In fund finance, preferred equity has become an increasingly popular liquidity and financing alternative to traditional GP-led secondaries, NAV financings and GP financings. Although the structure is not new, there is now greater awareness among investors and funds of the advantages that preferred equity offers—especially in periods of a market downturn, where the market for secondary sales may be uncertain and traditional lenders may be more selective and require stricter covenants.
What is preferred equity?
In the fund finance context, preferred equity refers to the issuance of new equity interests in a fund that rank junior to debt but have priority over the common equity of a fund in distributions. Preferred equity may be issued by an existing fund or, more commonly, by a newly formed special purpose vehicle (“SPV”) formed by the existing fund and, possibly, related funds. In an SPV structure, the existing and related funds contribute one, some or all of their portfolio investments to the SPV, which then issues common equity to the existing fund and preferred equity to the preferred investors. The SPV structure is favored by preferred investors because the preferred equity is structurally senior to any debt at the existing fund level that is not secured by the fund’s assets. The economic terms of preferred equity are typically implemented through the distribution waterfall of the issuing fund or SPV. After the administrative expenses of the issuer have been paid (often subject to a negotiated cap), the preferred investors receive priority in distributions until those investors have received repayment of their capital contributions plus either a minimum rate of return or a multiple on invested capital. In some cases, the preferred investors negotiate for a portion of subsequent distributions once the preferred return has been met, allowing them to share in the upside.
Uses and benefits of preferred equity
Preferred equity is useful in situations where existing fund investors want liquidity but traditional liquidity solutions are limited. In uncertain market conditions, where selling the portfolio company or conducting traditional fund or GP-led secondaries may not be attractive due to depressed activity or valuations, and where GPs see more growth potential and value in retaining portfolio investments for a longer period, preferred equity proceeds can be used for distributions to existing investors, providing them with liquidity before a full exit while allowing them to remain invested and retain any future upside. Preferred equity deals can often be executed in a few weeks, whereas a continuation fund can take months to close. Further, unlike continuation fund transactions, a preferred equity deal may not require agreement on a valuation of the fund assets, as the economics of the preferred equity provide for a minimum return and downside protection. For the same reason, preferred investors may be satisfied with focusing diligence at the fund level, without undertaking more detailed diligence at the portfolio company level.
While preferred equity is often used to provide investors with liquidity, proceeds from preferred equity may also be used to fund follow-on investments, support a portfolio company with a capital injection where it cannot get financing on a standalone basis, repay existing fund or portfolio company debt or to bridge capital calls from existing investors. Preferred equity thus represents an alternative to NAV financings, which typically have a fixed tenor of two-to-four years and covenants customary for debt investments, and may also require security over the actual assets. NAV financings often also include a provision that triggers an event of default if the loan-to-value ratio exceeds a specified threshold, requiring a sell down of assets within a specified period. In contrast, preferred equity terms tend to be more bespoke and tailored to the needs of the issuer and the particular deal. The preferred equity may have a longer redemption date or may have no redemption date, with distributions being made as portfolio investments are divested until the end of fund’s term. Preferred equity terms are also lighter on covenants than debt financing, thus offering downside protection to the issuer. As a result, however, preferred equity tends to be more expensive than debt, reflecting the assumption of equity risk and the greater flexibility afforded the issuer.
Preferred equity transactions have also become increasingly common for financing investments in private equity sponsors, with the proceeds often used to fund internal growth initiatives or larger GP commitments to underlying funds, as well as to provide liquidity to founders or departing investment professionals. In this context, preferred equity provides a lower cost of capital to founders as compared to traditional equity, which allows founders (and the next generation of investment professionals) to retain future appreciation in the business. At the same time, preferred equity investors typically require fewer minority protections than common equity investors, allowing founders to retain more control over the business.
Key issues in getting the deal done
Debt-like or equity-like?
Whether the terms in a particular deal are more debt-like or equity-like often depends on whether the investor is viewed as a credit provider or an equity investor and on the relative negotiating power of the issuer and its GP. Preferred investors will typically want consent rights above what ordinary LPs in a fund would receive, in order to protect the value of the preferred equity. Common consent rights include restrictions on incurrence of debt and other anti-dilution protections, restrictions on distributions outside of the negotiated waterfall, redemptions and other payments, and affiliate transaction protections. Some preferred investors may also seek consent rights over changes of control of the fund and acquisitions and disposals of portfolio investments. Preferred investors that are credit funds may negotiate for covenants that are customary in NAV financings, while an issuer may seek lighter covenants on the argument that the preferred investor is receiving higher pricing. The rights of preferred investors, and the degree to which they put constraints on the GP’s operation of the fund, are often heavily negotiated.
One issue that is a frequent point of negotiation is whether the preferred investors have a right to remove and replace the GP for bad acts at the SPV level or that relate solely to the preferred equity, without concurrence of the existing LPs. In negotiating preferred equity deals, GPs must often balance the demands of the preferred investors with fulfilling their fiduciary duties to existing LPs, who must be convinced that the deal provides more value than cost.
A preferred equity fund financing deal will most likely require consent of the LP advisory committee of the existing fund, a percentage of existing LPs, or both, depending on the structure of the deal and the terms of the fund’s partnership agreement. The need for LP consent may be triggered by the amendment to the fund’s distribution waterfall, by the establishment of an SPV and transfer of assets to the SPV (which may constitute an affiliate transaction), or by conflicts of interest issues. Even if LP consent is not contractually required under the fund’s partnership agreement, GPs may choose to seek consent due to potential conflicts of interest, the level of disclosure made to the existing LPs prior to their investment in the existing fund, or simply to maintain goodwill with the LPs. For GP financings, consent is not typically required of the LP advisory committee or a percentage of existing LPs unless the financing would trigger a change of control provision the sponsor’s underlying fund agreements.
Conflicts of interest and disclosure
Direct conflicts of interest may occur if the GP is participating in the preferred equity investment. Even if the GP is not participating, the requirement to provide the preferred investors with a preferred return prior to the existing LPs receiving their distributions may reduce or delay a GP’s receipt of its carried interest, which may in turn incentivize a GP to pursue different, potentially riskier strategies in order to obtain higher returns, such as delaying the realization of portfolio investments in order to obtain potentially higher valuations on exit.
Conflicts of interest may also arise where some, but not all, of existing LPs are participating in the preferred equity investment. These LPs, who hold a different class of senior securities, may be required, or may feel it is prudent, to recuse themselves from approving transactions in which the interests of the preferred equity holders and common equity holders are not aligned.
Disclosure of the terms of the preferred equity deal and conflicts of interest involved are critical considerations prior to closing a deal, whether or not consent is required.
As the markets become more subdued and uncertain, we expect to see a continuing increase in the popularity of preferred equity investments as a flexible alternative to other liquidity and financing solutions, as well as an increase in dedicated funds and strategies raised to invest in preferred equity.