Latin phrases like “pari passu” (PP) pepper both the business and legal worlds. It is relevant in various situations, including commercial real estate (CRE), bankruptcy, unsecured debts (i.e., pari passu debt), estates, and more. In fact, the pari passu clause plays a vital role in real estate. Read on to learn what you need to know about the pari passu clause before you enter into a real estate investment. In this article, we cover:
- What is Pari Passu?
- Pari Passu vs Pro Rata
- How It Works in Finance
- Useful Examples
- What You Need to Know
- How Assets America Can Help
- Frequently Asked Questions
Pari Passu Meaning
PP and pro rata are terms for paying investors and creditors. The pari passu meaning is “equal footing.” For commercial real estate, the pari passu clause requires that all obligations share the same priority and class.
PP refers to situations where two or more assets, investors, or creditors receive equal treatment. In real estate, the pari passu definition often describes how investors collect payouts.
In addition, the pari passu definition indicates that investors or creditors have equal claim to borrower assets after default. Contrast this to pro rata, where shareholders receive payments in proportion to the amount they invest.
What is PARI PASSU? – PARI PASSU Meaning, Definition & Explanation
Pari Passu vs Pro Rata
The difference between pari passu and pro rata involves classes of assets, debts, bonds, or other items. For example, we might say that a bond is “held in pari passu.” Pro rata refers to the distribution percentages of something based upon some criterion.
For instance, when unsecured debts are held in PP during bankruptcy, all receive the same priority of payments. In other words, the court directs pro-rata payments to all the unsecured debtholders. Clearly, the only way to distribute something held in PP is to distribute pro-rata.
Thus, there is little practical difference between pari passu vs pro rata. Normally, the two terms work together. Specifically, PP investments distribute payments pro rata to each creditor and investor because all have equal footing.
In another example, general partners receive pari passu treatment. That means that they all receive an equal percentage of payments, on the same dates, on a pro rata basis.
How Pari Passu Works
Frequently, Pari Passu applies to “waterfall and promote structures” within CRE partnerships. Usually, the PP portion of investment cash flows goes to all PP partners or investors at the same time.
Waterfall and Promote Structures
The waterfall model denotes CRE investments that distribute profits unevenly. Normally, a project’s sponsor or managing partner receives extra profits (i.e., “the promote”) when the project meets specified benchmarks.
A project’s owner agreement describes the precise nature of a waterfall distribution structure. Typically, the structure hinges on a “return hurdle.” This is the internal rate of return (IRR) required for the sponsor to receive a promote.
For example, imagine a CRE construction project in which the sponsor invests 5% equity and investors invest 95%. If the first hurdle is a 10% IRR, returns up to that amount give sponsors a 5% return. In other words, returns prorate up to the first hurdle. However, returns in excess of 10% give sponsors a 15% return while investors receive 85%.
The waterfall method often includes multiple hurdles. In the example, you might have additional hurdles of 20% and 25%. As the project returns exceed each hurdle, sponsors collect greater proportions of the profits. This structure encourages the sponsor to maximize profits. In other words, the sponsor is incentivized.
Preferred Returns in the Waterfall Model
Frequently, the waterfall model includes “preferred returns” for certain investors. These investors receive the first claim on profits until collecting a hurdle IRR. Therefore, if profits fail to achieve the hurdle return, preferred investors take the shortfall from other investors’ returns. Under this structure, non-preferred investors might end up with reduced or conceivably no return.
Upfront preferred distributions occur according to “catchup provisions.” Conversely, “lookback provisions” control other preferred distributions. Here, sponsors give back profits by the end of the deal to compensate preferred investors for hurdle return shortfalls.
Pari Passu Notes and CMBS Loans
Frequently, pari passu notes secure commercial mortgage-backed securities (CMBS). Typically, the sponsor divides the original CMBS loan into A-notes and B-notes secured from many commercial loans. A-notes have higher ratings than B-notes.
The A-note holders collect payments ahead of the higher-interest and riskier B-notes. Moreover, the B-note holders may not receive any payments if the A-notes default.
Normally, the sponsor breaks only the A-notes into multiple PP notes. Therefore, all A-piece investors have equal rights to payments.
For example, suppose a sponsor transforms a $40 million CMBS loan into three $10 million PP A-notes. Each of the three notes go into different CMBS pools that share equal payment priority. The remaining $10 million goes into a subordinate B-notes that don’t get PP treatment.
Pros and Cons for CMBS Loans
PP offers several benefits to CMBS sponsors and investors, including:
- The ability to quickly sell bundled loans in order to improve cash flows
- The ability to make new loans quickly, thereby encouraging CRE projects
- Provides a way to divide large loans into different CMBS, thereby encouraging B-piece investors
- Reduces default risk to A-piece investors
PP is not without problems:
- It makes workouts more time-consuming and difficult. For example, home mortgages may split into too many pieces, thereby hampering workouts and increasing losses.
- It’s harder to identify all the PP owners of seasoned notes. This complicates consensus-building and workouts.
- PP notes add complexity to the CMBS market.
Possible solutions including limiting the number of parties needed to approve a workout and limiting share transferability.
Pari Passu and Bankruptcy
In bankruptcies, unsecured creditors receive PP treatment. That is, they all receive the same fractional rate of debt paid at the same time.
Example of Pari Passu in Real Estate
This example of PP involves a pari passu real estate joint venture partnership in which partners must contribute equity. In this case, suppose the operating agreement requires a $1 million investment.
The sponsor must contribute 10%, or $100,000, and investors must contribute 90%, or $900,000. If there are (N) pari passu investors, then each one must pay $900,000 divided by N ($900,000 / N).
In another example of pari passu in real estate, suppose that the return of capital is PP. If a $200,000 cash flow distribution is available to the investor, then each investor receives $200,000/N.
Naturally, this assumes that each investor invested the same amount. If this is not true, then each investor receives a pro rata distribution equal to ($200,000 x Investor investment / total Investor investments).
Here is one sample pari passu clause from Law Insider:
Each Obligor shall ensure that its obligations under the Finance Documents rank at all times at least pari passu in right of priority and payment with the claims of all its other unsecured and unsubordinated creditors, except for obligations mandatorily preferred by law applying to companies generally.
Here is one more sample clause:
All obligations and liabilities of the Company hereunder shall rank at least equally and ratably (pari passu) in priority with all other unsubordinated, unsecured obligations of the Company to any other creditor.
What You Need to Know
Investors should know their PP rights before investing in a CRE project or bonds. Pari passu debt requires equal treatment to all parties within the same class.
For example, all holders of common shares have PP rights. However, the preferred-share class may have different rights than the common-share class. One important item to know is whether the loan includes a negative pledge clause (a.k.a., covenant of equal coverage).
Negative Pledge Clauses
A negative pledge clause is a negative covenant in bond indentures and loan structures. It stops borrowers from harming the bondholders’ security by pledging assets.
In other words, bondholders protect against defaults by preventing the issuer from assuming future debt. Failure to comply with a negative pledge clause can spark a loan default. Lenders usually give issuers a time period (often 30 days) to remedy broken covenants before pursuing default procedures.
Unsecured loans may contain a negative pledge clause preventing borrowers from pledging their own assets to collateralize other financings. Any such pledges would increase the risk of repayments should the issuer go bankrupt.
Typically, mortgage agreements have clauses preventing the homeowner from pledging the home against a new loan. In all cases, the goal of a negative pledge clause is to preserve the original lender’s liquidation priority.
How Assets America® Can Help
Assets America® is a high-end commercial loan brokerage firm. We can arrange loans starting from $10 million, with no upper limit. We can offer a wide variety of loans, including for deals under pari passu rules.
If you would like to discuss a financing arrangement, please contact us for a free consultation. You’ll be extremely pleased with our 35+ years of experience. Successfully closing your transaction is our highest priority.
Frequently Asked Questions
What’s the difference between pari passu and pro-rata?
Pari passu means all members of a class receive equal treatment. One way to enforce equal treatment is to calculate payments or obligations on a pro-rata basis. For instance, your bond interest income ties directly to the size of your investment.
How do you use pari passu in a sentence?
Pari passu is a legal term with a specific meaning. An example might be “The new tranche of debt will rank pari passu with the three existing ones.” Of course, PP seldom comes up in daily conversation.
What is the pari passu principle?
The PP principle means equal treatment within a class. For example, the PP principle ensures that all unsecured creditors receive equal treatment during an insolvency process. This includes liquidation, administration, and bankruptcy processes.
What is a negative pledge clause?
A negative pledge clause prevents a borrower from pledging any assets that would increase default risk to existing lenders. You’ll find these clauses as negative covenants in bond indentures and loan structures.