General and limited partners alike have needed a plentiful supply of oxygen to get through the toxicity of the worst real estate recession for a generation.

For those with funds caught between choked debt markets, plummeting occupancy rates and falling rents, the words “rock and hard place” spring naturally to mind. For many, there is little choice but to raise additional capital – “rescue” capital – to stabilise portfolios.

In a growing number of cases, this rescue capital is coming in the form of preferred equity offerings. There are currently about 20 such mezzanine equity offerings in the US, according to people familiar with the situation. That number, though, is expected to grow substantially in the coming 12 to 24 months, as funds face mounting debt maturities, declining – or zero – fund reserves and deteriorating real estate fundamentals.

Zoe Hughes

Such is the anticipated scale of fund-level distress that one private equity real estate firm was urged to consider raising a fund dedicated to the strategy, according to PERE sources. The firm declined. In the words of another industry professional: “Eighty percent of what’s out there is just not pretty.” When a third party has to consider existing leverage, contingent liabilities, recourse guarantees and potential cross-collateralisation, it’s easy to see why GPs considering preferred equity infusions would look to investments on a deal-by-deal basis rather than at the fund level.

However, there are fund-level opportunities available. PERE has been told of several notable fund managers who are in the process of closing or have already secured preferred equity capital, including The Carlyle Group, with one of its European real estate funds, and Walton Street Capital, with Fund V. Carlyle and Walton Street were unavailable for comment at press time.

Of course, the fact that GPs have been forced to seek rescue capital in the first place isn’t something many would brag about.

Limited partners are already angry at the fund management world for a multitude of reasons. Capital constrained fund managers, unable to source traditional means of debt, approaching their own investors for additional cash have only added to the levels of frustration. “LPs are naturally sceptical,” one fund manager said. The LPs recognise that either they – or a third-party – have to inject another dollar into the fund if the remaining 50 cents of equity is to be saved. “LPs are generally annoyed that they’re in this mess in the first place,” the person added.

But for limited partners in funds that have been able to secure third-party preferred equity, it can be seen as a vote of confidence – for them as well as for the fund sponsor. After all, an outside interest has just declared there is residual value to be had in the remaining equity. Not all funds today can say the same thing.

The typical preferred equity investor is looking for 20 percent-plus returns on capital and for a strong balance sheet with good cash flows that will help retire their position, according to Doug Weill, of advisory firm Hodes Weill & Associates.

And as part of the preferred equity negotiations, GPs will have likely secured concessions from lenders in terms of debt and/or maturities that provide fund-level stability for the medium-term. “Someone coming in with preferred equity or mezzanine capital isn’t going to back a plan that covers liabilities for just six to 12 months,” Weill said. “A recapitalisation should provide for balance sheet stability for at least two to three years. It may also be prudent to restructure certain aspects of the fund, such as resetting incentives and management fees, and revisiting key man provisions – in order to ensure a proper alignment of interest going forward.”

A third-party injection of mezzanine capital or preferred equity will also demand management team stability. New investors want to make sure a team stays in place, and is properly incentivised, to do the job at hand of protecting remaining equity in a fund and capturing any upside in the real estate markets. “This is giving a little bit more oxygen to those funds that are viable,” another industry professional told PERE.

The whole exercise may not be palatable for limited partners – not least owing to the fact that the preferred equity investor becomes first among his LP equals – but it does mean that the fund might actually survive.