Private Equity – Preferred Shares: A variety of uses and terms

Overview

Although preferred shares are used across a number of private equity and other investment transaction structures, the terms of preferred shares can be materially different dependent on the relevant transaction objectives, the jurisdiction of the transaction, and the deal issues which are being addressed. Preferred shares can be contrasted with ordinary or common shares, which generally participate equally amongst themselves for dividends, voting, returns of capital and on a winding up, although they can have different classes and priorities amongst themselves. Preferred shares provide for rights of priority as regards capital and/or income, redemption,  conversion rights, and because of their preferred nature, other bespoke investor protection rights, including e.g. governance and information rights. Since preferred shares can come with no voting rights, they are also used as a popular instrument where investors or employees remain passive investors enjoying their economic participation rights but the management of the investment vehicle and its decisions vests in a different person(s). Given the flexible nature of a preferred share, preferred shares can also be an option when investing into a foreign ownership restricted industry (depending on the exact nature of the restriction in that jurisdiction).

Although preferred shares can be highly bespoke, their functions and terms are dependent to a large extent on the type of transaction in which they are used.

Buy-out transactions

Function of preferred shares

Preferred shares are commonly used in the capital structure of private equity buy-out vehicles. The fixed return profile of the preferred shares, which are senior to the ordinary shares, provide downside protection for the PE sponsor and set a return hurdle ahead of any management upside participation through their management ordinary shares.

Preferred shares have become a more frequently used alternative to loan notes in UK buy-out structures since the introduction of limits on the tax deductibility of interest payments on loans. Using preferred shares will also  increase the statutory share capital of the relevant company when compared with the use of loan notes.

Preferred shares can also be used to provide further “equity” financing, such as for bolt-ons or capex, without further dilution to management’s ordinary equity.

Terms of preferred shares

Preferred shares used in buy-out structures usually have a fixed redemption date within approximately 5-7 years of issue (aligned with the exit horizon of the investment), are redeemable on an earlier exit or on certain events of default occurring, and accrue a fixed cumulative dividend on their issue price, which rolls up and is usually not paid until the final redemption date of the shares similar to a payment-in-kind (PIK) note.  The preferred shares do not share in the profits of the company over and above their fixed return and have no voting rights.  On a redemption, return of capital or winding up, the subscription price and arrears on the preferred shares must be repaid before ordinary and other junior shares participate in the assets of the company after payment of its liabilities, and on an exit the same waterfall is typically applied.  In the US, it is less common for preferred shares used in buy-out transactions to have a fixed redemption date (given that the PE sponsor ultimately controls the timing for an exit), and often times preferred shares will also incorporate the economics of common equity in a single security.

If other shareholders hold preferred shares alongside the PE sponsor, it would be prudent to ensure that, if the PE sponsor agrees to partially write-off the preferred shares in preparation of an exit, the other shareholders participating on a pari passu basis can be required to do the same.  In other words, preferred shares held by other shareholders and the amounts accrued thereon should not be a barrier to exit, in case the value of the issuer on exit does not exceed the accrued value of the preferred shares.  This principle should be mirrored in the drag-along rights, such that minority sellers can be required to sell their preferred shares below par value, provided that they are not treated disproportionately when compared to the sponsor.  In certain situations, it is becoming more common for preferred shares held by the PE sponsor to rank senior to preferred shares held by minority rollover investors (with such investors receiving a catch-up that results in pari passu treatment once the PE sponsor has received its preferred return).

Venture capital, high growth equity investments (growth equity) and other minority investments

Function of preferred shares

As part of funding rounds of venture and other high growth companies, preferred shares are typically used to grant favourable rights to the investors participating in the latest equity financing round, ahead of, or ranking pari passu with, earlier series of preferred shares that were issued as part of the previous funding rounds, and ahead of existing investors holding ordinary shares.  Each class of preferred shares is typically identified by reference to the relevant financing round, e.g. Series A Preferred, Series B Preferred, etc.

For other minority equity investments, they can be used to achieve various commercial objectives, or solve commercial issues like differences in valuation, protection against downside risks, a clear route to liquidity, certain governance issues (including through enhanced or reduced voting rights to give preferred investors less or more control), for the purposes of meeting specific funding needs, such as projects or M&A, to provide a guaranteed income stream for investors or to bolster a company’s equity balance sheet, e.g. for regulatory capital, credit ratings or to address financial difficulties.

Terms of preferred shares

Through their preferred shares, new investors in minority investments are often provided with a liquidation preference ranking ahead of certain investors, founders or other major shareholders, such that on a liquidation, winding up of, or an exit event involving the issuer, the new investors will be paid back their invested capital (with or without a premium) by way of priority.  Aside from those preferential rights, preferred shares used in minority investments are more equity-like than debt-like in nature, such that they share in the profits of the company alongside the ordinary shares.  This equity-like nature of preferred shares is often reflected in the availability of a conversion feature pursuant to which the preferred shares convert into ordinary shares on the occurrence of liquidity events such as an IPO or sale or, alternatively, at the election of the holder thereof. Conversion typically happens in a one preferred share for one ordinary share ratio, subject to certain mechanical adjustments for corporate actions, although the share conversion ratio can also be subject to adjustment in case of valuation issues.  Preferred shares issued as part of a minority equity investment typically have anti-dilution protection such that the new investors are compensated for in future funding rounds at a lower valuation than that based on which they invested (a so-called downround) based on a pre-agreed ratchet calculation.  Anti-dilution can be implemented through the issue of bonus shares to the new investors, or by way of an adjustment to the ratio in which their preferred shares convert into ordinary shares.

Minority investments through preferred shares may also have certain debt-like features, for example where the preferred shares have a fixed cumulative dividend as well as a profit participation after accrual of the fixed dividend.  They may have a redemption feature at the election of the investor after an agreed exit horizon or on the occurrence of specified events.  For investors, it will be important to agree call protection so that their preferred shares cannot be redeemed without their consent, in order to preserve any equity upside above their fixed return rights.  In addition, investors often seek to negotiate governance rights akin to a mix of equity reserved matters and debt covenants, which may blur the lines between a minority equity investment and fixed return preferred shares financing (often provided by alternative lenders, see further below).

The extent of the rights of investors typically depends on the number of investors already in the capital structure, the size of their shareholding, any immediate cash requirements of the issuer and the availability of other funding sources.  There are also circumstances where strategic investors who are expected to have a positive effect on the growth of the business going forward receive preferential governance rights, compared with what would have been expected based on their investment amount or percentage stake. The investment documentation for venture, high growth investment deals is typically based on the models of the British Venture Capital Association (BVCA) or the U.S. based National Venture Capital Association (NVCA) or the Singapore Venture Capital Investment Model Agreements and have a degree of standardisation and market practice.  Larger minority transactions are typically more bespoke.

Preferred shares financing as an alternative to debt finance

Function of preferred shares

Where companies, both sponsor and founder-owned, require financial resources in addition to senior or mezzanine financing, preferred shares can be a flexible solution.  Third-party preferred shares financing can be contrasted with mezzanine or junior debt on the one hand, and common shares on the other hand.  The most common providers of such forms of preferred shares financing are alternative lenders.

Terms of preferred shares

Contrary to loan financing, the terms of preferred shares financing can be more bespoke and will depend on the circumstances of the issuer and the risk profile of the funding.  The proceeds can, amongst other applications, be used to fund a dividend to existing shareholders, to finance bolt-ons or capex or to bolster cash resources and pay off existing debt.

The basic terms of third-party preferred shares financing include a fixed cumulative dividend on the issue price of the shares and a fixed maturity date and events of default upon which the shares must be redeemed. The benefit of preferred shares financing for issuers is that the dividend typically is PIK such that the issuer does not have to service the coupon accruing on the shares in whole or in part in cash, which may not be the case for other forms of financing.

Another advantage of preferred shares financing is that the shares may receive equity treatment from regulators or rating agencies in full or in part, which is beneficial from a regulatory capital perspective or for other fundraising efforts of the issuer (such as in relation to senior financing or bonds).  From an accounting perspective however, the fixed-term redemption feature may result in the shares being treated as debt. The preferred shares usually have call protection, such that they cannot be redeemed prior to the maturity date at the election of the issuer without the consent of the financing provider. Where redemptions prior to maturity are permitted or required, there is often a make-whole redemption premium which needs to be paid by the issuer.  On the other hand, if the instrument is not redeemed within a pre-agreed number of years, the coupon on the preferred shares often increases on a yearly basis to incentivise refinancing.  There can also be a feature which triggers the requirement to satisfy accrued dividends in whole or in part in cash. These tools are meant to put pressure on the company to redeem the preferred shares as soon as possible.  These features may also trigger in case of material breaches of documentation governing the preferred shares. It is also a popular alternative to debt funding because in certain jurisdictions and subject to certain conditions, preferred shares could enjoy a different tax treatment on returns of capital (capital gains) compared to a return on debt (income tax) or the withholding tax on dividends could differ from the withholding tax on interest.

The preferred shares typically have no equity participation rights, conversion rights or voting rights, as you would see in minority equity transactions.  Although the preferred shares themselves have no equity participation rights, they can be accompanied by equity sweeteners in the form of ordinary shares or warrants.  Any such accompanying equity instruments will likely complicate the financing transaction, as the financing provider will have dual capacities as holder of preferred shares and the holder of ordinary shares or warrants.  In that case, further thought will need to be given to the impact of future dilution on the ordinary equity held by the financing provider, exit terms, governance and the relationships between the ordinary shareholders going forward.

The more bespoke elements of the preferred shares concern the positive and negative covenants or reserved matters for the benefit of the financing provider, as well as remedies for non-compliance and default.  The extent of the agreed covenants, including information rights, will depend on the respective negotiation positions of the issuer and the financing provider, but are often more extensive than attach to preferred shares in minority equity investments.

The parties will need to strike a balance between the rights that lenders would typically receive when compared to those of minority shareholders.

Preferred equity in Secondary transactions

Function of preferred shares

In secondary transactions, preferred equity can be used as a liquidity solution, as an alternative to other transactions such as the sale of fund interests by individual underlying investors, full or partial sell-downs at the initiative of the sponsor to another vehicle controlled by the same sponsor (GP-leds) and NAV financings. Proceeds can be used to provide liquidity to underlying investors, or for the purposes of financing bolt-ons, capex or other funding needs of the assets.   

Terms of preferred shares

The preferred equity provider will typically acquire preferred shares in a new SPV holding vehicle below the sponsor fund, which can give the provider exposure to one or more assets of the sponsor fund.  The provider will be entitled to receive a share of returns of the relevant assets until the principal plus coupon has been repaid, subject to any further equity participation rights. 

Contrary to preferred shares as alternative form of financing at company level which is often provided by alternative lenders such as debt funds, preferred equity as part of a secondary transaction is also provided by secondary funds and specialist fund finance providers.  However, the terms, covenants and points of contention of the instrument itself can be quite similar as between asset level financing and secondary financing.

Limitations of preferred shares

Investors in preferred shares need to be conscious of the fact that, whilst the terms can be debt-like, from a corporate law perspective they are still part of the share capital and subject to capital maintenance rules in the relevant jurisdiction.  This means that generally dividends, redemption payments and other returns of capital will require distributable reserves or other corporate capacity of the issuer in order to be paid, in addition to having sufficient cash resources. Depending on the jurisdiction of incorporation of the issuer, payments on preferred shares may, in addition to distributable reserves, require solvency tests as well as minimum net asset requirements.  These maintenance of capital factors significantly complicate enforcement of claims in respect of preferred shares, when compared to credit instruments, but potentially also refinancing.  Some jurisdictions are more stringent than others when it comes to capital maintenance, so it is worthwhile considering the jurisdiction of the issuer, if there is flexibility, subject to tax requirements.

By their nature preferred shares are unsecured and subordinated to all debts of the issuer.  Generally, preferred shares are also structurally subordinated, with any debt financing sitting at a level below the issuer in the group structure. Finally, payments out of capital by a company can require shareholder and/or court approval, so it is prudent to obtain contractual commitments from other shareholders of the issuer to cooperate with any payments on the preferred shares.

Tax considerations of preferred shares

When rules were introduced introducing limitations on the deductibility of interest payments, the attractiveness of loan notes in private equity transactions reduced.  Since UK withholding tax applies on the payment of interest, loan notes create (i) tax leakage on payments of interest to investors who are not eligible for treaty relief or (ii) additional costs and regulatory burden if the loan notes are listed to mitigate withholding tax.  If the company is not able to deduct all its interest costs from its corporation tax liability, these additional costs might outweigh the benefits.

This has increased the use of preferred shares in private equity transactions since no UK withholding tax applies on the payment of dividends to the holders of the preferred shares. A disadvantage of preferred shares is that stamp duty will apply on the transfer of the preferred shares on a future exit (although this is generally paid by the buyer).

Given the debt-like features of the preferred shares, consideration should be given to how dividends will be taxed in the hands of the investors in their jurisdiction of residence (i.e. as equity or debt) and whether any mismatches under any applicable anti-hybrid mismatches might arise.  For UK shareholders, preference shares that are redeemable and non-participating or fixed rate might be taxed as loan relationships if there is a tax avoidance motive.

The tax considerations describe above assume that the issuing company is a UK company.  If preferred shares were issued by a non-UK company, dividend withholding tax might arise on the payment of the dividends.  For example, in Luxembourg (a jurisdiction frequently seen in private equity structures), withholding tax would apply on the payment of dividends by a Luxembourg company.

Next steps

Preferred shares are by their nature bespoke instruments which can have a variety of terms depending on the type of transaction.  Dealing with the complexity involved can require a multi-disciplinary team of lawyers to identify and mitigate issues and points of contention.  At Hogan Lovells, our private equity, funds, growth equity, secondary transactions and acquisition finance teams regularly work on preferred shares transactions of all types.

Please contact any of the authors for further information.

Authored by Cees Brouwer, Siew Kam Boon, Kevin Burke, Graham Nicholson, and Natasha Newey.