Ground leases, rate risk, and the return of the participating lender

Participating debt is not new. It returns whenever the gap between what an asset can service and what a lender requires becomes too wide to close with margin alone, and it has returned now for exactly that reason.

The structure is straightforward: the lender accepts a coupon below what the risk would otherwise command, in exchange for a share of realized value on disposal or refinancing. The difficulty is not commercial. It is that a lender with an equity-like return begins to behave like a party with equity-like control, and the documents rarely address the point directly.

Participation should not attach to operating decisions

Where the lender's participation is calculated by reference to disposal proceeds only, its interest in day-to-day asset management remains what a lender's interest normally is: that the security is maintained.

Where participation is calculated by reference to income, valuation, or any measure a manager influences month to month, the lender acquires a rational interest in leasing decisions, capital expenditure, and timing. It will then seek consent rights over them, and the borrower will have sold operational control for a rate reduction it may not have priced.

Define the disposal trigger tightly

Participation clauses fail most often on what counts as a disposal. A sale is obvious. A refinancing, a partial disposal, a corporate reorganization, a lease surrender and regrant, or a transfer within a group are not, and each has been argued.

A closed list, with an express statement that anything not listed is not a trigger, resolves in drafting what would otherwise be resolved in correspondence three years later.

Ground leases and the index nobody modeled

The same period has exposed a related problem in long-income assets. Index-linked ground rents drafted in a low-inflation environment frequently contain collars, caps, or compounding mechanics whose behavior at sustained higher inflation was never modeled by either party.

We have now advised on several restructurings where the review mechanism produced an outcome neither the freeholder nor the leaseholder intended, and both accepted that renegotiation was preferable to enforcement. Where a portfolio contains long index-linked income, the review mechanics are worth modeling at the extremes before a review date arrives rather than after.