Preferred Equity
The current investment landscape presents a nuanced challenge: balancing the immediate liquidity needs of promising portfolios with a potentially constrained funding environment. While investors navigate this dynamic, preferred equity emerges as a compelling solution. This flexible financing tool can bridge potential funding gaps, either by bolstering a fund's overall portfolio or strategically supporting individual high-potential assets.
What is Preferred Equity
Provision of cash by a preferred equity provider who, in return, will hold equity instruments with a preferred return over a portfolio or single asset. These instruments typically have priority over the common equity held by LPs in the proceeds waterfall. Cash funding is typically capped at 50% of the loan loan-to-value (LTV) ratio.
Typical structuring steps
The existing fund transfers a portfolio of assets or a single asset to a newly established vehicle (“Newco”) in return for equity in Newco.
Newco issues preferred equity instruments to preferred equity provider in exchange for cash.
Newco contributes cash to the underlying portfolio/asset to meet working capital needs or make follow-on investments.
Key drivers for GPs
Additional investment capacity and access to cash for underlying portfolio whilst avoiding NAV discounts or capital calls from existing LPs.
Potential carry liquidity or potential to avoid/reduce carry clawback.
In contrast to GP-led secondary transactions or debt financing, GPs may have broader flexibility around LP engagement or the ability to focus on a smaller number of key investors.
Key drivers for LPs
Liquidity at the fund level without selling down the fund position.
Retains future upside of fund performance once preferred return is achieved.
Mitigates further capital commitments to private fund assets in line with internal allocation limits, particularly where LP is experiencing the “denominator effect” due to a fall in the value of liquid assets.
Benefits over credit solutions
More downside control is retained by GP/fund in contrast to bridge debt financing.
No security over assets or LP commitments; lower risk of LP giveback.
No servicing of cash interest.
Limited maintenance and financial covenant.
More flexibility in the waterfall structure.
No fixed term for repayment.
Alternative structures
Combined with GP-Led Secondary with New Continuation Fund
Why? Combining a preferred equity solution with GP-led secondaries can maximise optionality and provide early liquidity for existing LPs. The preferred equity provider may even acquire the entire continuation fund and sell down common equity and/or other secondary buyers or fund a secondary buyer through preferred equity.
Fund-level financing with participating LPs
A preferred equity provider may directly finance an existing fund in return for the preferred instrument. Existing LPs have the optionality to (a) provide additional cash and participate in the preferred equity alongside the preferred equity provider, (b) remain invested in the fund without participating (and agree to rank behind the preferred equity holders) or (c) sell their entire interest in the fund to the preferred equity provider (and/or a separate secondary buyer).
LP-led preferred equity solutions
Beyond GP-led transactions, preferred equity solutions can also provide strategic advantages for individual LPs managing diversified portfolios. In such cases, a preferred equity provider might offer a lump-sum payment or establish a revolving credit facility tailored to the LP's specific needs. This arrangement grants the provider preferential access to future distributions across the LP's designated portfolio, ensuring a prioritised return. This structure empowers LPs to unlock immediate liquidity, effectively address capital calls, or capitalise on new investment opportunities - all while preserving their existing portfolio exposure.
Preferred equity funding
For early-stage investors in rapidly growing ventures, preferred equity offers a strategic tool to navigate subsequent funding rounds without diluting their ownership. By providing the necessary capital to exercise pre-emptive rights, preferred equity financing empowers these investors to maintain their proportionate stake and participate fully in future upside. This approach bridges potential funding gaps and allows investors to strategically manage risk and leverage the favourable economics often associated with preferred equity arrangements.
Other general considerations
Waterfall adjustment and ratchet: The distribution waterfall can incorporate protective mechanisms, such as Loan-to-Value (LTV) and diversification tests, to ensure alignment and manage risk.
Distribution waterfall: The distribution structure prioritises alignment and fairness among stakeholders. Typically, fund management fees and operational expenses are addressed first. Subsequently, distributions may follow either a prioritised approach, where the preferred equity provider receives a preferred return up to a predetermined threshold, or a blended model, where returns are shared proportionally between the preferred equity provider, LPs, and the GP (including carry participants) up to a specified level. Beyond these initial distributions, remaining proceeds are generally allocated to LPs and the GP according to the established common equity arrangement.
Conflicts of interest: While offering strategic advantages, introducing preferred equity necessitates carefully considering potential conflicts of interest. A nuanced balancing act is required to harmonise the GP's fiduciary responsibility to maximise returns for all LPs with the desire to accommodate liquidity needs, both for key investors and the portfolio companies themselves.
Tax considerations: Tax implications warrant careful examination as they can vary significantly depending on the chosen transaction structure.
