Financing a Development Project Abroad: Senior Bank Loan, Mezzanine, Preferred Equity and Investor Loans, and What the Lender Will Require of You

The first question Israeli developers ask about financing abroad is "how much will the bank give". The question worth asking before it is "what will the bank get in return". Project finance is not a mortgage on an apartment. It is a system of agreements that determines who is repaid first, who is in control when something goes wrong, and which rights you have given up to get the money.

This guide goes through the customary financing layers in a development project, what lenders require, and the considerations on the Israeli side. It is general, and actual financing terms depend on the country, the bank and the project.

1What is the capital structure of a development project made of?

The capital structure (capital stack) is the order of priority of the sources of finance. Whoever is at the top is repaid first and takes lower risk, so receives a lower return. Whoever is at the bottom is repaid last, takes the high risk and receives the profit that remains.

Not every project needs all the layers. A small project is sometimes financed with equity and a bank loan only. But the more layers you add, the more the agreements between them become as important as the commercial terms.

2What will a local bank require before financing a project?

A bank financing development requires three things: that you invest your own money first, that it can examine the project in depth, and that it has sufficient control if something goes wrong. The details vary, but the structure is similar in most countries.

• Equity first. Usually the equity must go in before the first drawdown of the loan, and sometimes the bank sets a minimum ratio between equity and the project cost.
• Due diligence. Land registration and encumbrances, the building permit and its conditions, budget and timetable, the construction contract and the contractor's financial strength, insurance, and sometimes also pre-sales.
• A monitor on behalf of the bank. An engineer who checks construction progress before every drawdown, whose cost is usually borne by you.
• Conditions precedent to every drawdown. The monitor's approval, no default, compliance with the budget, and sometimes a sales threshold.
• Ongoing covenants. Reporting, financial ratios, a prohibition on further encumbrances and on distributions until repayment.

3What security and step-in rights will the lender ask for?

The security package for a development loan is much broader than a mortgage on the land. Its purpose is to allow the bank not only to enforce against an asset, but also to take over the project and complete it if necessary.

Pay particular attention to the guarantees. A completion guarantee or a cost overrun guarantee that you give personally takes the risk out of the special purpose company and transfers it to you. This is customary, but it is worth negotiating the cap, the guarantee period and the conditions for its release.

4What is the difference between mezzanine and preferred equity?

Mezzanine is debt, and preferred equity is equity. Both sit between the senior loan and the developers' equity, but the difference affects what will happen in difficulties.

Mezzanine is a subordinated loan. Since the senior bank holds the mortgage over the asset, the mezzanine lender usually receives a pledge over the shares of the holding company above the special purpose company. The relationship between the two lenders is set in an intercreditor agreement: when the mezzanine lender may receive payments, when it must wait before enforcing (Standstill), whether it may cure the developer's defaults towards the bank, and whether it has an option to buy the senior loan. The European loan market association, the LMA, publishes recommended forms for such agreements in real estate, which were updated in April 2023.

Preferred equity is an investment in shares that confers priority in return and repayment over common equity. It has no creditor status, so it cannot enforce security. Instead, it receives governance rights: a veto over certain decisions, and sometimes a right to take over management if the project deviates from its targets. The senior bank will want to check that these rights do not contradict the loan agreement.

5What do you need to know about shareholder loans and loans from investors?

Shareholder loans are the common way for developers to put money into the special purpose company, because it is easier to repay a loan than equity. But the bank will almost always require them to be subordinated to its loan and not repaid before it.

There is also a tax side. In the European Union, the Anti-Tax Avoidance Directive (ATAD) limits the deduction of a company's exceeding borrowing costs to 30% of earnings before interest, taxes, depreciation and amortisation (EBITDA), with an option for member states to set an exemption threshold. In addition, interest between related parties must be on market terms under transfer pricing rules. Local rules vary, so the interest rate and the volume of loans are checked with a local tax adviser.

Loans from private investors in Israel are a separate topic. A company's undertaking to repay a loan with interest to many investors may be considered a security under the Israeli Securities Law, 5728-1968, and such fundraising is subject to the rules on offers to the public. We cover this in a separate guide on raising money from Israelis for a project abroad.

6What should you check on the Israeli side?

• Currency. The project's income is in the local currency or in euros, and your capital is in shekels. A fluctuation in the exchange rate can change the capital you will need to top up or the return that comes back. Check hedging options with your bank in Israel, and factor the fluctuation into the business plan.
• Personal guarantees. A personal guarantee you have given to a bank abroad exposes your assets, and in some cases also in Israel. Read the guarantee and check its cap, the law governing it and the conditions for its release.
• Financing from Israel. A loan from an Israeli bank secured by an asset in Israel to finance equity for a project abroad concentrates risk: if the project gets stuck, the asset in Israel is still mortgaged.
• Transferring funds. Banks on both sides will want to understand the source of funds and the holding structure. Prepare the documentation in advance so that transfers are not delayed exactly when construction needs them.
• Reporting and taxation. Holding a foreign company may require reporting to the Israel Tax Authority, for example on Form 150, and interest or dividends you receive will be taxed in Israel under the law and the relevant tax treaty.

7In what order does the money come back?

The distribution order (waterfall) is set in the financing agreements and in the shareholders' agreement, and must be identical in all of them. A typical order looks like this:

1. Ongoing project costs, taxes and payments to the contractor.
2. Interest and principal of the senior loan.
3. Interest and principal of the mezzanine, if any.
4. Preferred return and repayment of the preferred equity, if any.
5. Repayment of shareholder loans.
6. Return of the shareholders' capital, followed by distribution of the profit according to the agreement.

8What should you do before approaching a lender?

Prepare a business plan with a delay scenario, make sure the land, the permit and the construction contract are ready for review, and build the shareholders' agreement so that it fits the lender's requirements. We accompany Israeli developers in negotiating financing and security agreements, and in coordinating the loan agreement, the construction contract and the partners' agreement, together with lawyers licensed in the project country.

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