Becoming involved with a distressed asset is like deciding to read "War and Peace", but discovering that your copy of the book starts on page 400. It takes a lot of catching up. Getting to know the asset’s history and stakeholders, and the stakeholders’ motivations and legal positions, is critical. It can make the difference between a successful investment and a protracted struggle with multiple creditors.

Investing in an asset that is subject to complex financing structures requires careful evaluation. In an earlier era, a large commercial real estate project might have been primarily financed by first-priority and possibly second-priority mortgage debt, together with a substantial equity investment by the project owner’s principals. By contrast, at the height of the boom several years ago, financing on a comparable project may well have included, in addition to a mortgage loan, one or more levels of mezzanine debt, loan participation arrangements, and various derivative transactions such as loan securitization.

Even for those familiar with the rights and collateral positions of mortgage lenders in a distress setting, the peculiarities of mezzanine lending can be surprising. This column will focus on considerations to bear in mind when evaluating a proposed distressed investment with a mezzanine-financing element.

What is a mezzanine loan?

A mezzanine loan is fundamentally different from a mortgage loan because its collateral is equity, not real estate. With a standard mortgage loan, the lender lends money to the owner of a real estate project. The mortgage lender’s primary security for the loan is a lien on the project. If the borrower defaults, the mortgage lender can foreclose on the mortgage. Whoever purchases the project at a mortgage foreclosure sale —most often the mortgage lender itself — becomes the new project owner.

By contrast, a mezzanine loan is made not to the owner of the project, but to the parent of the project owner. The “parent” is a holding company set up for the purpose of owning stock or other equity interests in the project owner. The parent, in turn, is owned by the primary investors or principals behind the real estate project. The mezzanine lender’s primary security for the mezzanine loan is a lien on the parent’s equity interests in the project owner.

When a mezzanine loan default occurs, the mezzanine lender can foreclose on the parent’s equity interests in the project owner. The foreclosure will not cause any change at the real estate level. Title to the project stays in the name of the same project owner company as before, and mortgages and other real estate documents remain in place. However, the impact at the equity level is profound. The purchaser of the equity interests at the mezzanine foreclosure sale — most often the mezzanine lender itself — gets the right to own and control the company that owns the project, the next best thing to holding title to the project itself.

Mortgage versus mezzanine lender rights

When a distressed asset is subject to both mortgage debt and mezzanine debt, the mismatch in collateral types has the potential to create major disputes between the mezzanine lender and the mortgage lender. The mortgage lender is concerned that if a mezzanine foreclosure takes place, the new equity owners of the project company may be less creditworthy or have less industry experience than the original equity owners. That could lead to further woes for the project.

For its part, the mezzanine lender worries about any potential mortgage foreclosure. If the project owner loses title to the project due to a mortgage foreclosure, the project owner’s assets are drastically diminished, and any equity interests in the project owner will be worth far less as a result.

Thankfully, in the overwhelming majority of these credit arrangements, the original mortgage lender and the mezzanine lender sign an intercreditor agreement when the financing closes. The intercreditor agreement sets up in advance ground rules about the rights of the mortgage lender and mezzanine lender in a distress scenario. That can minimize future conflicts between the lenders.

While the balance of power between mortgage lender and mezzanine lender varies from one intercreditor agreement to the next, such agreements usually include provisions on the following major distress topics:

• The mezzanine loan is generally made subordinate to the mortgage loan. If there is not enough money to repay both loans, the mortgage loan is repaid first.

• However, the mezzanine lender has certain rights to protect its interests. For instance, if the project owner defaults on its mortgage loan obligations by missing a mortgage payment, the mezzanine lender may have the right to “cure” the default by making the missed payment to the mortgage lender. The mezzanine lender also may have the option to buy a defaulted mortgage loan from the mortgage lender at “par,” a dollar price equal to the total outstanding mortgage debt.

Such a costly purchase may be worthwhile if the mezzanine lender’s alternative is losing the value of its investment in a mortgage foreclosure. In some defaults, the mezzanine lender may have the right to carry out its mezzanine loan remedies before the mortgage lender can begin to take steps on the mortgage loan.

In summary, the presence of mezzanine debt on a proposed distressed investment will most likely add complexity to the investment. However, the mezzanine debt should not be considered a fatal flaw from a legal perspective.

Indeed, depending on the nature of a proposed investment position and the lenders’ intercreditor agreement rights, a mezzanine loan/mortgage loan structure may provide a wealth of leverage points for the investor who understands the ins and outs of that structure. Before embarking on such an investment, though, be sure to give all the participants, including the lenders, the same level of legal and business scrutiny you give to the real estate asset itself.

Katherine M. Lewis is a partner in the Atlanta office of McKenna Long & Aldridge LLP, where she focuses on loan workouts and financial restructuring. She can be reached at klewis@mckennalong.com.