Capital stack is the most important factor in an investor’s due diligence prior to making an investment. It refers to the legal organization of the capital that has been placed in a company or is secured through a legal asset through borrowing or through investment. The capital stack is the way that determines the legal rights to assets and income, in which order each party can be given authority or is repaid, or even the order in which each party receives priority of payment if there is an uncured default, or the order of liquidation in the event of bankruptcy.
In a nut shell, the order of your stake in the capital stack can make the basic difference between a full recovery and a total loss of the investment when the scenario becomes negative. It determines the depth of the tax benefits the investor is entitled to get and how the investor can categorize the income that he receives from the investment. It is imperative that the investor knows his place in the capital stack and also the collateral and the value that back the investment.
The seniority of the security and the order of priority of claims increase as the investor is placed lower in the capital stack. The lower in the capital stack that you are placed; the more secure is your position. The order of the capital stack will determine that in the event of liquidity or bankruptcy taxes are paid first, then is the employee wages, then the senior secured bonds, and so on. If there is sufficient liquidity after this the unsecured stakeholders are left with only a fraction of what are actually entitled to. The common equity and the preferred equity holders are almost left without anything.
In rare times when there is a fraud or scam, even the secure bondholders may be left with no returns. The bondholders may decide to hold the assets for alternate productive uses or to liquidate the assets to recover at least a portion of the investment /capital owed. It is therefore very important to know the position the investor holds in the capital stack and the exact value of the collateral backing the investor holds.
The next important position in the capital stack is of commercial real estate. Real estate investments can be simple equity or mortgage. As with company collateral, the real estate taxes go out first, followed by the first mortgage the second mortgage, mezzanine trading and then preferred equity and lastly simple equity. Any default in the chain allows the defaulting party to take over the property. A substantial drop in the values of the property and the subsequent drop in the income from the property can cause a multiparty default and leave only the most secure investors to take back the property from foreclosure.
If taxes remain unpaid a tax lien can be issued on the property that may cause the property to be passed on to the other party paying the same. The new investor will have to satisfy the remaining liens and take over the property. Being a first or second mortgage holder does not guarantee that you might not lose your investment.
If an investor is averse to the higher potential of capital erosion, low loan-to-value and first mortgage positions in first rate real estate and secured corporate bonds in credit-worthy corporations are the most secure investment positions that can be considered. The capital risk of investments tend to be low and so are the returns, and reflect the low risk potential for capital erosion.. Inflation is easily the largest risk in these investments since the returns are generally fixed at lower rates for a longer time. There is generally no income tax or capital gains tax benefit.
If the investor is interested in capital appreciation or in hedging his position against inflation and is tolerant to higher risk, stock investments or real estate equity are the order in the capital stack for the investor. Investors must be sensitive to fluctuations in the valuation of the collateral of their investment as they are the ones who will face any losses first and will generally be the last in line for recovery in the worst-case liquidation scenarios.
Hence the pecking order and legal organization of the cap stack should be concrete and well planned.