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Article by Matthieu De Donder, Partner at Molitor, and David Micheli, Assistant Vice-President at Oaktree Capital Management, as published in Insight/Out magazine #36.
In a market defined by geopolitical uncertainty, elevated interest rates, and a search for performing assets and attractive returns, Private Capital sponsors are seeking ever more creative and flexible ways to deploy monies. Against this backdrop, preferred equity instruments have surged in popularity in recent years, evolving from a niche financing tool into a recognized asset class and a recurring feature in the investment strategies of certain private capital funds.
Sitting at the crossroads of traditional debt and common equity, preferred equity offers a means of balancing the diverse commercial objectives and risk-return expectations of both issuers and investors.
Before exploring further its applications and underlying reasons of success, it is useful to first clarify what is meant by preferred equity.
1. The Concept of Preferred Equity
Unlike common or ordinary shares, which typically grant equal rights to dividends, voting, and capital returns, preferred equity, as the name implies, confers certain economic and political preferential rights upon its holders.
The forms and terms of a preferred equity instrument are typically highly tailored and adaptable to the specific objectives of a transaction, the risk-return profiles of the investors and issuers and their respective exit strategies. Luxembourg, in particular, is one of the jurisdictions of choice for the issuance of such instruments, owing to its robust legal and corporate framework. Its toolkit encompasses a wide range of corporate forms and types of instruments including, for example, preference shares, warrants stapled to debt instruments, beneficiary units (parts bénéficiaires), PECs or CPECs, etc.
This versatility has attracted a broad spectrum of investors, including traditional Private Equity firms, Private Credit funds, Secondary funds, and other alternative lenders. As we will see below, these investors are drawn to an instrument that can offer higher returns than traditional debt while incorporating downside risk protection.
A. Economic Rights
Preferred equity holders typically benefit from a fixed return profile (e.g. a non-compounding or compounding interest priority return), payable in cash or, more commonly, satisfied, by way of a payment-in-kind. Typically, in the context of a buy-out, these returns accrue and are paid upon a liquidity event (e.g. sale, refinancing, IPO), sitting above common equity in the distribution waterfall but below debt.
It is particularly this priority in payment that makes the instruments so appealing, as it still holds a higher return than traditional debt whilst having priority over regular equity. Though it is structurally subordinated to debt, some additional contractual features (like conditional mandatory redemption rights via put options or even drag-along or tag-along provisions in an exit scenario), may still provide investors with enough exit flexibility.
Preferred holders’ upside participation can differ and its structure significantly depends on the nature of the investment and negotiation context: it can be for instance reflected by way of a simple yield on the invested amounts, capped returns or equity-like participation whereby, once a predetermined hurdle rate is achieved, the preferred holders participate in additional profits similarly to common equity investors. Certain instruments are even structured (with convertible features or paired with warrants) to provide the investors with an upside aligned with the common equity holders in case of value creation exceeding the fixed return.
It is crucial however to remember that, even when structured with debt-like features, preferred equity carries a structural compromise as it remains, in principle, an equity instrument from a corporate law perspective. This distinction has significant consequences: payments to preferred equity holders, such as dividends and redemptions, may be subject to distribution rules applicable to shares, including for the requirement that issuers have sufficient distributable reserves, limiting the timing and/or amount of pay-outs to such holders.
B. Governance and Related Rights
Investors’ rights often extend beyond economics to include extensive information rights (e.g. with respect to periodic financial reporting) and a set of positive and negative covenants similar to those found in debt agreements.
While preferred equity typically lacks full voting rights, it often comes with safeguard provisions. This can for example include protective or veto rights over certain key matters (e.g. M&A transactions, new financing rounds, changes to business plans, or issuance of senior securities), allowing investors to nonetheless have some degree of control over material events affecting the company.
In some cases, preferred investors may be granted board observer rights or even board seats, particularly where the instrument is a meaningful part of the capital structure or in distressed situations. Otherwise, what is also a possibility is to provide for information rights, including regular financial reporting, budget approvals, and updates on specific metrics.
These rights ensure transparency and allow investors to keep an eye on the performance of the investment and even, if necessary, enforce protective covenants. Such covenants are usually light in nature and are typically tailored to downside protection rather than control. These can include minimum liquidity thresholds, limitations on leverage, or restrictions on dividend payments and asset disposals. These covenants fall short of traditional bank loan covenants but are designed to align stakeholders and can technically still avoid value leakage.
Depending on the transaction dynamics, the leverage of the investors, and the amount injected as preferred equity, investors may even push to include stronger downside protection in the documentation in the form of step-in governance rights, effective upon the occurrence of certain material events (e.g. financial underperformance, breach of the above-mentioned covenants, failure to exit by a certain deadline, etc.). Such rights, often structured to allow investors to ultimately nominate the majority of the directors and take control of the board of the issuer, give investors the possibility to steer the business strategy or, the case being, force a sale process.
2. The Multiple Applications of Preferred Equity
The appeal of preferred equity also lies in its versality and adaptability across a diverse range of transactions and structures. Below is a short overview of its most common uses.
A. As an alternative to Traditional Debt
Private credit funds and other alternative lenders increasingly offer debt-like preferred equity as a flexible financing solution, positioned between junior debt and common equity. Aside from the reasons mentioned above, the growing prevalence of preferred equity instruments as a debt alternative can be attributed to several further considerations:
* Return repayment: Unlike mezzanine debt or subordinated loans for example, a key benefit for issuers is the preferred return (PIK or paid only at maturity) because it avoids the contractual cash interest burden of debt, as returns are typically deferred dividends, PIK and cumulative, and will thus preserve monies within the portfolio company, resulting in a significant advantage over other financing forms.
* Regulatory and Ratings Treatment: The instrument may receive full or partial equity treatment from rating agencies or regulators, which can be beneficial for the company’s balance sheet and efforts to raise senior debt where debt capacity is constrained, or cost of debt is too high. The fact that many accounting frameworks (e.g., IFRS or local GAAP, as applicable) do not classify it as debt has a significant impact on leverage ratios and covenant compliance. This makes it a useful tool for sponsors and corporate issuers alike when optimising capital structures, as it will also come into play when doing capital adequacy calculations (particularly where more risk-heavy assets are involved) or in situations where senior debt is already maxed out.
* Other debt-like features: These instruments often include a fixed maturity date, with corresponding call protection to discourage early redemption or make-whole premiums that compensate the holders in case of early repayment. They may also provide for coupon step-ups – increasing the return the longer the capital remains outstanding – to incentivise refinancing.
A crucial point to remember is that preferred equity is structurally subordinated to all of the issuer’s debt. A classic trap for the unwary investor is to accept debt covenants that mirror those in a senior credit facility: it is therefore imperative to negotiate strong anti-layering provisions that prohibit the issuance of new and priming layers of debt or equity.
B. In Venture Capital and Growth Equity
In financing rounds for startups and high-growth companies, preferred equity has long been a staple when a company is raising funds with venture capital firms (e.g. Series A, B, etc.). It can offer downside protection through liquidation preferences in case of a modest exit or outright company failure, with the investors being paid back their invested capital (and return) before founders, employees and other common shareholders.
Depending on how the preferred equity is structured, it is common to see VC funds holding “convertible” preferred equity. These instruments allow investors to convert their preferred equity into common shares in case of value creation, i.e. the company achieves significant growth or a successful exit, allowing them to take part in the company’s profits and growth alongside ordinary shareholders, especially upon a liquidity event like an IPO or sale, and hence capture the upside. Alternatively, some structures -known as “participating” preferred equity -are even more investor-friendly. In such a case, investors not only receive their preferred return and capital back first but also participate alongside ordinary shareholders in any residual upside, effectively combining the benefits of both debt-like protection and equity-like upside.
An additional key feature which can be seen in venture capital and growth equity particularly, is a “ratchet” provision in the convertible preferred equity documentation that allows to adjust the conversion ratio if new shares are issued at a lower price – a so-called down round. In other terms, it prevents the investor’s effective conversion share price (the price they actually paid or will pay per conversion share) from becoming unfairly high compared to new investors buying in at a cheaper price per share during a down round. In startups and scale-ups, valuations can easily fluctuate so that different funding rounds may have diverging valuations. Anti-dilution clauses adjust the conversion rates of the convertible preferred equity into common shares so that the investor’s ownership is partly preserved notwithstanding any fluctuations.
C. In Buy-Out Transactions
In leveraged buy-out structures, Private Equity sponsors commonly use preferred shares in their capital structure for several strategic purposes.
For the same reasons outlined above, Private Equity sponsors may use it as an alternative to debt or other form of loan notes, because the issuance of such instruments will not strain any credit metrics and leave the company at acceptable debt levels, allowing to circumvent further leverage.
In a typical buy-out structure, the preferred instrument holder’s exit is generally aligned with that of the Private Equity sponsors and the underlying investment. The preferred instrument would in such cases carry a fixed, cumulative dividend that is usually rolled up and paid on redemption (i.e. on the date of the exit), similar to a payment-in-kind (PIK) note.
It further provides a flexible means of raising capital without diluting the ownership and control of the sponsors: as noted above, preferred equity holders in such settings typically receive limited voting rights, nor do they participate in day-to-day decisions of the business. This dynamic is particularly evident in minority recapitalisations or non-core carve-outs, where sponsors or existing shareholders seek to monetise part of their investment while retaining control over the core business. Although a portion of the equity or a division may be sold, the remaining stakeholders often aim to secure additional funding in a manner that preserves governance simplicity and limits external influence over strategic decisions.
D. In Special Situations
The adaptability that preferred equity can provide is especially effective in distressed or turnaround situations (including refinancings, restructurings, recapitalisations, etc.), where preserving enterprise value and stability for management and senior creditors is essential.
Concerned companies can usually not afford any additional impact on their leverage ratios, this is where preferred equity would provide an affordable opportunity which gives investors a certain degree of priority on return, and which will offer them potential for capital appreciation should the investment be successful (via conversion or direct participation).
In distressed circumstances, the cash flow is inherently weak, making it virtually impossible to take further debt burden and the associated interest payments. Depending on how the preferred instruments is set up, no strict amortisation is required, and the dividends or fixed payment can be set-up in a way to align with the company’s available cash.
Conclusion
Preferred equity stands out as a highly flexible and adaptable tool in the private capital landscape. Its bespoke features enable investors and issuers to strike the right balance between risk and reward, making it valuable across a wide range of transactions. With deal activity on the rise and a significant wave of debt nearing refinancing, we anticipate that preferred equity will feature even more prominently in capital structures going forward.
