Navigating the rapidly evolving preferred equity market

[Music] So thanks for joining us for this podcast to discuss the rapidly developing market for preferred equity investments across both the US and Europe. I'm Peter Banks, a private capital partner based in London and part of our capital solutions group. And joining me are three other esteemed partners in our capital solutions group, being fear abit bull based in the US and New York, who leads our structured equity practice over there. Caron McMaster, partner in our restructuring team based in London and Michael Mountain, private capital partner also based in London. [Music] So why are we here? What are we talking about? Well, we've seen a significant development in the market for preferred equity in Europe and in the US over recent years. So we're going to do a very quick level of what it is, but then quite quickly get into how the markets are developing some of the key points that we're seeing negotiated, where we think the market is currently sitting on those and also what happens when things start to go wrong. So maybe just to start, maybe I start just by a very quick leveler on what are we talking about. I mean, we've seen preference shares in private equity buyouts for years, often just used as the preferred return instrument, whether it be providing a hurdle for a management incentive scheme or an easy way to extract capital, but but more so that then downside protection. Whereas what we're now seeing is that these preferred equity instruments are being used as standalone investors by a specific group of investors who look at a return profile that is slightly lower than your traditional buyout fund, but higher than your traditional credit fund. This is often using the same technology that we've all seen before in Shell's agreements. You get exit rights, you get governance rights, you get waterfalls, but there's a very specific market that is developing around these. And that is something that I think we are seeing a growth of, particularly in Europe and I think has been in the US for a while. Thank you. I think in the US, this market has been going on probably a little bit longer. It is effectively been created by folks giving opportunity to finance a business at a level that is below the debt as you say for a higher return. So we've seen it in both investment grades attached to debt in big buyouts or small buyouts. We've seen it come in as growth equity, which is really providing additional equity into a business to give it additional equity runway before an eventual exit. And we've seen it in the special situations opportunistic credit market where it's really a debt like instrument or it is used to provide an extension or an ability to deliver the business in the current environment. Has this market in the US been around, I mean, certainly been around for longer, I think, as a developed market than in Europe. But how long has it been around? Has it been around forever in the US? Is this a fairly recent phenomenon? I think it's still a fairly opaque market. It's hard to say that there's standardization of terms. Perhaps more in the investment grade side where you see it in big acquisitions with big debt providers on the private credit side. There is more standardized terms, but certainly been around a while. I personally started working on it 10 years ago during the wave of restructuring that happened in the oil and gas industry in 2015. And then these pieces of paper were put in with a preferred return governance, some protections to basically allow these oil companies to survive the low price environment that we had then. And that's how at least I learned to do it. It probably existed before, but it's been developing since and has been applied throughout the variety of industries. Yeah. I think in Europe, it's interesting, probably more recent market with very different reasons. I mean, you've seen in recent years where credit has maybe been a little bit more difficult to obtain companies maxed out on credit on their balance sheet. And so equity is the solution, but common equity prices are depressed. And so at this point, structured equity becomes an obvious option. Right. I think the interesting is when I was seeing in Europe this market develop a bit like I expect the US did. And you're starting to get this bifurcation between more investment grade end of the spectrum, which looks much more like just a minority equity sale with various structures that can be deployed to make it more attractive to investors. And then non investment grade true preferred equity structures and these two markets are definitely generating a lot of traction and a lot of interest from sponsors looking to deploy. Yeah. And I think the in the sense of having a non control, if we use that term outlook, a lot of the investors, thinking historically, who would have been much more comfortable in the credit space started to make this for a into what we might call the hybrid instrument space. So looking further at the structure for a more risky instrument, but with higher return profile. What we've, I think then seen is the compression down from the undulations of the buy out market less availability of good assets over the last few years given various economic uncertainty geopolitical conditions that have meant that you have. I think people looking to deploy capital in more flexible ways. I think people coming out of their traditional LBO investment philosophies and looking to take what historically would have been the preserve of credit funds and looking to get what is effectively an equity instrument with, as you said, a commercially a debt profile. I think the, I guess true form of hybrid instrument is probably the prefer equity instrument that has a fixed return and doesn't participate. So even as opposed to say a convert, you know, convertible debt instrument, which then ultimately has the capacity to then participate in upside on the conversion. I think what we're seeing a lot of is pure fixed return preference instruments that really do look and feel like a debt instrument commercially. But have as you said the bells and whistles that you're used to seeing from a shareholder's perspective. So really occupying that sort of hybrid part of the market commercially debt technically legally equity. I think there's a few pressures going on at the same time. So you've got both these credit funds that with the increasing competition, they've become a new us the number one lender way beyond banks at this point. They have to juice the returns to attract more capital. And so they created pools for these more, let's say exotic higher risk higher term investments and it become more interested in it. The other pressure is that all of these sponsor backed issuers are facing valuation issues. And so when you have facing of lower valuation than where you were potentially a debt maturity wall, you're not necessarily going to look to sell. So the sponsor doesn't want to sell it at lower valuation. It can't necessarily refinance the debt when EBITDA has gone down or there's some other pressure on the business. So this prefer equity is a good way for the sponsor to say, I'm going to give up a piece of my upside to give the company more runway more capital potentially to do an acquisition or some other transformative thing. Yeah, when we're talking about the end of the prefect equity market that is really a capture turn as you were saying Michael looks a lot more like debt. I mean, I suppose the obvious question sort of Karen is why are people not just taking me as debt or secondly in debt in that situation, why are they taking prefect equity? Does it really differ? I think the two main drivers I've seen for that have been one, I don't think we've touched on this already, but the instrument that all the capital is going in to support a deal of bridging and because that's the only way the company can refinance its senior secured debt. And so it has to go in as equity from that purpose, but it's high risk and people who are providing it want to see a path to an exit. So we'll touch on this, but it's got the bells and whistles that people have talked about. The second is where we're seeing full and angel investment grade structures, which really from a ratings perspective and accounting perspective can't incur further debt. And therefore, we're seeing things that are either prefect equity or structured equity and more often not even prefect equity, something without a preferred return, but with some sort of economic incentive to encourage the class B shares, for example, to receive a dividend that mimics a return that you would have been commercially wanting. And that is probably reactive to these quite blue chip companies that just currently are facing pressures on their ability to refinance and keep all the balls in the air. That requirement to maintain a credit rating to protect a credit rating is actually one of the very specific rationales behind issues doing these sorts of instruments that makes it a very specific market because as we know dealing with rating agencies, they'll have very specific requirements and they'll have red lines in order to ensure that this is for rating purposes treated as an equity instrument, not as a desk instrument. I mean, you touch on one of them there, Karen, which is that the rating agencies tend to view as a bit of a no go any sort of a liquidation preference, so there has to be another way in which the investor gets some sort of preferred return that makes this instrument at least a little bit more debt like than just common equity. Yeah, exactly. So we see economic incentives that make the counterfactual, very unattractive to the A, shareholder. So that actually if they don't pay enough of dividends at the right amount of time, they're faced with the dividends going through the roof and never their own return being significantly compromised. So, and that's the sort of thing that I think as advisors, it can be sometimes difficult to negotiate against rating agencies. They're going to say what they're going to say, but the rating agencies also adapt to structures as well. So, I think this market's very fluid because the rating agencies are not going to let structures develop that are effectively cutting across what they're trying to test the robustness of, but at the same time specific structures do tend to work for at least a period of time. We've seen in the US is effectively keeping any cash distribution always at the option of the issuer and no ability to actually put the security to the issuer rather than have a redemption mechanic where additional capital would have to be raised. And that's gotten people comfortable that it sort of passes the smell test with the rating agencies. But you're right, it is fluid. I think it definitely affects the market and what the terms are. And probably it's fair to say that the more pressure you see on balance sheet, the more heightened scrutiny of this, we will see. You mentioned the point and I think something that we've been thinking about in various structures on the European side. On the US side, do you see people look to try and get a put against the sponsor? So the shareholders opposed to the company to circumvent that issue around the being a repayment obligation. And then on the back of that put option, perhaps look for that to be backed by security. Because there's something I think that we've seen people consider as a workaround. Not coming from this background as we alluded to of this credit mindset and trying to get as much protection as possible will come onto our exit rights. But yeah, and it's definitely a question, isn't it, that we're often asked by funds as a sort of a first question, can we possibly take security over this instrument? Actually, maybe just we'll give fear time to think on that question in particular. I mean, Karen, as an opening question, can these sorts of instruments be secured? I think the short answer is no, they can't because they're equity and that's quite different creature from debt. I mean, basically they don't have a right to be repaid at a certain point. And if you don't have the usual remedies you have as a debt holder to either force the issue or into an insolvency because you've got a crystallised debt claim, and if you don't have a crystallised debt claim, you can't really take security. What we do see is put rights and other or call options being granted as Michael's alluded to. And if you can create a crystallised ability to force someone to pay you back, you can secure that. Yeah, I think in the US, it's pretty clear that you can't get a security in any scenario because it'll just be subordinated as equity. I don't think that's valid under the UCC, so the uniform commercial code. I think to your question, Michael, about going after the sponsor, I would say that in general the US is a much more quencoats seller or sponsor-friendly market than perhaps other markets. And so like we almost never see in demonities against funds, I have never seen a remedy directly against the sponsor. Even in a highly distressed situation, people just don't go there. What we do see though is a sort of fairly, and I think it's landed in a fairly settled place now of how this would play out if you get to the end point of the security or the end of life and you haven't been paid yet, which is, and we'll talk about this in more detail, but you'll go to a request for payment, right? Here's what you owe. Assuming that does not happen in a specified period of time where you leave some time for the company to go get capital, you go through a mechanic of forcing a sale or starting a process to force a sale. So this can be as detailed as you're required to hire an investment banker within X amount of time and that investment banker is required to run an auction. And then if the sale doesn't happen, I think that's the part that's less settled, what happens then if you haven't been paid. The problem with put options is two-fold. One is a rating agency problem, slash senior debt problem because I think if you actually have a put option saying you have to buy me out, I think that may be a disqualified security under the many senior secure debt documents in the US. So the put option is not something that we typically see in the states at least. The bigger problem is that even if you do have a put option and they haven't paid you, then presumably they can't pay you, right? So I don't know that the put option does anything other than to create a situation in which you've given out a notice saying you have 60 days to buy me out and then you're in litigation already. I think that's right and I think from my experience it's very rare that you would implement a put option. I think the only time that I've seen it effectively used is where you have not the issuer but the common shareholder who is effectively willing to underwrite the investment of the pre-feiquity investor, inevitably sponsors as common shareholders are very reluctant to do that. So I'm really talking about where you have a shareholder that is a corporate, an individual, a family office, whatever it is. But even then it's very rare to get that inequity underwrite. A put option of course, to Karen's point, that when exercised could create a debt obligation which if someone fails to perform, then you can secure that put option or the breach of payment under a put option but actually it's a very specific set of facts that I think would facilitate that being put in place without impacting any other ratings or accounting equity treatment requirement. And a lot of these things I think it's worth emphasising do tend to be quite bespoke even where there's a world where they're becoming quite commoditised as well. So I think depending on the nature of the investment, a corporate or a family office, etc. might be prepared rather than give you the governance rights and the underlying entity to use whatever other shares they have, whatever other collateral they have to give you access to that in order to, as you say, underwrite the return. Yeah, very bespoke. And then also you get a whole bunch of jurisdiction specific factors to consider as well. Not least you've got questions around equitable coordination in different jurisdictions. You've also got questions around how enforceable is a contractable agreement to what extent can you amend the underlying constitutional documents, potentially even antitrust considerations depending on what you're sort of springing governance rights look like. I mean, there's a general point you completely write very, very bespoke instruments. Yeah, absolutely. And I think the ideal, if you have any governance rights or exit rights is to have some sort of embedded instrument that in itself gives you the right to exercise those rather than having to be looking at the common shareholder to do the things they said they were going to do. Because obviously that introduces both breach risk but also insolvency risk. But that in itself is really can you do that in a local jurisdiction and then how strong is your leverage position to get to there? According to the US, I think it's pretty settled that if you have a right in an agreement amongst shareholders that's not the constitutional documents, so an investor writes agreement or some other thing like that, then that is a contract that's subject to rejection and bankruptcy and I don't think it does very much for you. The best way I think to do this is to be the side that sends the letter that says here is what happened, now comes to me rather than the other way around. And so we think very carefully about designing the constitutional documents so that if there is a trigger, say a breach or an insolvency, especially if you think about it, a breach of the consent right to file bankruptcy, then the right to take over the board or take some other governance thing and we can touch about what it is, but in the US we think about it as taking over the board should be automatically triggered. The way you would do that is you actually would auto increase the size of the board. And I think judges, I mean there's not been a lot of cases on this because it just hasn't happened, but I think theoretically speaking, there's a sense that judges would honor that and then you would actually be inside the chapter 11 as a majority of the board which would give you a seat, they wouldn't otherwise have as an equity pillar. Let's maybe do a bit of a deeper dive into this because the base case for all of these investments is generally that there's a redemption of these instruments, particularly if it's fixed return through distributions over the life of the investment, possibly a sort of a bullet redemption that gets refinanced at some point. That's if everything's going well, but a lot of these investors that we're dealing with their closed-ended funds, they've got a fixed investment horizon, they need some surety of an exit. And so if you don't get these instruments being taken out through distributions in the ordinary course or refinanced, how do those investors secure an exit? And then I suppose step further, what happens when things go wrong and you start to get into that insolvency scenario? I mean, maybe if we start with just exit rights more generally, what are we seeing where the market is landing on, what investors can obtain by way of exit rights, what are the effective exit rights here as a prefect equity holder? Maybe just starting with the US, I think what we're seeing as far as exit rights is both a recognition that if the sponsor or the issue is not willing or has not paid anything out of them. preferred as the time to redeem it as arriving. It's likely one of two things. Either there's some nefarious behavior going on of them trying to prioritize their own payments or there's just not enough money in the system which is the more likely answer. And so I write like I put right or let's be talking about before as just may not be as effective. So what we have landed on is again a sequence where you start with a sale of the company, typically the company would control that right the issue would control that it would have some time to get it done but it should be pretty prescribed how it gets done meaning you want to go into the detail of hiring an investment banker. With sufficient leverage you might even say that the investment banker needs to be acceptable to you and then you would presumably think that there's some third party price in which that deal can get done. Now if that doesn't result in a deal or in a deal that pays for the preff which would be you should specify that that's the minimum price in which it could get done without your consent. But if that doesn't result in a deal then one of two things can happen. One is you either think you can run the company better and that's probably the most heavily negotiated provision about we were talking about before and again and it's actually so important we'll probably talk about it again but it's a springing government right to take over the board or this is the ideal set of remedies but this is heavily negotiated and bespoke and I admit doesn't happen in every deal but we do get it in the majority of deals is the right to drag into a sale. So that means you go find your own deal and for a lot of these funds especially the highly sophisticated ones with many different pockets of capital this might be selling it to yourself right and so that's something that is sure is very concerned about that there'll be some deal that that preferred plus one dollar for you to move this into a maybe a longer view source of capital pay out your LPs their return and then you'd be able to play with round with it in some different bucket and maybe you're able to find you know an actual deal when you think the company is dragging its feet so it's actually a very powerful remedy to make sure that in the period for selling the company they're actually doing what they're supposed to be doing. You can't force a CEO whose whole return is built on the common to go pursue a bad deal to attend the management presentation right if he doesn't want to go he's not going to go and so that's the type of incentive you need to be thinking about in a downside scenario. Yeah and I think with drags I mean the way that I always see them talked about is that this is a sort of an Armageddon situation if you're fixed return pref holder can drag the common that's an Armageddon scenario no one wants to happen and so what it's basically doing is it's creating to Karen's point a structure that is a huge economic incentive on the common equity order to refinance the pref before you get there and as a result we only see those sorts of drag rights kicking right at the back end way beyond the expected repayment date for these sorts of pref instruments. And for that reason it's a backstop effectively I think because of the mindset that you've got a lot of these investors are coming into these instruments with it is an important backstop to have in there because it's effectively their path to liquidity ultimately because if they're coming in thinking about repayment profilties that phrase we don't like that phrase because I think the issues around redemption we know that the redistribute for reserves issues you can't technically be obliged to be repaid but having that drag as a backstop I think if you don't have that in there and you're simply prodding away with rights request or sell process rights to implement an IPO all of which can end up having practical difficulties then you're not frankly in a great place so I think the one salient point I think on exit rights is that you always want to ultimately have at some point that drag right kick in and we'd always funnily enough there is a bit of a contrast with the US I think here because we'd always look to put that drag in a shell does agreement back with the power of attorney almost as the kind of the priority item on the list with then articles supporting that and creating another framework for transactions being void if they're not complied with but I think we'd see that shell does agreement drag as a really crucial part of the protection that we'd look to get I've seen sponsors definitely oppose it from the perspective of and this is what I tell clients to because you need to be realistic about your remedies right so if you have a drag in the US and you think you're going to find a better third party buyer than an auction then I think that's highly unlikely both for the litigation risk right the reputation risk you're gonna get some low price and so I think sponsors just I'm just a fibrill say you want this drag in there to be able to sell it to yourself or to some affiliate or in some an incredible discount over my common equity value and that's fine there may be buyers out there who are willing to take that risk but these buyers aren't paying top dollar and if they're smart they would say I would pay you half of what your preferred is yeah right and so you have to always think about I think there's the contractual remedy and what it says but I think in practice I personally I've not seen too many drag along deals actually get done I've seen people threaten to use them but they just don't tend to get done people negotiate some other outcome that's why I think in the US where we've landed on the the better remedy or the better hammer is this board takeover yeah but that has its own issues it brings into play issues like at that point you are effectively taking control of the business you have a range of investors looking at these products who are not natural control shareholders they're not natural common equity holders leave aside the issues that you can have around antitrust and regulatory filings you've obviously got to ensure that any senior the change of control isn't triggered and that is often looked at as part of putting these transactions in place where you have springing governance rights though it's not as you say as simple yeah you're right I think the regulatory piece is very important but it's probably not a huge concern for some of these funds from an actual technical antitrust risk although the regime in the US is evolving so you don't know where you're going to be but I do think it's a sufficient hammer to say to a sponsor that has a duty to its own LPs to manage its investment that you're going to take it away from them to negotiate some reasonable agreement with you look a lot of these investors in these piece of paper are not in the business of taking on director duties period they don't want to do that and rightfully so as in somewhat opportunistic investors but you definitely want to have that hammer around to say to a sponsor real if you don't start seriously think about refinancing me out of this this is going to be a very bad look in front of your LPs in particular and so the private credit funds or these minority type investors want to take over the boards potentially higher new management potentially like start a new incentive plan all the things you would do as a control investor probably not but it is I think viewed as the most effective hammer and particularly when you're coming into real bankruptcy maybe we should hit that and I think that's a good final topic actually which is that obviously base case repayment through distributions or refinancing in the ordinary course things start to go wrong in the sense that you're not repaid when you should be and that's when you start looking at this exit ride springing governance rights we talked about why happens when it gets really messy when a business goes into insolvency proceedings or close to and we've seen a couple of examples that have either gotten close or have actually gotten into insolvency proceedings in that circumstance as a holder of a preferred equity instrument where do you stand are you any better really than a common shareholder in that scenario well I think in certain circumstances you won't be you're obviously a very subordinated instrument in the capital structure and you'll be paid with parry with the common equity or ahead of the common equity if you're a preferred and obviously there's not enough value there there's not enough value there I think though obviously in the restructuring market valuation is key and one thing if you're a subordinated creditor you're always concerned about is to make sure the whatever process has been used as maximising value I think we do get questions we've sort of touched on this previously in in dealings we have preferred equity saying can I credit bid my preferred equity as their ways to embed that into the structure so that I've got some comfort that I can actually use that as an instrument to buy the group myself and I think it's interesting because if you're a subordinated creditor if you're a second lean creditor in Europe you'll be stood still generally through an into creditor from taking any enforcement action if this in you secured won't allow you to do that certainly for a period of time and you will mainly be concerned about some sort of risk some sort of deal senior secured led that you know is a low ball deal that just covers themselves credit bid or you'll be concerned about in particular a deal between the sponsor and the senior secured that cuts you out and just with the business is valued at a low valuation and in some respects actually from a preferred perspective if you've got this techniques you're just talking about where you can take control of the process that is a better situation to be in where you've cut the sponsor out from a control perspective and now you're in control both in order to make sure the process is robust from a valuation perspective and also to maximize the amount of information you have information being key in a restructuring so I can see a world where actually a stood still secondly in creditor who's been cut out of the discussions and is susceptible to a deal between the senior secured and the sponsor is actually in a worse position than a preferred shareholder who has more information, potentially more governance rights. Yeah, I tend to agree. This is where you want to be really careful in the US. So, first thing you would do is you'd analyze, and there hasn't been too much case law, by the way, in the US, that has thought about it in the context of a preferred. But you'd have to analyze whether the preferred is a claim in bankruptcy, or is it a right? And so, if it's a claim, it's subject to the stay, and if it's subject to the stay, you can't take any of the remedies we've talked about. If it's a right, then theoretically speaking, and this is, I think, tested at least once, but not much more than that I'm aware of, then the remedies will work effectively, and that's where you want to be really careful about where your rights are sitting. So, for example, a contractual right to take over the board and share all the rights agreement, I don't think goes far enough to not be a claim. So, that's a contractual claim that contract can be rejected in bankruptcy, and then you're sort of out. If it's in the constitutional documents, a certificate in corporation, LLC agreement, so on, then presumably you're in a pretty strong spot for that to just trigger at the right point. And then, I agree with you that if you do have a seat at the table at the board, then at the price of taking fiduciary duties, which you may not want to do, but maybe you can appoint a third party who's willing to do it, that's going to represent your interest, there's lots of ways to do that. You would have a seat at the table, and a seat at the table helps you be a part of a deal, even if you technically are not the full-crime security. So, to keep you happy, there may be some value to be extracted that way. I think that the thing to think about when it comes to at least the US bankruptcy, and this is important, is that you can't have any sort of ability to credit bid or have any security interest or anything fun like that because you'll just be equity-supportinated. You can't have both equity, and you might even have tax consequences if I try to do that. So, as we round out the podcast and considering all the things we've talked about, any final thoughts from you all? Yeah, I think, for me, the most important point is to think carefully about some of these remedies and how they're going to play out. Have your covenants, have your remedies, always keep in mind that despite maybe having done a lot of debt, this isn't debt, and use that interplay to really understand where you're going to be in each point in the deal. So, regular upside scenario, downside scenario, how are you going to react, and how are you going to be the side that's not sending the angry letters? And I think to that point, particularly as this is a developing market really, and there's a lot of things that we'll take from, as we look back on the discussion we've had, you know, there are a few themes coming out of the downside protections and certain key elements of the instruments that, from our perspective, you really want to be thinking about upfront. I think what becomes really important then is that initial high level commercial term sheet that is on every deal, but perhaps in markets which have been really developed, there is a certain level of understanding and market practice and a slightly more level of vanilla terms to certain features of the deal. And I think these deals we're seeing, they are quite bespoke and the circumstances and sponsors and versus founders, elements vary, and really being on top of these key legal terms upfront in the commercial term sheet stage, I think is more important than ever. I just second those points really, I think it is important to consider the underlying jurisdiction of the company throughout, especially European entities and how I'd insolvency or restructuring process might play out, and that may well dictate how you think about governance rights and when they kick in. And I think we're probably starting to get a bit of a sense as to what we think is possible to be implemented legally in different jurisdictions, so this golden share rights, put rights, you know, how will different jurisdictions think about that, what are the tax issues likely to be, and that will end up driving the bus to some extent as well. So I think we also probably have a good sense by now as to what you can if you can't get the gold standard in terms of control rights, where do we think the market's landing and what you can push for legitimately. That's great. I think the market is opaque and I think different sides of the market are trying to push it to land in a convenient spot. I do think some discipline is going to be helpful for the people who want to be in the security being this position, get the higher return, but keeping in mind that there may be a downside case at some point, and despite the market being opaque, there's some fundamental principles that you should want to insist on. And that's great. Well, thanks all for joining. I think that's all we've got time for, and thanks everyone for listening. Keep an eye out for the next one. Thank you. Thanks Peter. [BLANK_AUDIO] [BLANK_AUDIO] [BLANK_AUDIO]