against the real property. In either case, the senior lender will be required to provide the mezzanine lender with notice of the triggering event.
Upon receipt of such notice, the mezzanine lender must provide written notice to the senior lender of its intent to purchase the senior loan. The purchase price of the senior loan can be a highly contested matter. A senior lender will demand the senior loan be purchased at par, together with all unpaid interest and fees. A mezzanine lender will generally try to purchase the loan for less than par and limit the associated fees and expenses due to the senior lender.
Upon completion of the purchase, the senior lender will transfer and assign all the loan documents to the mezzanine lender, who then steps into the shoes of the senior lender. The mezzanine lender can then complete a foreclosure or other disposition of the real property collateral to repay the senior loan and the mezzanine loan.
A mezzanine lender should be aware that the purchase option will automatically expire upon a transfer of the real property by a foreclosure sale, trustee’s sale, or the delivery of a deed in lieu of foreclosure. This places a burden on the mezzanine lender to exercise its purchase option in a timely manner or risk losing the real property collateral as a source of repayment.
Lenders can achieve higher returns through mezzanine financing, but this type of financing also comes with risks not associated with standard real estate loans. Before you enter any mezzanine financing agreement, make sure you understand those risks and how to minimize them.
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