When "senior" isn't senior
What happens when you invest in debt without the benefits
Happy Thursday!
When LPs evaluate a deal, they focus (or at least should focus!) on which instrument type they’re investing in.
This gets a little tricky, so I wanted to dig further on the topic today and explain how small nuances in the instrument you’re investing in can cause fairly drastic consequences to you as the investor.
First, let’s do some simple definitions - when there’s cash available (typically from a sale) the order of who gets paid is:
Senior Debt - first in line. Gets paid before anyone else and has the strongest claim on the asset.
Mezzanine Debt - sits between debt and equity. Higher return, and often has rights to take over the equity if things go bad.
Preferred Equity - equity with priority over common. Typically earns a fixed return (sometimes in cash and sometimes PIK) before the GP participates.
Common Equity - last in line. Highest upside, highest risk … and this is where the vast majority of syndications lie.
How It’s Supposed to Work
In a traditional structure:
An LP invests into a lender or pref equity position
That entity is independent from the sponsor (we’ll come back to this in a bit but this is critical)
If the deal underperforms, that investor (on behalf of you!) can:
Enforce remedies
Take control
Protect capital
Note that the entire purpose of investing higher up in the capital stack are the remedies that come with that benefit (otherwise why would you accept lower returns than equity without the additional downside protection - right?)
Example:
You invest in a mezz fund or a single mezz piece in a building
That fund lends to a third-party sponsor
Sponsor defaults
Mezz lender forecloses on equity and takes control - notice that you, as LP, are “riding along” with the mezz lender and are now in control of the building together with them
What Happens Frequently
In many deals I come across, the lines begin to blur: