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The REPE M&A Process, Part Three: Equity3/11/2020 Like what we have to say and want to learn more? Support us with a Leveraged Breakdowns membership, which grants access to the best real estate private equity course available online.
Beyond debt, onto preferred equity and equity This series provides a high-level view of the REPE M&A investment process. Right now, we’re discussing the capital stack so we can better understand the true meaning of net asset value. The previous post covered the following: (i) what is the capital stack, (ii) who is the most senior member of the capital stack, and (iii) how the cost of capital is tied to risk and return. This post will focus on the final two pieces of the capital stack after debt: preferred equity and equity. Who else is in the capital stack? Preferred equity Every layer of the capital stack has an increasing cost of capital because each layer accepts an increased risk that they will not get their money back. After debt, you have preferred equity. Preferred equity is just a fancy name, it is basically debt and hardly ever exercises any actual control. They just lend money and get a higher interest rate than debt. It’s important to note that a lot of preferred equity can PIK, which stands for payment-in-kind. This just means that the company can pay the preferred equity holders with “IOUs” that increase their balance. But be careful, because PIK coupons accrue, and in future quarters you will be charged interest on the total balance representing the old balance plus the new PIK. Equity is the residual claimant The final member of the capital stack is equity. There is a special name for this final position: the residual claimant. After everybody else gets paid their fixed share, equity has the right to claim all of the remaining money. Equity’s residual claim is important for two reasons: equity will command the highest cost of capital, but equity also has unlimited upside. Equity will command the highest cost of capital because it gets its money back last, after all debt and preferred equity. Yet because it is last in line, it gets everything that’s left. All other tranches of the capital stack claim a fixed dollar figure, after which their position runs out and they move on with their lives. Equity however, has unlimited upside because it gets everything that is left over. And that could be a lot. Or a little, or nothing. But that’s the nature of equity risk, and it’s why equity is the riskiest investment available. What is private equity? Private equity just refers to the ownership vehicle. Public equity is available for exchange on public markets such as the NASDAQ and NYSE. Private equity, however, is raised in private funds and available only to accredited investors with deep pockets. Furthermore, private equity generally has a fixed life, since funds are meant to last for ten years or so before returning the capital back to their investors. Thus, private equity funds are under the gun to find suitable deals that meet their return targets (aka hurdle rate IRRs). Conclusion After reading this post and the previous post, you should understand the following concepts: (i) what is the capital stack, (ii) what seniority is and what are the names of each common tranche, (iii) the interplay between risk, return, and the cost of capital, (iv) how equity is the residual claimant, (v) how equity is exposed to unlimited upside, and (vi) the core differences between private and public equity. Now if you’re ready to cut your teeth on a real estate private equity interview case study, check out what many call the best real estate private equity course -- only at Leveraged Breakdowns.
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