Downside protection and control: Innovative strategies for junior lenders in real estate financing

Where a sponsor's real estate debt requirements are not met from the whole loan market, an alternative is a senior / mezzanine financing structure. Alternative capital providers are prepared to take slices of junior, mezzanine, subordinated, or holdco debt to achieve their higher target returns. Such lenders provide creative capital solutions, often structuring deals as combinations of debt-equity, and cash pay-PIK, to meet financing needs.

A key focus for these lenders is downside protection. When things go wrong, a fund lender cannot risk getting stuck in an extended enforcement or insolvency process, which will likely destroy value, limit options, and can (more acutely) damage the fund's internal rate of return (IRR) and ability to make distributions to its limited partners (LPs).

This note discusses some approaches that junior real estate lenders can consider to maximise control and limit risk in a downside case. Evidently, the best way to improve options and recoveries on the way out is to be well prepared long before that – and to make sure that the deal is set up effectively on the way in.

Enforcement strategy

It is now often standard for funds to ask their advisers to produce an enforcement memorandum when the deal is originated – so that the exit strategy in a downside case is clear and well-defined. While a "day one" enforcement memorandum is always a useful starting point, a deal can often change or develop during its life, and an enforcement memorandum will generally not be updated on an ongoing basis. Accordingly, in the case of distress, internal asset management and legal teams should focus on understanding their options and leverage points at the earliest opportunity and seek external advice where appropriate.

An exit strategy will generally involve effecting a sale of the real estate assets / platform; and/or the lender taking the relevant assets onto its own balance sheet to effect a lender-led "workout". It is worth noting that where the secured assets are a development project, enforcement can be particularly challenging – a distressed development is likely to see construction stall (or even stop completely), and significant cost overruns. Few lenders or debt funds are set up to manage developments effectively in-house (in terms of time, resources and/or expertise), so taking the development assets onto balance sheet can often be a last resort.

While security enforcement will generally be possible, in many European jurisdictions it can be slow, expensive, public, in-court, and/or uncertain in outcome. A critical point here is that to avoid value destruction a lender will want a sale process to be controlled and, as far as possible, out of court and outside of an enforcement / insolvency process.

While this type of sales process may be possible where the sponsor is co-operative and is prepared to run the process, if that is not the case a lender will first want to effect a pre-packaged enforcement pursuant to which the lender has taken full equity ownership. At that point, the lender can itself run a controlled sale process or manage out the assets, without risk of the sponsor seeking to frustrate.

It will therefore be key in every case to ensure appropriate structuring – usually aiming to achieve a single point of enforcement in a jurisdiction where security is readily and easily enforceable. The UK or Luxembourg will be preferable, as these are "creditor friendly" jurisdictions where share pledge enforcement is tried, tested and predictable, and (in particular) cannot be prevented by an insolvency process of the pledgor. Junior lenders will also look for junior-only security, so that senior lender consent is not required to the junior lender taking equity control, pursuant to an acquisition right.

Acquisition right – junior replaces equity

A junior acquisition right is effectively a right for the junior to take enforcement action at Holdco level and disenfranchise the equity. This is a key protection for a junior lender. As well as giving the junior lender control of a junior-led enforcement, it also means that a senior-led restructuring is more dependent on junior consent than equity consent.

The intercreditor agreement (ICA) will include a built-in senior change of control waiver so that the senior debt is not mandatory repayable where the equity in the structure becomes held by the junior lender. Where the senior debt is also in default, the junior lender may be required to cure material senior defaults, such as non-payment or breach of financial covenants, with any cure payments added to the junior loan.

However, while a junior acquisition right should be acceptable to the senior, there may be practical enforcement challenges vis-à-vis the equity. These include valuation issues, which are relevant to every restructuring. If the value very clearly breaks in the junior debt, the position should be straightforward, but – except in the most distressed deals – there may still be potential value in the equity. And there may not be sufficient information available to the junior lender to establish a value of the shares with confidence.

Where value breaks in the equity, the lender cannot acquire the equity without accounting to the existing shareholders for the excess, sometimes known as the "equity overhang". This principle exists to avoid an unfair "windfall" for a lender. However, when enforcing or appropriating shares, no lender wishes to write a cheque to the sponsor, especially where the valuation may be somewhat unclear and future recoveries uncertain.

So how can this be avoided? Appropriation¹ is becoming a more popular remedy, and it has become more common to include provisions in share security documents that any obligation to account to the security provider for excess equity value post-appropriation can be deferred, for (say) up to 12 months. As far as we are aware this has not been tested in the English or Luxembourg courts, but our view is that it should be effective. Further, immediately post-enforcement it should be possible to effect a transaction akin to a "post-pack", pursuant to which the assets of the group would be marketed for sale immediately after appropriation, with payment of any excess value to the equity on consummation of that transaction.

Accordingly, with proper structuring the sponsor should not be able to prevent enforcement, but an uncooperative sponsor can generally add cost, complexity and risk (including litigation risk) to any enforcement process. Ultimately this will need to be priced in – as even if a lender ultimately prevails in litigation, the cost and timing can further eat into IRR, and potential (adverse) publicity for the lender may be somewhat unquantifiable.

Buyout right – junior replaces senior

A buyout right, pursuant to which the junior can purchase the senior debt, is also standard. The purchase price will almost always be par plus accrued interest, and the senior lender would also require any early repayment or make whole fees to be paid.

Acquiring the senior debt will likely involve a large capital outlay by the junior lender, so consider the following:

1. In an already distressed scenario, does the junior lender have appetite to invest further capital? To avoid putting "good money after bad" it would make sense for a debt fund lending to underwrite this as a new investment opportunity, in the context of the wider group and its structure.
   
   
2. Does a debt fund have sufficient available capital to deploy to acquire the senior, in particular where the fund's investment period has ended, and the end of fund life is approaching? If not, the fund manager could consider deploying capital from (if available) a different fund or separately managed account (SMA) – subject to internal allocation and conflict issues – or could potentially structure a loan-on-loan transaction to acquire the senior debt using external third-party capital.

Control of enforcement - standstills

The rights above are helpful protections for a junior lender, but the junior lender will clearly need confidence that it can exercise its rights without the senior lender derailing its plans. A senior lender will generally agree to "standstill" for a period of time to give comfort to the junior lender that if it elects to exercise an acquisition right or buyout right, the senior lender cannot take other enforcement action during this period.

More generally, a junior lender may seek a senior standstill period on enforcement such that even post (or absent) the exercise of an acquisition or buyout right by it, a junior lender can control a sale process.

It is conceptually reasonable that where the senior debt is well covered and is continuing to be paid current, the junior should be in the driving seat. Accordingly, unless the senior lender can adduce strong valuation evidence to demonstrate that value breaks in the senior, and provided that the junior lender is prepared (if necessary) to fund payment of interest to the senior where the borrower fails to pay, the junior lender can argue for control of an enforcement process. While this is not always "standard", a junior lender should be able to get a level of accommodation from the senior lender in this respect.

A senior lender will often be more conservative and less inclined to take enforcement action, in particular where they are in the money. So in any event a restructuring transaction will often start with standstill negotiations between the lenders, pursuant to which the senior lender may accept that the junior lender can control enforcement, on terms agreed at the time. Of course, the more that this can be baked in at the start of a deal, the stronger and more certain the junior lender's position will be.

Other structural ideas

Increasingly, we are now seeing creative security structures proposed by junior lenders, aiming to increase junior lender control and maximise downside protection. A lender implementing these structures will need to consider whether the additional costs, and potential difficulties caused by them (for example, in terms of more fraught negotiations and challenges to relationships) merit the additional protection offered.

Examples of the more creative structures include:

• A call option in favour of the junior lender, exercisable on default, pursuant to which the sponsor agrees to transfer shares to the lender's nominee following an event of default, at a pre-agreed price. While this should work as a matter of contract, it is still likely to require some cooperation from the sponsor, and practical effectiveness may be limited. Validity of such an arrangement may also be questionable as a clog on the equity of redemption².
  
  
• A dematerialised Luxembourg law-governed share pledge. Here, Holdco shares are dematerialised and transferred to a Luxembourg securities account, over which the lender has security. These are commonly used in Italian deals. While enforcement of this security should (in theory) be simple in Luxembourg, there may be practical challenges, in particular because in Italy court approval is typically needed to validate a transfer of title following enforcement.
  
  
• A lender holding a "golden share" with reserved matters and voting rights exercisable following an event of default, to give a lender a level of equity control. Actually exercising such control may however expose a lender to risk, and a lender must also be mindful of equitable subordination issues in relevant jurisdictions (for example Spain and Germany).
  
  
• In France, the "fiducie" involves transfer of secured assets such as shares to a third-party trustee and is a strong security interest which should give a lender a readily enforceable right to appropriate shares over which it has security, notwithstanding any insolvency of the debtor. However, given the involvement of a third party and additional documentation, this can be expensive to set up, which may not be merited on smaller transactions.

Bad Acts guarantees

So-called "bad acts" guarantees are an import from US market, which are increasingly being used in European deals.

Pursuant to such a guarantee, a sponsor will accept (personal, in the case of an individual sponsor) liability for losses suffered by a lender (or in some cases liability for the full debt claim) should certain "bad acts" occur. Bad acts typically include fraud, misappropriation of funds, and acts aimed at limiting the value of the secured real estate assets or the ability of the lender to access those assets (e.g. sale or encumbrance in breach of the finance documents, or causing deliberate damage to a property)). This is an exception to the usual "non-recourse" nature of real estate financings, and accordingly such guarantees are also known as "[non-recourse] carve-out guarantees".

It is notable that there is currently no jurisprudence relating to challenge / enforceability of such guarantees – while enforcement may be threatened, there are seldom attempts to formally enforce a bad acts guarantee. The real practical value of such guarantees will depend upon the nature, substance and attitude of the sponsor, and may exist more to enable a lender to exert leverage and put pressure on a sponsor to ensure their "good behaviour", than to effect real financial recovery under the guarantee (which would likely involve protracted and expensive litigation). We will discuss bad acts guarantees in more detail in a separate briefing.

Conclusion

There is not necessarily a "market" position here, other than the market position of junior lenders pushing for more creative and aggressive protections. What they can achieve will depend on the strength of the junior lender, how competitive the debt process is, and how essential the junior debt is to execution of the deal.