Leveraged Breakdowns

Real Estate Private Equity Interview Prep: The Capital Stack

The following real estate private equity interview questions should be practiced deliberately as if you were answering in-person in front of a real investor. The focus of these questions is on the capital stack and how it relates to net asset value, seniority, and return expectations. These are basic concepts to master before your next real estate private equity interview.

What is the capital stack?

The capital stack refers to the debt, preferred equity, and common equity that together comprise the full ownership structure of a company. The most straightforward way to explain the various tranches of the capital stack is to identify who gets paid back first during a bankruptcy. Senior secured debt holders are paid first, followed by senior unsecured, then junior, then mezzanine, then preferred equity holders, then finally common equity holders. Common equity holders are special because they assume the most risk yet are subject to the greatest reward. Private equity invests at the top of the capital stack, hence the name.

Describe seniority. Who is the most senior member of the capital stack? The least senior?

Seniority represents the order in which the various debtholders, preferred equity holders, and finally the common equity holders get paid back in the event of a bankruptcy. If a company goes bankrupt and liquidates for $140, but it has $100 of senior debt, $50 of junior debt, and no preferred equity, then the common equity is completely wiped out. Also, the senior debt is fully repaid and the junior debt receives $40 of its $50 principal and owns whatever else may be left of the company. In a basic restructuring that does not result in a liquidation, the junior debt holders would become the new common equity and the old common equity holders would lose everything.

How does the cost of capital scale between each tranche of seniority?

Put simply, the more risk you assume, the more return you demand. So senior secured debt holders expect the lowest return and common equity holders expect the higher return. Mezzanine and preferred equity holders are between the two. For an opportunistic investment, the senior debt holders may only expect a 6% to 7% annual return, but that’s because their position is far more secure when compared to the equity holders, who would subsequently target a 20% return.

How does the capital stack impact net asset value?

Net asset value represents the sum of all asset value, known as gross asset value or GAV, less the balance of all debt, mezzanine, and preferred equity. In other words, when you subtract the pre-equity components of the capital stack from GAV, the difference represents net asset value. Net asset value is equivalent to the market cap of a publicly traded company. If a company is trading at a discount to its net asset value, it could represent a good investment opportunity.

Ready to step it up?

Leveraged Breakdowns puts these concepts and much more into practical application through our flagship course, Breaking Down Real Estate Private Equity. Prepare for your next real estate private equity interview with our free simulators and free case study. We have been both working in and mentoring for this industry for a number of years, and can help you prepare for the exact real estate private equity interview questions you should expect when searching for your dream job.

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