During the real estate boom of the 90s and early 2000s mezzanine lending became a commonplace source of capital for developers and other sponsors. Now, as the economic downturn continues and real estate values continue to fall, more and more mezzanine lenders are finding themselves with defaulted loans. In this series, we will examine five critical considerations for mezzanine lenders to weigh before commencing enforcement action.
Valuation, Due Diligence and Cost Analysis
Before taking title to the mezzanine collateral and indirect title to the real property, a lender must form an opinion as to the value of the property. A prudent lender may wish to seek one or more appraisals or broker opinions of value, in addition to producing a discounted cash flow or other financial analysis.
A meaningful valuation of the property requires current and accurate financial information about the property and its operations, so be sure to review the reporting requirements in the loan documents and request everything to which you are entitled. Other legal and underwriting due diligence such as UCC searches on the debtor, review of material contracts and leases, title, environmental, and property condition reports and other due diligence will often reveal factors that affect value or the cost of foreclosure.
By comparing a current valuation of the property to the capital stack, mezzanine lenders can inform their foreclosure strategy. Is the borrower’s position in the money or close to being in the money and therefore how likely is it to put up a fight? Is the mezzanine lender’s position underwater so that a workout with the senior lender will be required in order to realize any value? Does the cost of foreclosure negate any value remaining in the mezzanine position? Answers to these basic questions will determine the foreclosure strategy, so it is important to value the collateral, conduct due diligence and investigate costs of foreclosure as early in the process as possible.
The Intercreditor Agreement
The single most important document for a foreclosing mezzanine lender to review is the intercreditor agreement with the senior lender, which will set forth the restrictions and requirements that the mezzanine lender will have to comply with in taking any enforcement action against the borrower.
If the senior loan is also in default, generally the mezzanine lender will have to cure the default before commencing enforcement action, which means a full payoff of the senior loan if a maturity default has occurred. A mezzanine lender may wish to simultaneously pursue workout negotiations with the senior lender instead of paying the loan in full (more on this in the second part of this series).
Typically, the mezzanine lender will be required to provide a new guarantor to replace or supplement the guaranties provided by the existing sponsor. The standard language in most intercreditor agreements requires a replacement guarantor only in the event the existing guarantor is “removed.” There has been some disagreement between foreclosing mezzanine lenders and senior lenders as to when a guarantor is deemed “removed”, but you can expect that a senior lender will take the position that a replacement guarantor is required.
Other requirements that a foreclosing mezzanine lender can expect to encounter in an intercreditor agreement include delivery of a non-consolidation opinion, funding of reserves, and obtaining a rating agency confirmation. Also, if the lender plans to sell or otherwise transfer the collateral to a third party, the intercreditor agreement will typically require that the recipient be a “Qualified Transferee”, the definition of which can vary from agreement to agreement but generally requires the transferee to be a large institutional investor.
With so many restrictions on the exercise of remedies by a mezzanine lender, it is important to undergo a thorough review of the intercreditor agreement early on in the process.