Pari passu is a latin term meaning “on equal footing” and is usually used to describe a class of assets, equities, investors or creditors. When a class of people or assets is held pari passu, everything within that class has equal rights of payment and possesses the same level of priority. They are equally managed without preference.
How does pari passu work?
In a typical pari passu deal, a pari passu clause is included in the contract to signify that all parties involved in the deal possess the same rights, rank and seniority. For example, a company may offer bonds on a pari passu basis. This means all the bondholders are of equal rank and there is no priority for bondholders who have purchased the bonds earlier.
However, the pari passu principle may not hold between two different classes. The company may also offer stocks in addition to bonds. In this instance, bondholders have a priority in receiving payments over stockholders. This means that payments for bondholders will be distributed first before dividends to stockholders. The class of bondholders and stockholders are not on equal footing and the pari passu principle does not hold in this scenario.
Example of a pari passu deal
Two investors enter a pari passu deal whereby the total invested sum is $100,000. Each investor injects $50,000 into the investment. If the total return from the investment is $200,000, each investor in the pari passu deal receives $100,000 in returns, at the same time.
It is assumed that both investors invested the same amount. However, there may be instances where investors enter a pari passu deal but invest different amounts of capital. The returns would then be distributed on a pro-rata basis.
Why pari passu is important for a retail investor
Pari passu is important for a retail investor as it provides a degree of protection. Unsecured debt means there is no collateral tied to the debt, which poses a higher risk for the investor. The investor would want to know if there are other investors who would receive their returns before them. When a retail investor enters a deal with a pari passu clause, should the borrower default, the retail investor will have equal claim on the borrower’s assets as the other investors. The borrower’s assets would then be liquidated and distributed proportionally based on the proportion of each investor’s initial capital.
In the absence of a pari passu clause, other investors may be entitled to repayment ahead of the retail investor and he may not be able to recover any repayment in the end.
With pari passu, investors bear a lower level of risk as large commercial loans can be split into smaller ones. It is also a more equitable way to distribute profits.
Read also: An Overview of Institutional Investors
Other terminologies - pro rata
A latin term that may be used in conjunction with pari passu is “pro rata”. Pro rata has the meaning of “in proportion” and is often used to describe how profits are proportionately distributed. This means that everyone is allocated his respective share in proportion to the combined whole.
When a pro rata real estate company structure is formed where all the shares are held pari passu by the various shareholders based on their respective individual shareholdings, it means that the shareholders of the company would receive their respective profit distributions according to their respective shareholdings in the company and the returns would consequently be distributed to the shareholders at the same time. This ensures that all shareholders have an equal footing and no preferential treatment is accorded. This principle is applicable to investors who are deemed as equity shareholders and are not specifically identified as preferential shareholders.
For example, a real estate company may have three (3) shareholders with different shareholdings. In such a pro rata scenario, the profits generated by the company will be proportionately distributed in accordance with their respective shareholdings. Thus, if the three shareholders A, B, and C hold 5,000, 3,000 and 2,000 shares respectively out of the total combined share capital of 10,000 shares, then their corresponding proportion of profit sharing would be 50%, 30% and 20% respectively. If the company distributes $100,000 of the profits either as dividends or otherwise, then based on the corresponding pro rata distribution, shareholder A would receive 50% of the profits, which is $50,000. Shareholders B and C would similarly receive 30% and 20% of the profits, which are $30,000 and $20,000 respectively.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.