The Real Estate Private Equity M&A Process, Part Two

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How do REPE investors invest in companies?

The first post of this series on the REPE M&A investment process focused on: (1) defining our goal (make good investments), (2) defining the type of investment (long only), (3) defined NAV (essentially it’s our view on a company’s equity value), and (4) briefly touched on market efficiency (and how we believe inefficiency exists, resulting in potential disconnects between a company’s share price and its intrinsic NAV).

This post will focus on an important concept for any career in real estate private equity: the capital stack. Namely, how does the capital stack define ownership? What does seniority in the capital stack represent? Who is the most secured member of the capital stack, and why do they receive the lowest return?

Once you understand the capital stack, you will be prepared to appreciate exactly why NAV and market equity are twin concepts. And most importantly for your career in repe, how a disconnect between NAV and equity market capitalization could represent a buying opportunity. Understanding these nuances will greatly prepare you for a career in REPE.

What is the capital stack?

To understand NAV, you must understand the capital stack. The capital stack, more formally called the capital structure, can be thought of as a layer-cake. Everyone in the capital stack owns the company, but in varying degrees of seniority. Seniority is just a fancy way of defining the tranches (read: layers) of ownership. Think of it this way: if the company goes bankrupt tomorrow, who gets paid first? The more senior members of the capital stack get paid back first.

Who is the most senior member at the bottom of the capital stack?

The debtholders are at the bottom of the capital stack. They get paid back first in a bankruptcy. Of course, there are finer tranches that subdivide the the debtholders’ positions. Let’s dive into these tranches.

The very first tranche of debt is called senior secured. Senior means they are the most senior, and secured means that specific assets belong to the debtholder until they get all of their money back. Then, there is senior unsecured. This tranche is next in line, but has no specific assets that it can lay claim to ahead of anybody else. Next is mezzanine, which is basically middle seniority. Then, there may be a junior tranche of debt after mezzanine.

Cost of capital, risk and return

It is important to understand that a debtholder is only ever owed a fixed amount of money. Once they get their money back, any additional funds go to the next member in line on the capital stack. Because senior debtholders are exposed to the lowest levels of risk (first in line to get paid back), their money costs the least. This concept is referred to as the cost of capital. If a bank loans me $100, how much will that cost me? Certainly, the bank won’t give it away for free. Though the interest rate they charge me depends on market dynamics, you can rest assured that the senior secured tranche will have a lower interest rate (coupon) than the senior unsecured tranche, and the senior unsecured tranche will have a lower coupon than the mezzanine tranche, and so on.

Conclusion

The capital stack is a crucial concept to master before interviewing for a career in real estate private equity. Understanding the debt in your capital stack is a first step toward fully understanding your investment opportunity. Real estate private equity holders get paid after the debt, so they must understand what the debtholders are owed. The next article in this series will focus on the final members of the capital stack, including equity. Eager to learn more? Sign up for Leveraged Breakdowns’ seven-day free trial to explore all of our courses.