Pari Passu is Latin for “on equal footing”. In the world of finance it refers to a situations where two or more classes of people or transactions are managed without preference. Assets, obligations, securities, investors, and creditors can all be managed with a pari passu structure. One classic example of pari passu is the way unsecured creditors are treated in a bankruptcy. All the unsecured creditors get paid at the same time and the same fractional rate of the debt they were owed. In commercial real estate the pari passu structure is often used in commercial mortgage backed securities (CMBS) or in the waterfall structure of commercial real estate partnerships. In this article we’ll discuss pari passu in commercial real estate and clarify with some relevant examples.
Difference Between Pari Passu and Pro Rata
First of all, let’s tackle a commonly asked question about pari passu. What’s the difference between pari passu and pro rata? The terms pari passu and pro rata are often confused with each other. Pari passu is used to refer to a class. The debts or bonds are held pari passu. Pro rata technically refers to how something is distributed. In the bankruptcy example above, the unsecured debts are all pari passu. They are of the same class and will be paid on the same priority and without preference. Because the debts are pari passu, they must be paid pro rata. Distributing the money otherwise would give priority to some of the unsecured debt over others. In a practical sense there is little difference between pari passu and pro rata because when anything is held pari passu, the only way to preserve the “equal footing” is to distribute profits or losses pro rata.
Pari Passu in Waterfall Structures of Commercial Real Estate Partnerships
Pari passu is often used as part of a waterfall structure in a commercial real estate partnership. In its simplest form, some portion of the cash flow from an investment is distributed to all the pari passu investors or partners at the same time. There are usually certain targets that trigger the distribution of the cash flow. There are also usually one or more hurdles that, when cleared, allow for the managing partner to get paid an extra share of the cash flow. This is typically called the “promote”.
How does pari passu work in a waterfall structure? While waterfall structures can vary widely, it’s common to have all cash flow “pari passu” up to a preferred rate of return, say 8%. That is, up to 8% all cash flows are distributed in proportion to the investment amount (in other words, pro rata) to both the investor and the sponsor. Then, to provide the sponsor an incentive to achieve higher returns, certain tiers or return hurdles are set where (if met), the sponsor receives a larger disproportionate share of cash flow. These hurdles essentially break the pari passu structure and create increasingly disproportionate splits of the cash flow at each hurdle.
Understanding Pari Passu Structure in CMBS
Investors like pari passu structures because they allow risk to be widely allocated. Everyone is going to get paid at the same time. This reduces the risk of a project suddenly failing after some investors have been paid and leaving the remaining investors to bear the full brunt of the loss.
In CMBS a large loan on a single commercial property or project is split up into several smaller pari passu notes and those notes are packaged into different CMBS offerings. While not all the notes will be of equal size, all the pari passu notes will have the same payment priority.
These smaller notes are easier to sell as part of a CMBS because a buyer knows that a given project will only represent a small portion of the overall pool. Before the widespread adoption of pari passu structures by CMBS industry a single project might have been 20% of the pool in a single CMBS bundle. Now, usually the biggest notes are only 5% of the total pool.
Here is how a large commercial loan might be broken up in pari passu pieces and placed into a series of CMBS. The commercial loan will typically by made up of a primary note, sometimes called an A-note, and a subordinate note, sometimes called a B-note. The A-note will be split up into several different pari passu pieces and placed into different CMBS. Typically private parties hold B-notes instead of them being placed into a CMBS.
A single CMBS will be made up of several pari passu pieces of several different A-notes from many different commercial deals. The owners of the CMBS then own small pieces of the primary A-note from many different commercial loans. All of the loans that go into a CMBS are rated by a rating agency. Loans that have a low risk of default are given an “A” rating. Riskier loans are given some type of “B” rating. These ratings only relate to the risk of default and having nothing in common with the A-note and B-note designations from the original loan.
The first investors who buy the CMBS are called A-piece investors, because they are buying on the strength of the A-rated loans bundled in the CMBS. These investors will get paid first, but at a lower interest rate.
However, it is the second group of investors, the B-piece investors, which really control the CMBS market. B-piece investors have a subordinate interest to the earlier investors, but get a higher interest rate. They are buying the CMBS based on the rate of return of the B-rated loans. If a loan defaults or there is some other payment problem, all of the A-piece investors will get paid before any B-piece investor is paid. There are always buyers for the A-rated loans. But, if no one is interested in buying the B-rated loans, the CMBS system and market would collapse. CMBS are usually organized to appeal to the B-piece investors.
History of Pari Passu and CMBS
The idea of pari passu notes has been around a long time. CMBS have also been around for a long time. However, it was only after the events of September 11, 2001 that pari passu took on such a pivotal role in CMBS.
The loans for the World Trade Center were split into two different CMBS. While all bond holders were fully compensated after a period of time, the market became skittish of large commercial loans. The possibility of a single large default was suddenly seen as too big of a risk.
Pari passu solved this problem by spreading the risk of a single default across many different CMBS. No single investor or group of investors would bear a significant amount of the risk for a single loan. The use of pari passu for loans on large projects means that the holdings of a single CMBS are more diverse and therefore more stable.
Benefits of Pari Passu
The commercial real estate loan market has come to depend on pari passu. Lenders want to bundle up loans and sell them as quickly as possible to improve their cash flow and allow them to make additional loans quickly. Placing loans, or pieces of loans, into a CMBS improves the lenders capital position.
However, investors, especially the all important B-piece investors, are no longer willing to buy a CMBS where one note is a significant portion of the security. The only practical way to split up the large loans into different CMBS is to use the pari passu structure. Pari passu improves the liquidity of the entire system.
It allows investors to buy CMBS with confidence that the risk of default is low, it allows lenders to make more loans, and it allow developers to continue to pursue large commercial real estate projects. Virtually all of the growth in the CMBS market since September 11th is due in part to the pari passu structure.
Problems with Pari Passu
However, pari passu is not without its critics. Credit ratings agencies have voiced concerns for years that pari passu notes make workouts more difficult and time consuming. One of the problems during the housing meltdown and the Great Recession was that the home mortgages were split up into too many pieces and it took too long for loan workouts to take place. The longer it takes for a workout to be completed, the greater the losses end up being.
Credit rating agencies worry that the longer a note is on the market the harder it will be to track down all of the pari passu owners. Not only is it time consuming to track down all the stake holders in the case of a loan workout, but also the more stake holders the harder it is to reach a consensus. All of the delays could lead to a default that is not in anyone’s interest. Too many defaults and the CMBS industry could crash similarly to the way the home mortgage industry suffered in the Great Recession.
Pari passu notes add an extra layer of complexity to what is already a complex financial instrument. CMBS investors may feel more secure with the risk of default on a single loan more diffuse, but some critics worry the complexity increases the risk of systemic risks spreading through the system more quickly.
For now the overall default rate in the CMBS sector is well below 1%. The industry has seen the number of B-piece investors grow and shrink over the past decade and a half, but the market has always fond enough B-piece investors to keep the commercial loan to CMBS pipeline flowing.
Proposed Solutions to Pari Passu Concerns
Even though the CMBS market is largely seen as healthy and stable, there are two main things that could lower the potential risks posed by pari passu structures in CMBS. The first proposal would change who has authority to agree to a workout. The idea is that if the greatest risk is simply the large number of people that have to agree to a workout, shrink the number of people who have authority to agree to the workout.
This could be done in several ways. The B-piece investors could be given the sole authority to agree to a workout. The idea would be the first B-piece investor in the first trust where a pari passu note is placed is given the opportunity to take control of the B-note. If the first B-piece investor declined, the next B-piece investor would have the same opportunity. However, at least one B-piece investor would have to take control of the B-note and the authority to agree to a workout.
Another way to limit the risk of pari passu is to limit the transferability of shares. This would make it easier to know who needs to be consulted in the event of a loan workout. It would also mean that some later buyers would only get limited shares. They would not get workout authority with their shares. This idea is based on the way the syndicated loan structure has evolved.
Even with its critics, pari passu will remain integral to the CMBS industry for the foreseeable future. Investors are enthusiastic about it and large commercial real estate lenders see it an indispensable to keeping their business running smoothly.