Preferred equity has become an attractive alternative M&A financing instrument to European sponsors in the midst of the Covid-19 pandemic disruption of the market. It has helped keeping leverage at acceptable levels for creditors and has avoided some difficulties in equity pricing, sources told Reorg.
Preferred equity structures require a fixed return at a set date, somehow comparable to a maturity. On the other hand, the instrument is a class of equity, with the respective shareholders waiving voting rights that would usually attach to common equity. Sponsors would provide an equity investment for a transaction without acquiring voting rights in exchange, which would usually be the case with plain equity investments.
The structure, mainly used by private equity firms seeking to acquire strong businesses with an added boost of external capital, also has advantages for lenders and borrowers. Private equity firms would add additional capital to an acquisition target, but they would not increase the debt levels of the target company.
This supports private equity investments without alarming credit rating agencies or regulators as it is considered an equity injection rather than additional debt.
In some cases, lenders would advise certain borrowers to seek preferred equity to de-lever by one or a half turn and return to more sensible leverage levels, market players said. That way the lenders would reduce their risk levels in times of crises.
There was increased demand for preferred equity earlier in the year when covid-19-related lockdowns put pressure on companies’ access to liquidity and when private equity sponsors weren’t always in a position to provide capital to portfolio companies, sources told Reorg at the time.Equity Pricing
Private equity firms can also use the instrument in an acquisition to curb their own equity investments. “Preferred equity can help facilitate a sponsor putting less equity into a transaction,” Peter Glaser, head of European direct lending at Alcentra said.
With uncertain market conditions affecting the existing portfolio as well as new business, pricing equity in an M&A deal has been challenging for sponsors in 2020.
“Pricing ordinary equity in a volatile market environment like we are facing now can be expensive as the range of possible outcomes is very wide. Sellers naturally gravitate to the top of this range and buyers to the bottom,” Floris Hovingh, head of alternative capital solutions at Deloitte, said.
As preferred equity typically generates yields in the range of 14% to 16%, taking on higher risks in a financing structure, it would be provided by larger debt funds rather than bank lenders, market participants said. Fund managers, such as HPS, Blackstone’s private credit arm GSO, Carlyle, PSP or MV Credit are known to provide those instruments. Specialist fund 17Capital also offers the product and spoke to Reorg in a webinar
series in April.
The instrument can be deployed in a variety of financing structures and deal sizes, but it is often seen in large cap transactions which involve syndicated loan financing.
“Historically preferred equity instruments have been seen in deals which perhaps require a larger amount of external capital with the benefit that the pref equity amount can avoid being treated as debt for leverage, accounting and rating agency purposes,“ Faisal Ramzan, partner at Proskauer Rose said.
One example for a deal with a preferred equity part in the structure would be the public-to-private transaction of Merlin Entertainments in 2019, according to market players. Merlin’s buyout by private equity firm Blackstone was backed by a debt financing of over $3 billion.
-- Kerstin Kubanek