Hospitality & Leisure Trend Watch
In recent years, hotel sponsors and developers have increasingly turned to alternative capital sources, like preferred equity, to finance and reposition their existing assets and fund new acquisition and development opportunities. As lenders reevaluated their exposure to hospitality assets and tightened underwriting following the onset of the COVID-19 pandemic, preferred equity helped sponsors fill a gap in the capital stack. In addition, as demand for travel has increased, preferred equity has served as an important source of capital for entrepreneurial developers seeking to capitalize on market opportunities but who lack sufficient cash to satisfy equity requirements for debt financing. Against this backdrop, we have seen an increased focus by hospitality capital providers on preferred equity investment opportunities.
Structuring Preferred Equity Investments
Preferred equity investments are typically structured as an equity investment in a joint venture between the sponsor and preferred equity investor. The joint venture is typically formed as a limited liability company whose sole members are the sponsor and the preferred equity investor. The sponsor is typically appointed as the managing member of the company with authority to manage the day-to-day affairs of the joint venture, subject to certain major decision rights in favor of the preferred equity investor. In the event of a material default by the sponsor under the joint venture documents (which material defaults can be similar in scope to the types of events of defaults often seen in loan documents), the preferred equity investor’s principal remedy is the right to takeover control of the joint venture by removing the sponsor as the managing member. In addition, upon a material default the sponsor will often lose the right to receive distributions and the preferred equity investor will also typically have the right to terminate agreement(s) with the sponsor’s affiliate, thereby terminating any fees paid to the sponsor group.
As security for the sponsor’s obligations under the joint venture documents, some preferred equity investors will take a pledge of the sponsor’s membership interests in the joint venture. And, it is not uncommon for the preferred equity investor to require guaranties and indemnities from a creditworthy affiliate of the sponsor for, among other things, bad boy acts and environmental liabilities, which guaranties and indemnities may be on substantially similar terms as comparable loan guaranties.
Financing and Recognition Rights
Because preferred equity is often tapped as an additional source of financing (for example, to meet construction loan equity and loan-to-cost requirements or to recapitalize a company), a preferred equity investment is often made contemporaneously or in conjunction with mortgage financing. As such, in closing a preferred equity investment, preferred equity investors must pay particular attention to the loan documents and their impact on the rights and remedies of the preferred equity provider.
In most cases, the lender’s standard form loan documents will materially restrict certain of the principal rights and remedies of the preferred equity provider under the joint venture documents. For example, the lender will typically require that during the term of the loan, the sponsor must retain control of, and maintain a certain minimum ownership interest in, the joint venture. Such control and ownership requirements are generally important to the lender, who is underwriting the sponsor. At the same time, lender restrictions on its rights leave the preferred equity investor in a difficult position.
In order to preserve their rights under the joint venture documents, preferred equity investors must negotiate with the lender for so-called “recognition rights”. Of utmost importance, the preferred equity investor must ensure that a takeover of the joint venture by the preferred equity investor is expressly permitted as a carve-out from the control and ownership requirements under the loan documents. If the lender agrees to this, it is typically conditioned on the delivery of new loan guaranties from a creditworthy affiliate of the preferred equity provider, often on the same terms as the loan guaranties delivered by the sponsor. In most cases, the lender will require that the scope of such new guaranties cover liabilities arising before, on, or after the date the same are delivered. In negotiating the control and ownership requirements in the loan documents, preferred equity investors should carefully review the scope of such new guaranties and consider seeking to carve-out liabilities arising during the sponsor’s period of management.
In addition, in the event that the joint venture documents permit the preferred equity investor to dilute the sponsor’s interest in the company following a failure of the sponsor to fund capital (for example, to fund loan balancing shortfalls during development, capital improvement projects or hotel operations), the preferred equity investor should seek to ensure that the exercise of such remedy will not result in a breach of the minimum ownership requirement applicable to the sponsor under the loan documents.
Preferred equity investors must also be sensitive to protecting their investment in the event of a loan default caused by the sponsor. Thus, they should ensure that they are entitled to receive notices of default from the lender. In addition, preferred equity investors should seek to negotiate for a separate cure period for defaults under the loan documents, which cure periods run after the cure periods afforded to the sponsor. While lenders may resist this, preferred equity investors should take the position that an additional cure period is needed to provide time to take over the company and cause the company to cure the underlying loan default, particularly in the case of non-monetary defaults that are not susceptible to cure by the preferred equity provider without taking control.
Hospitality capital providers that are new to the preferred equity space should be sensitive to the need for recognition rights as they plan their investments. Because the sponsor often takes the lead in sourcing financing for a project and may have the relationship with the lender, it is important for the preferred equity provider to raise the need for recognition rights early, preferably at the term sheet stage, to facilitate a smooth closing.