The waters can get a little muddy when modeling out deals with preferred equity, mezzanine debt, and/or traditional debt financing. Let's look at how these things differ.
Relevant Templates:
- Preferred Equity Model with Subordinate IRR Hurdles for Common Equity
- Preferred Return Model
- Preferred Return with Multiple Accruing, Non-compounding Hurdles
- Preferred Return (with IRR Hurdles)
Preferred equity and debt financing are two distinct methods of raising capital for a company. The main differences between the two are:
- Ownership - Preferred equity represents ownership in a company, whereas debt financing does not. When a company issues preferred equity, the investors become part owners of the company and have the right to receive dividends and potentially vote on certain matters. In contrast, debt financing represents a loan that must be repaid with interest, but the lenders do not have any ownership rights in the company.
- Priority in payment - Preferred equity holders have priority over common equity holders in terms of receiving dividends and the proceeds from a company's liquidation. However, they are subordinate to debt holders who have priority in payment. This means that if a company faces financial difficulties and is forced to liquidate, debt holders will be paid before preferred equity holders.
- Fixed vs. variable returns - Debt financing typically offers a fixed rate of return, meaning that the interest rate and payment schedule are predetermined. In contrast, preferred equity often offers a variable rate of return (hurdle dependent upside participation and accruing feature dependent), with dividends fluctuating based on the company's financial performance.
- Maturity - Debt financing typically has a fixed maturity date, after which the loan must be repaid in full. In contrast, preferred equity may not have a maturity date, and the company may continue to pay dividends indefinitely.
- Tax implications - Preferred equity dividends may be treated differently for tax purposes than interest payments on debt. Dividends may be taxed at a lower rate than interest payments, which could make preferred equity a more tax-efficient financing option for some investors. This all depends on what is classified as return of capital vs. a dividend payment and things can get tricky here if you don't have a solid tax guy that is used to optimizing structure to get the best tax treatment possible for all parties in the joint venture.
Usually, real estate deals will have preferred equity as part of their equity stack and the reason why is that the expected cash flows are fairly steady and predictable so investors are willing to come in for less equity and less risky returns. You have REFI and exit events that help keep the LPs at least getting their money back in bad scenarios (poor debt structures can wipe out deals and lose people money, especially in rising interest rate environments).
In summary, while both preferred equity and debt financing can be used to raise capital for a company, they have different characteristics and implications for investors and the company. The choice between the two depends on the company's financial situation, objectives, and risk tolerance, as well as the preferences of potential investors.
