The Trials And Tribulations Of The Mezzanine Finance Piece in the Capital Stack (Real-life Case Studies)
You’re a property development business building your capital stack. Your equity and senior are in place, and now you’re approaching mezzanine finance lenders. What pitfalls await you? And how can you avoid them?22 June 2021
You’re a property development business building your capital stack. Your equity and senior are in place, and now you’re approaching mezzanine finance lenders. What pitfalls await you? And how can you avoid them?
This article looks at common issues developers experience when trying to secure the mezzanine piece of their property development finance.
Assembling your capital stack can be like playing snakes and ladders
Every step of the way, there’s a chance of landing on a snake, sending you back to square one – having wasted valuable time.
The trouble with most mezzanine finance lenders is that they say ‘yes’ fast because they like the initial look of the property and want to hook you in. But then, a variety of things can happen behind the scenes as you wait for the final approvals.
One scenario relates to that fine print on the term sheet – ‘subject to legals, due diligence and underwriting.’ The lender said ‘yes’ quickly, but once they look more deeply into the project, they discover it’s different than they’d assumed.
Another scenario relates to the mezzanine lender’s liquidity. It’s not uncommon in the market for lenders to green-light a deal initially without having the capital in place. Then, while they’re doing legals, due diligence, surveys and intercreditor agreements, they work on securing the capital. This can lead to delays depending on how easily they can raise funds. And they may not be able to raise the total amount promised.
In both these scenarios, you can be close to the finish line, only to find yourself back where you started because the stack falls apart or your mezzanine finance lender hasn’t been able to deliver everything you need.
3 common pitfalls involved in securing mezzanine financing
As you’re playing this game of snakes and ladders, there are 3 broad categories of pitfall property development businesses often experience.
The first pitfall relates to intercreditor agreements. When a property developer is working with different senior and mezzanine finance lenders, intercreditor agreements need to be in place. This negotiation process can easily take 6 to 8 months as the lenders go back and forth negotiating.
This leads to the second pitfall, which is around managing multiple decision makers. When you piece together senior and mezzanine financing separately for any property, you have multiple sets of legals, surveys and underwriting. This greater complexity means there are greater chances of delay – and more opportunities for something to go wrong.
All this contributes to the third pitfall, which is around risk. During those 6 to 8 months of negotiation, nothing is set in stone. If one lender doesn’t like how negotiations are going, they can pull out, which means you’re back where you started financing-wise. Equally, during that period, the market may shift or a lender’s risk appetite may change, leading to liquidity issues or an unwillingness to fund you. Again, this leaves you scrambling to find a new lender (through no fault of your own). These delays add extra risk to your project because every day not spent progressing the scheme puts your investment case at risk. In the worst case, it could lead to you losing out on securing your site.
Now, let’s look at common ways these pitfalls play out.
Case study 1: Mezzanine finance lenders kept pulling out
This first case study illustrates those risk-related pitfalls.
A developer with a strong track record had their senior piece in place and was trying to secure the mezzanine piece of their capital stack. Time and time again, they were given a term sheet and a quick ‘yes’, only to have the lender pull out during the process of legals, surveys and intercreditor agreement negotiation.
After 7 months of being messed around by different mezzanine finance lenders, the developer got a call from their senior lender. The senior was getting impatient and losing appetite for the deal. They recommended the developer speak to Hilltop about funding the whole capital stack.
We immediately saw the opportunity. The developer had a sophisticated deal memo in place, which meant we could move quickly. Within approximately 2 months, we had fully funded them.
Case study 2: Mezzanine lender came up £1 million short
In this case study, the developer was well-established with a strong track record. They were working on a 90-unit scheme in South East England, and had been trying to piece together their senior and mezzanine packages for more than a year.
They secured the senior piece first. Then, they got an initial ‘yes’ from a mezzanine finance lender. This lead to 6 months going back and forth on due diligence, legals and intercreditor agreements. After those 6 months, the mezzanine lender gave their final approval – but for £1 million less than the original offer.
After the developer spent a bit more time trying to make up the shortfall, their senior lender pulled out – saying it had taken too long to secure the mezzanine piece and they needed to reallocate the capital.
The developer was back to zero.
Then, they were introduced to us. We saw the potential in the location and the price point the developers were targeting. And we decided to fund the entire capital stack. We were flexible and pragmatic, working with the developer to solve issues that arose and honouring the amount of funding we promised to provide.
The project is now underway and on track to offer affordable, quality housing in an area undergoing rapid regeneration.
Case study 3: Developer lost out on deals because of dithering mezzanine lenders
This is a common scenario – losing out projects because financing wasn’t all in place in time.
This developer was prolific in their local area and busy with a strong project pipeline and great professional team. They had multiple projects to finance and really needed stretch. Unfortunately, they lost out on 40% of the projects because they couldn’t get mezzanine finance lenders to commit. In some cases, it was because the lenders ultimately came up short on the amounts originally promised. In other cases, the time spent dealing with multiple decision makers and piecing together agreements meant they couldn’t seize the opportunity.
When another project came up, they found Hilltop and seized the opportunity to partner with a one-stop funding solution. There was an extra advantage on this particular deal because a legal issue came up – something out of everyone’s hands and involved waiting for lawyers to resolve. Based on their past experiences, the developer was worried we’d pull out. But we worked with them throughout the process, reassuring them all their funding was secure – which it was.
Learn from these trials and tribulations of securing mezzanine finance for property development
As you plan your capital stack, consider the pitfalls and risks we’ve discussed in this article. When you speak to different mezzanine finance lenders, make sure you’re clear on processes and commitments. And consider the differences between traditional and progressive funding partners as you weigh up your options.