Senior lenders’ relative negotiating power has increased since 2008. This is due to the consolidation or withdrawal of previously available property finance lenders - as smaller domestic banks, foreign banks, specialist finance houses / debenture lenders and, to a lesser extent, mortgage trusts reduced their participation in the market. Even larger banks that had active mezzanine lending capability either no longer do, or they maintain it at reduced levels.
This power shift has exacerbated an imbalance of intercreditor terms between senior and mezzanine loan providers that, even pre-GFC, was already more weighted towards senior debt than in other jurisdictions.
There are some key issues that investors need to be aware of where mezzanine finance is being considered in post-GFC deals. This is particularly so for investors in residential and other development projects. We’ve outlined some of these key issues for you.
No standard intercreditor terms in property finance generally
In contrast to the acquisition or leveraged financing market,1 there is no current market standard intercreditor agreement or set of principles for financiers / investors to regulate intercreditor issues in the property sector.
Even if such a precedent form was available for property deals, it is likely in many respects to be favourable to those who made it. Additionally, commercial real estate loans vary greatly in form and size. These characteristics impact how senior financiers and mezzanine financiers view their respective rights in any given deal. King & Wood Mallesons has significant experience in commercial real estate finance acting for both financiers and borrowers and can advise on appropriate, tailored solutions on intercreditor matters across a variety of finance structures.
“Everything else is equity or pseudo equity”
Senior bank participation cannot now be taken for granted where third party mezzanine debt finance (as opposed to pure equity) is required to fund a project. The above, heard on a recent deal, is indicative of senior financier attitude to non-senior debt funding (and even preferred equity funding) in the real estate sector.
Given this, an intercreditor discussion often now commences with senior lenders regarding improvements to the intercreditor profile of mezzanine debt over equity as ‘concessions’.
A first version intercreditor arrangement on behalf of senior lenders can contain the following:
- No repayment of mezzanine debt without prior consent until senior debt is repaid (with no permitted payments)
- Enforcement restrictions on mezzanine security applying at all times without a right to take action if specified events (other than insolvency) occur
- Mandatory release of mezzanine security upon disposal of property common to both mezzanine and senior security packages with little to no mezzanine input on any disposal process
- Freedom for senior lenders to amend senior documentation, including as to loan size, repayment profile, fees and interest rates, without reference to mezzanine lenders, with corresponding restrictions on mezzanine lenders amending any equivalent provisions in their documentation.
Each of the above items has a variety of compromise positions available (with heavy negotiation) that are progressively more favourable to mezzanine financiers. The final point of agreement on these items can be deal contingent and can also be contingent on even the identity of the mezzanine finance provider.
Who are the senior lenders anyway? A post-GFC issue
While finance documentation is prepared on the basis of the identity of the "day-one" finance parties, the identity of finance parties may change over time and might be quite different (and with different priorities) at the time of any enforcement action where a project is in distress.
Where trading of senior debt occurs, and distressed debt providers hold that senior debt, mezzanine financiers can find themselves subordinated to parties who on any enforcement obtain significant returns, even where disposals occur at less than original par value of senior indebtedness.
This can occur even though senior lenders may in certain circumstances seek a restriction on assignments of mezzanine debt and the identity of mezzanine financiers.
To mitigate the risk of this occurring, mezzanine investors (and also the borrower) should carefully negotiate enforcement and disposal provisions in real estate loan documentation vis-a-vis senior financiers. Ideally, they should hard-wire a market-based disposal procedure and also mezzanine enforcement rights in agreed circumstances.
Discuss and agree the role of mezzanine finance upfront with senior lenders
Too often real estate sector investors fail to seek agreement upfront with prospective senior and mezzanine lenders as to intercreditor terms. Equally, false assumptions are made as to mezzanine rights that are based upon pre-GFC conditions or conditions applicable to foreign, not domestic markets.
Even though mezzanine investors are not in a strong negotiating position, they can alleviate drawn out negotiation in the midst of a transaction through bullet point, terms sheet stage agreement upon terms relating to permitted payment, security enforcement, release and amendment.
1. See Loan Market Association “Intercreditor Agreement for Leveraged Acquisition Finance Transactions” (Sept 2012), as well as, in the Australian market, the Asia Pacific Loan Market Association’s Intercreditor Project, with which King & Wood Mallesons is assisting.