Our own Steve Gord was featured in the below article written by Zack Miller of PitchBook, discussing the prevalence of preferred equity as part of today’s capital mix.
Current market conditions are teasing out preferred equity transactions. The tool has become more common in private credit deals of all sizes, according to market participants. It is also appearing in syndicated loan transactions.
Borrower companies have used preferred equity to raise capital without adding cash-pay interest. The tool can also bring down leverage to meet loan covenant requirements.
In return, preferred equity investors, who are often the private credit lenders, unlock attractive yields and hone the risk profile of their investments.
Cash a la carte
Preferred equity refers to a range of capital solutions between mezzanine debt and common equity in the capital stack. It includes debt-like structures, returning a flow of dividends, and more conventional equity structures in which the preferred investors rank higher than common shareholders.
Preferred equity’s flexibility allows investors to adjust their portfolio leverage and return profile. It also allows investors to fine-tune their attachment and detachment points: where the first and last dollars of their investment rank, relative to other claimholders in a potential bankruptcy.
“It’s much more open-ended compared to when the company signs up for a debt deal, which has covenants and a maturity date. Preferred — not so much,” said Hidden River Strategic Capital co-founder Steve Gord.
Many companies will initially seek the cheapest possible route to raising money, according to Gord.
“When they learn what goes with that, it’s going to change to the more expensive deals. Because you go feature by feature, and the company decides, maybe they want to suffer a little bit more dilution to get a lot more flexibility,” Gord said.
Two types of preferred equity are “participating” preferred and “convertible” preferred.
Participating preferred equity structures tend to favor investors, with an accrued dividend paid out over time, alongside common equity warrants. The result is a structure more like mezzanine debt with the return of an initial investment, a dividend, and a chunk of the company.
Convertible preferred equity, like in the case of NFL helmet supplier Riddell, tends to favor the company. The investor can choose to exit an investment with the initial investment compounded at a given interest rate or conversion of preferred equity to common equity at a given ratio.
These simple, standard models belie a wider array of potential deal terms and payout structures.
The Preferred Equity Era
“We hadn’t seen preferred equity to this magnitude at all, prior to the past couple of years,” said PineBridge Investments’ Joe Taylor, head of capital markets.
Preferred equity was ideal during the pandemic. At the time, many small- to medium-sized businesses had good long-term prospects but were tight on cash. Multiple forms of junior capital, including mezzanine debt, became more popular. Those dynamics are continuing in the “higher for longer” inflationary environment.
“There are a lot of companies that continue to be good businesses that can grow through acquisitions or organically, opening new facilities and such. They just can’t tap additional cash-paying debt,” Taylor said.
“Even mezzanine requires borrowers to have some type of cash-pay around it. So this is a good non-cash-pay solution,” he added.
In a March 7 report from Akin Gump Strauss Hauer & Feld LLP, “Trends in Special Situations & Private Credit,” the law firm said the rise of preferred equity — and higher rate junior debt in general — is a sign of private equity sponsors getting creative as they refinance aging maturities in a higher interest rate environment.
Preferred equity will likely show up more in private credit transactions, particularly in light of the maturity walls in 2025 and 2026, potentially offering investment opportunities to private credit lenders.
“We… expect to see a growing demand for hybrid capital in 2024, be that preferred equity or structured equity with debt-like features, which continues to play into the hands of private credit, offering more potential to increase yields,” the report said.
While preferred equity is on the upswing among the direct lending crowd, the tool has been around much longer in other markets. Preferred equity’s flexibility has made it a mainstay of the venture capital world for decades, where younger companies with negative cashflow seek structured financing.
“It’s really kind of a function of where we are in the credit cycle,” Gord said. “When leverage multiples are getting more conservative, you would expect to see the use of preferred stock to increase a bit.”
He added, “When the debt markets get more aggressive, and companies are able to raise as much money as they possibly want on a debt basis, sometimes that will squeeze out the market for preferred.”
Fun for the whole family?
Even with a range of options, preferred equity isn’t for everyone.
“What we’ve seen, with very limited exceptions, is that the yield parameters of preferred equity is in the high-teens percentage,” said Configure Partners managing director Joseph Weissglass. “It is not cheap. In the case of private equity-backed companies, the private equity sponsor considers that cost of capital and often decides that they would rather write that check themselves than pay another investor high-teens returns.”
Typical pricing for preferred equity is roughly 14%, down from 15-16% in 2023, market participants said. The majority of loans are paid in-kind, or a mix of PIK and cash interest. Lower-cost options are achievable, though they may carry less attractive terms.
Market participants were quick to note that preferred equity is not necessarily the same thing as a rescue financing. It has uses for both stressed and performing companies, particularly in an environment of constrained exit opportunities for sponsors.
“It’s really, at this juncture, a cheaper form of equity that the private equity firm can tap into. There’s a lot of variability, so, from a pricing perspective, it’s competitive,” Taylor said.
That extra layer of flexibility can make a preferred portion of a deal a valuable asset for direct lenders, giving dealmakers headroom to negotiate on terms outside of pricing.
“Sometimes we’ll use it as a way to bridge a valuation gap,” said Granite Creek co-founder Mark Radzik. “An owner could say, ‘Hey, Mark, I think my business is worth $50 million.’ And I say, ‘I think it’s worth $35 [million].’ And they’re like, ‘How can you say that? I put my whole life into this business.’ We may say, ‘How about we bridge the gap by investing a little more debt than we previously proposed, because we don’t love that valuation. But we’ll still do some equity, too, because we want to be partners. But we’ll invest equity in a preferred to make sure we feel safer, but the entrepreneur gets their valuation, because we’re at the top of the equity pile. So, we’ll convert at your equity valuation, but we’ll earn a PIK of 10% a year. This creates a win-win.’”
Some have linked preferred equity deals with cash-strapped borrowers, under the assumption that a borrower company would rather reach for debt in most circumstances, but need to settle for preferred equity if they can’t handle the burden.
Some levered companies can’t borrow more, and turn to preferred equity instead, but that isn’t always the case.
“Undoubtedly, there are those projects where we would say, this is a borrower that’s maxed out on what typical debt providers would provide, and they still have a significant capital gap, and so they’re trying to plug it with [preferred] equity,” said Enhanced Capital president and CEO Michael Korengold. “Provided there is overall credit worthiness, and as long as that [preferred] equity provider goes in eyes wide open with respect to priority and other terms including the return profile, it might still be an attractive thing to do.”
He added, “On the other hand, we see plenty of situations where it really is a creditworthy counterparty, that, if other reasons didn’t exist, a deal could probably be styled as debt and conventional lenders would probably participate.”
The utility of preferred equity may hinge on the language defining it.
“There’s a lot of different flavors of preferred,” Gord said. “And depending on what the company wants to do, you basically can just make it up. And you just have to have lawyers that are creative, and know how to describe things in enough detail, so that everybody knows what they’re getting into.”