An old buddy of mine, Dave Repka of Bison Financial Group, taught me an interesting, new term this week - promotable preferred equity. To understand promotable preferred equity in commercial mortgage finance, one first has to understand preferred equity.
To understand preferred equity, perhaps it is easiest to first understand preferred stock. In the old days, before there were were organizations known as limited liability companies (LLC's), most businesses were owned as corporations. How much of the corporation you owned was based on how many shares you owned. Most shares were known as common stock.
Remember, we're tyring to help you to understand the term preferred equity, and we said the best way to do this was to first help you understand the term preferred stock. The best way to do this is to use an example.
So the year is 1972. You own a small wood-products manufacturing corporation, and you come up with the brilliant, new idea to build houses in a factory. This way you won't have to pay union carpenters outrageous wages to build the homes on site. You just need $2 million to open your first home-building factory.
Therefore you go to your father-in-law and beg for money. He offers to loan you the money, but you confess that you won't be able to make the monthly payments on a $2 million loan, at least for awhile. You then suggest that you could give him half of the shares of your corporation. He replies that he doesn't want to run a company. He's retired. He needs income the moment you can afford to make payments.
After negotiating for awhile, he agrees to buy $2 million worth of preferred stock in your corporation. The thing about preferred stock that is better than debt is that you don't have to make monthly principal and interest payments. After all, preferred stock is a form of equity. Equity does not have required monthly payments.
And thank heavens for that! For the first two years, your new-fangled product was slow to catch on. You only sold a handful of manufactured homes. Year three was different. You sold a lot of homes and made a decent profit. You decide to pay out $160,000 in dividends to the shareholders.
Your father-in-law owns 2 million shares of $1 face-value preferred stock with a yield of 7%. The thing about preferred stock is that the preferred shareholders get paid first. They are shown a preference, and common shareholders only get paid if the all of the preferred shareholders have first already been paid.
A seven percent yield on $2 million is $140,000. Therefore you have to pay your father-in-law $140,000. This only leaves $20,000 left of the $160,000 in profit to distribute to you and your wife. Drat! As Tommy Smothers (of the Smother's Brothers) once said, "Mother always loved you best."
The next year, however, your company does even better. You have $400,000 in profit to distribute. Your father-in-law only gets $140,000 because it was agreed when the shares were issued that the yield on these preferred shares was only 7%. Once you pay your father-in-law his 7% interest, he is NOT entitled to anything else. You are distributing $400,000 in profit. Your father gets his $160,000, and you get the remaining $240,000!
This is how preferred stock works. A yield is agreed upon, but the preferred shareholder only gets his yield if there are profits to distribute. In addition, the preferred shareholder only gets a return up to the agreed yield. If the profits of your corporation are $1 million the following year, your father-in-law still only gets his $160,000.
But almost no one uses corporations anymore. Instead, most new companies formed in the last 18 years have been LLC's. Instead of shareholders, LLC's have members. Shares are called membership interests. Members whose membership interests enjoy a preference are called preferred equity holders. There are no required monthly payments on preferred equity, although in commercial mortgage finance, if the managing members miss an interest payment, the managers can be ousted by the preferred equity holders.
Now, with this refresher completed, I can finally explain the concept of promotable preferred equity.
In commercial real estate finance, its is customary to have two parties, the sponsor and the equity provider. The sponsor is the guy who finds the deal and typically manages the commercial property. The equity provider is the guy who puts up the majority of the dough, the downpayment to buy the property and the money to fix up and lease the property.
Now let's suppose Bob, a frequent sponsor of commercial real estate investments, finds a vacant car factory in South Carolina. Bob has heard through the grapevine that Volkswagon is looking around the South for a new manufacturing plant.
Now Bob goes to the family office of one of Sam Walton's children and pitches the deal. Together they will buy the industrial plant, they'll clean it up, and then lease it out. The family office agrees to be the equity provider; i.e., the Walton Trust will put up most of the dough.
The total amount of the capital to buy the former auto plant and to fix it up is $100 million. The Walton Trust will put up $90 million, and Bob will be required to put up $10 million.
Rents and profits from the venture might be distrubuted as follows:
- The Walton Family and Bob share proportionately (90/10) in the rents and profits until both of them enjoy a preferred return of 8%.
- Any additional return is shared 90/10 until both parties have received a 12% internal rate of return (IRR), plus the return of their original principal.
- After both parties have gotten their principal back, plus a 12% IRR, Bob gets promoted.
- Any additional return is distributed 80% to the Walton Trust and TWENTY PERCENT to Bob! Note: Bob got promoted from 10% to 20%.
- After both parties have received all of their dough back, plus a 20% IRR, Bob gets promoted again to 50%! After the 20% IRR is reached, Bob gets FIFTY percent of any additional return.
A profit distribution plan where the formula changes as more profit targets are met is called a waterfall.
As my buddy, Dave Repka, puts it: "Promotable preferred equity is how dudes (sponsors) get rich!" Thanks for the education, Dave!