Intercreditor Agreements in the Real Estate Finance Market: The Quest for Efficiency
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Introduction
As the real estate finance market continues it's strong recovery, we are increasingly seeing mezzanine lending on real estate finance deals.
The Loan Markets Association (LMA) continues to refine its eagerly awaited template Real Estate Finance Intercreditor Agreement, and announced on 8 May 2014 at the LMA Real Estate Finance Market Conference that this document, together with a term sheet, will be released shortly.
Questions have been asked by the lending community, both senior and mezzanine, bank and non-bank, about the merits of trying to create a "standard" Intercreditor Agreement, given the competing commercial requirements of senior and mezzanine lenders, the specific requirements of certain (particularly the German Pfandbrief) lenders, and that there will be specific requirements of individual debt funds on documentation or to reflect quirks of a particular asset being financed.
The good news is that there is no doubt that developing a common starting point for an Intercreditor Agreement will help deal efficiencies, speed of execution, and at the term sheet or intercreditor principle stage, allow borrowers and lenders to compete and evaluate transactions on a playing field that, whilst not level, at least sets out some basic rules of the game.
That said, the key issues for senior/mezzanine loans and Intercreditor Agreements will remain the same, and will be subject to commercial agreement.
Fortunately, the LMA and the drafting committee responsible for the standard Intercreditor Agreement say that they recognise that, accordingly the standard will, once released, include a range of options.
Some of the key issues relevant to Intercreditor Agreements and deal execution in the real estate finance market are set out below.
Intercreditor Principles:
Prior to drafting finance documentation, and indeed if possible before even agreeing heads of terms, both lenders and the borrower should try and agree a clear set of intercreditor principles summarising the commercial terms of the intercreditor arrangements.
It is widely accepted this will in the long run save in legal fees, the time taken to execute a deal, and allow parties to evaluate competing offers fairly and effectively.
Deal Structure
The importance of a clear understanding of the corporate structure of the borrower group is often overlooked, but this importance is amplified on a senior/mezzanine deal.
It appears from presentations made at the LMA Conference referred to above that the LMA Intercreditor Agreement will be prepared on the assumption of a "triple holdco" structure (explained further below). This structure may not be suitable in all cases, especially in our view on mid market transactions or where there is little equity in the deal, where the cost of the additional complexity may outweigh the benefit. There is also the need for a tax analysis in the event that additional companies need to be inserted into the corporate structure for the borrower concerned.
The "triple holdco" structure is, simplistically, where the mezzanine lender makes its loan to a legal entity ("Mezzanine Borrower") three levels higher up the corporate group from the entity to which the senior lender makes its loan ("Senior Borrower"). Mezzanine Borrower will lend downstream the mezzanine loan proceeds to a SPV subsidiary ("Mezzanine Holdco"), who will make a corresponding onward loan to another SPV which owns the shares in the Senior Borrower and which on-lends the proceeds it has received to the Senior Borrower.
Security is then created by the various entities in the structure to ensure that the Senior Lender and the Mezzanine Lender will share in the “transaction security” - being the real estate mortgages, account charges, rental assignments and antecedent security (typically granted in favour of a common security trustee), but where the Mezzanine Lender also benefits from separate security over the shares in the Mezzanine Borrower and the proceeds of the mezzanine loan that is on lent downstream, such that it can in a mezzanine default situation, “squeeze out” the original equity sponsor, through enforcing the share charge, but leaving the senior debt intact, leaving the mezzanine lender controlling the borrower group.
Note that under this structure, whilst the Mezzanine Lender will share the common transaction security package with the senior lender, its ability to enforce that security (by directing the common security trustee) will be restricted by the Intercreditor Agreement.
This triple holdco structure is now the norm for big ticket and upper mid market transactions, but it remains to be seen, in a competitive market, if the structure will be required by senior and mezzanine lenders in the mid market and, as mentioned above, if it is an inappropriate structure for the mid market and below.
It may be more cost efficient on such deals to revert to a more simplistic and old-fashioned approach. For example, the mezzanine lender to lend to the same legal entity as the senior lender and take equivalent but second ranking security to the senior lender, subordinated appropriately in the Intercreditor Agreement.
If it is a requirement of the Mezzanine Lender that it needs the right to “squeeze out” the original equity sponsor, the Intercreditor Agreement itself can be adjusted so that the mezzanine lender could, if required, enforce share security over the borrower to put it in the same position commercially, in terms of squeezing out the equity, as it would have been under the triple holdco structure.
From a lawyers perspective, it cannot be emphasised enough how important it is to have a clear understanding on the structural issues before commencing drafting, and that there is a clearly agreed list of senior and mezzanine finance documents together with an understanding of which party is responsible for drafting the relevant documents.
The Intercreditor Principles:
In addition to corporate and security structure, the following issues are all important for the intercreditor principles (this list is non-exhaustive):
Enforcement and Fair Value:
In what default situations the senior lender can enforce the common transaction security and ultimately liquidate or dispose of the properties and other secured assets.
If enforcing, any controls or valuation fairness measures on the terms of any disposal (to avoid a fire sale).
The ability of the mezzanine lender to cure any senior defaults and limits on the amount of cures.
Any standstill terms and periods.
The ability of the senior lender, and circumstances in which it can stop payments to the Mezzanine Lender.
Additional Senior Debt:
The senior lender will typically wish to build in some headroom for new debt to rank above the mezzanine debt and an ability to make property protection loans. The mezzanine lender will want to set clear parameters around this.
Additional Mezzanine Loans:
Similarly, there will need to be some controls around increasing the mezzanine loans, the obvious exceptions being where it is agreed the mezzanine lender can inject funds to cure a default.
Ranking of Hedging:
Typically, senior hedging will rank pari passu with the senior debt. Hedging exposure can therefore dilute the security for the mezzanine lender. A clear hedging strategy is therefore important. Note certain senior lenders will insist on hedging ranking behind the senior debt.
Amendments/waivers and consents:
Placing controls on the ability of the senior lender to amend the senior debt and vice versa for the mezzanine lender is important to preserve the economic fundamentals of the original deal. That said, there should be a straightforward mechanic to allow non-material amendments without a protracted and expensive consent process.
Option to purchase the Senior Debt:
It is usually uncontroversial that the mezzanine lender has a right to buy out the senior debt at par. More controversial are where the parties wish to negotiate exemptions to break costs and make whole payments. Often the mezzanine lender will request the right to make a sub-par offer for the senior debt, which is rarely accepted in documentation.
Dispute Resolution:
In key areas, such as what constitutes fair value, parties could consider a mechanism for resolution where parties cannot agree (for example on valuations) prior to litigation. Ultimately however, the senior lender will insist on being in control.
Assignments and Transfers:
This can become a difficult and emotive area in any financing, even more so in a senior/mezzanine deal where the risk of lending entities changing can dramatically alter the way a deal would be handled in a distressed scenario (which, post closing, and barring an amendment or consent, is when everyone starts reviewing the Intercreditor Agreement in detail again).
In summary, senior lenders will want to preserve the rights they have agreed with the relevant borrower to assign or transfer without the mezzanine lender having any veto. However, the senior lender will usually be very sensitive and require a consent to any assignment by the mezzanine lender, unless to an affiliate.
About Field Fisher Waterhouse LLP
Fieldfisher acts for senior lenders, mezzanine lenders and borrowers. Our real estate finance team has a wealth of experience advising on Intercreditor Agreements, on all deal sizes from the mid market to big ticket, including, during the downturn on disputes, and during the recovery, on interpreting Intercreditor Agreements written in the CMBS boom.
We bring a discrete, pragmatic, commercial solution to transactions with an emphasis on being partner led, high quality, efficient and cost effective.
For more information contact Philip Abbott or your usual contact at Fieldfisher.