How To Use Preferential Equity To Preserve Your Development Capital

Preferential Equity is a debt/equity hybrid – essentially a debt that gives the lender the right to convert to an ownership and control position in the event of a prolonged un-remedied default.

Preferential Equity is generally used to fill the gap between what the bank will fund and what the developer is willing or able to contribute towards a project. If structured correctly, the main advantage of Preferential Equity – as opposed to Mezzanine Debt – is that Preferential Equity does not require a Registered 2nd Mortgage, nor often a Deed of Subordination to the senior lender (such as a bank).

Preferential Equity is often misconceived as an expensive funding option that is only for developers who are trying to complete projects too big for what they can afford.

The reality, however, is far from that – in fact many of Australia’s largest and most successful developers use Preferential Equity to vastly improve their Return on Equity (RoE) while diversifying their risk.

The simple maths to the improvement in RoE can be explained by an example of a typical project:

Based upon the above:

If Preferential Equity is then provided, to a total LVR of say 75%, the result is:

• Developer’s margin drops to 16%, working out to a return of $6.02m
• However, only $4.6m equity is required
• Which provides a far stronger RoE of 131%

The key to leveraging off this is: what can you do with that equity that is no longer required in that project?

If you put that $2.4m of released equity into another project and make another 131% RoE, you’ll make another $3.14m profit.

Combine these two projects together – now instead of making a $7.55m return using only “cheap” Senior debt on one project, you’ve instead made $9.16m by spreading the same amount of equity across multiple projects.

Other key benefits of using Preferential Equity can include:

• Bringing a project to market faster and thereby realising development profits sooner;
• Banks are more willing to allow Preferential Equity, as opposed to Mezzanine debt, as they are reluctant to consent to 2nd mortgages for construction projects;
• The strength of DFP’s Preferential Equity funders can provide the Bank with comfort that there is a readily available source of cash in the event of cost over-runs;
• Fast access to illiquid equity lying dormant in property assets;
• Ability to restructure debts and rectify loan covenant defaults to avoid suffering significant losses under forced asset sale;
  
• Ability to restructure ownership/equity/partners within existing property portfolios;
• The Preferential Equity’s returns are usually fixed, reducing the potential for conflict with respect to calculating the “Project Profit” – giving the developer the opportunity and incentive to make additional profit if the project achieves profits beyond those originally forecasted.

Naturally there are potential downsides to Preferential Equity, including:

• Being more expensive then Senior debt, it needs to be used wisely to avoid destroying equity over time;
• Higher leverage can significantly increase risk of losing your equity in the event of adverse project issues – conversely, when used wisely with a well-planned portfolio strategy, it can reduce overall risk by spreading capital across multiple projects;
• In the event of an un-remedied event of default, the Preferential Equity lender can enforce step-in rights to take control of the development company to ensure the project is completed and their capital and return is preserved.

DFP’s Advisory approach to its clients and their projects assist developers to assess and mitigate these risks prior to the structuring and placement of finance, to ensure that their position and project variables are appropriate for the use of Preferential Equity.

Whilst the market for Preferential Equity is relatively thin compared to the pre-GFC days, Development Finance Partners have the proven capability and experience in structuring and settling transactions in projects of all sizes, natures and locations.

Development Finance Partners is a full service finance, project management and advisory consultancy with working with clients nationally.  For more information about their full range of services visit www.dfpartners.com.au