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Preferred and structured equity investments in the spotlight amid uncertain markets

trapeze artists performing dangerous maneuvers
Preferred and structured equity investments in the spotlight amid uncertain markets

Preferred equity investing is on the rise amid a search for yield and a fall in the number of high-quality assets coming to market. Here we explore the growing appeal of preferred equity instruments, outline the terms that are heavily negotiated in deals—and explain their impact on M&A. To find out more, you can listen to our podcast, which explores preferred equity trends from a U.S. and European perspective.

Preferred equity instruments (preference shares in the UK; preferred interests or shares in the U.S.) have long been used by private equity firms in buyout structures, including to structure their own returns, as a hurdle for management incentive schemes, to enable profits to be easily distributed or as a simple instrument to provide liquidity for investors.

Today however, a market has developed for preferred equity as an asset class in its own right. Investors—including traditional private equity firms, private credit funds or specialized vehicles in these institutions—are attracted by the fact that preferred equity instruments may incorporate debt-like features (e.g., fixed or sometimes floating dividend rates) yet offer higher returns than traditional debt securities to compensate investors for taking on equity risk, as well as governance rights and distribution waterfalls that give holders priority claims on assets and earnings above subordinated investor classes, and therefore a level of downside risk protection. They can be designed in a variety of ways and can offer investors conversion features to common equity or upside participation without conversion, as well as acting as pure fixed-return instruments.

Preferred equity issued in variety of contexts

Preferred equity can be issued in a variety of scenarios, including to provide additional capital for M&A or capex; to deliver a liquidity event for existing shareholders; or to inject financing into a new JV or aggregator vehicle for the purpose of an acquisition. These contexts are often dependent on local dynamics and have resulted in different market for the terms of a typical preferred security, reflecting the associated level of risk (i.e., is the security transferable? Does it represent an investment grade obligation? etc.)

We are also seeing preferred equity attached to debt provided by credit funds in large acquisition financings (particularly in the U.S. and Europe); in “fallen angel” investment grade structures; and in the special situations market, where they are used to refinance senior secured debt in circumstances where additional credit or new common equity may be unavailable or unattractive economically.

The latter two scenarios are driving much of the uptick in investor interest across the world.

Option for investors looking for creative ways to deploy capital

Preferred equity instruments are attracting investors looking for creative ways to deploy capital in an environment where fewer quality assets are coming to market as a result of prevailing economic and geopolitical uncertainties. Increased competition among credit funds has also driven sponsors to expand their menu of options as a way of attracting new investment.

For investment grade issuers unable to take on further debt without it impacting their credit rating, preferred or structured equity is a good way to inject capital, with the preferred return acting as an incentive for existing shareholders to participate.

As far as investors are concerned, these instruments operate much like minority holdings, albeit with added features to manage downside risk. However, they need to be carefully structured to ensure they are considered equity by ratings agencies; too many debt-like features (in particular mandatory payment obligations) and they could trigger a downgrade.

In this context we are also seeing common/minority equity structures (so called "structured equity") with no embedded preferred return but with economic features that encourage an early (and preferred) exit or dividend stream and with similar governance and downside protections. These structures may be designed to achieve a certain accounting or ratings treatment for what are otherwise investment grade corporates.

In a distressed or special situation context, preferred and structured equity can act as an “extension” for sponsor-backed issuers facing a debt maturity wall but where valuation issues make a sale unlikely or commercially unattractive, injecting new capital that can be used to reduce leverage, or pursue acquisitions or other strategic alternatives. The proceeds can be deployed to remedy covenant breaches in the event that asset valuations fall, while preferred equity issuance also gives sponsors an alternative to a secondary sale, enabling capital to be returned to investors without transferring the asset to a continuation fund.

As previously mentioned, preferred and structured equity instruments do not carry the same repayment rights as debt, and do not provide holders with the right to force an issuer into insolvency if they are not redeemed at the end of their investment's life. However, preferred equity investors are often closed-ended funds and therefore need certainty over an exit, making redemption rights and forced sale provisions a key focus in deal negotiations. With that said, they typically contain equally heavily negotiated investor protections and covenants, with the most important often being leverage restrictions, priming restrictions and limitations on transactions with affiliates, among other things.

Focus on exit mechanics in negotiations

Exit mechanics may include “drag” rights that allow the investor to initiate a sale process (or even force the closing of a sale) if the issuer has not redeemed its stake by an agreed date. Such clauses are invariably bespoke, and may, for example, require the issuer to hire an investment banker within a set period (possibly with the investor approving their choice) who would then be obliged to run an auction. One area of caution for issuers is that where the investor is a fund with different pockets of capital, any sale could be to themselves. Here, even the placement of the rights will be bespoke, and it is important to consider the treatment of the proposed rights in a bankruptcy/insolvency context.

Springing governance rights provide downside protections

Critically, the most effective remedy that investors may look to include are provisions stating that, in the event of a breach, they are automatically able to take over the company’s board or assume another governance position. This will give the investor a seat at the table and could in turn lead to a sale, but where the investor has greater influence over the process. 

Board takeovers in this context are typically executed by increasing the size of the board to the point where the investor has a majority. Should the business then continue towards insolvency, the investor would sit at the heart of the process, giving them more information rights and greater leverage to steer the process in a way that maximizes their returns.

It is critical for investors considering preferred and structured equity opportunities to think carefully about their remedy options, particularly if they are more used to operating in the credit markets. Here, those negotiations need to be informed by a sophisticated understanding of how restructuring and insolvency processes play out in different jurisdictions. Investors with large portfolios would also need to consider the antitrust implications of assuming ownership of the asset.

Preferred equity in focus: Asia Pacific

In Asia, prevailing macroeconomic headwinds and persistent challenges in securing exits are prompting private equity sponsors and sovereign wealth funds to pivot away from traditional growth equity investments and towards buyouts or preferred equity instruments that closely resemble loan-style financings. These instruments are increasingly favored by investors and funds with the appetite and flexibility to move through the capital stack, and are frequently issued by operators of data centers, logistics or other real estate assets, as well as in connection with special situations opportunities.

In these transactions, redeemable preference shares are generally non-convertible but are paired with warrants designed to allow investors to capture the potential equity upside. The two instruments are typically detachable, such that even following redemption of the preference shares, investors may elect to retain the warrants, which are ordinarily cash settled upon the occurrence of a liquidity event such as an IPO or a trade sale. 

These opportunities are commonly structured through a credit investment lens. Investors will typically look to negotiate debt-like protections, including:

  • make-whole payments for the event of early redemption of the preference shares
  • step-up in preferred dividend rate if the issuer opts for PIK interest in any given period
  • enhanced governance rights if PIK interest accrues beyond a specified percentage of the total investment.

Given the prevalence of sponsor involvement, investors often negotiate "put" rights, permitting them to transfer the instruments to the sponsor shareholder at the agreed consideration if redemption is impracticable, or alternatively, a parent guarantee conferring equivalent protection. Other common investor safeguards include leverage restrictions that not only restrain the issuer's ability to incur additional indebtedness, but also extend to its subsidiaries, thereby mitigating the risk of structural subordination.

Unlike in the U.S. and Europe, where preferred equity is sometimes deployed in connection with continuation vehicles, such transactions are relatively uncommon in Asia. Further, as many issuers in the region are not investment graded, the impact of preferred equity instruments on credit ratings is generally not a material consideration.