What it is
Preferred equity, or "pref," is an ownership investment in a deal that gets paid before the common equity but after all lenders. It usually earns a fixed or target preferred return, and often a share of profits above that. Because it's equity, it doesn't have a mortgage lien or a pledge in the same way debt does.
Where it sits
In the capital stack, preferred equity sits below senior debt and any mezzanine debt, and above the sponsor's common equity.
| Layer | Paid |
|---|---|
| Senior loan | First |
| Mezzanine loan | Second |
| Preferred equity | Third |
| Common equity | Last, gets what's left |
How it works
- Structure. The preferred equity investor becomes a member of the ownership entity, with its rights set out in the operating agreement, not a loan agreement.
- Return. A preferred return, which may be current-pay (paid from cash flow), accrued, or a mix.
- Redemption. The sponsor typically buys out the pref investor by a set date or on a capital event like a refinance or sale.
- Remedies. If the sponsor misses payments or the redemption date, the operating agreement may give the pref investor rights such as taking over management or forcing a sale.
Preferred equity versus mezzanine debt
| Mezzanine debt | Preferred equity | |
|---|---|---|
| Legal form | Loan | Equity |
| Security | Pledge of ownership interests | Rights in the operating agreement |
| Remedy | Foreclosure on the pledge | Control rights or forced sale |
| Senior lender view | Subordinate debt, may need consent | Often permitted where mezz isn't, but varies |
Economically they can look similar. Legally they're different, and senior lenders treat them differently.
Why sponsors use it
Sponsors use pref equity to fill a gap when senior leverage isn't enough and mezzanine debt isn't allowed or doesn't fit. It also suits recapitalizations, where existing owners need to bring in new capital without refinancing the senior loan.
What lenders look at
Senior lenders review the operating agreement to understand the pref investor's rights, especially any right to replace the sponsor. Many treat "hard" pref equity, with mandatory redemption and strong control rights, more like debt.
Common mistakes
- Assuming senior lender approval. Read the loan documents for transfer and control provisions.
- Underestimating the cost. Pref equity is usually more expensive than mezz.
- Ignoring control rights. A sponsor can lose control of the deal if it misses the redemption date.
In the package
Show the full capital stack, each layer's terms, and a summary of control rights. Lenders want to know who could end up running the property.