In the wake of COVID-19’s disruption and the attendant uncertainty with respect to future liquidity needs and available funding sources, numerous private equity firms have encouraged their portfolio companies to draw down on their credit lines. With many credit lines fully drawn and, as the current crisis continues to evolve, we expect private equity sponsors will pivot to more creative and bespoke financing solutions to support their portfolio companies – both defensively and offensively.
One such solution is fund-level preferred equity. In its simplest terms, a fund (Fund) issues a security to a new investor (Investor) with the security granting the Investor a priority right to distributions from the Fund’s underlying portfolio companies until the Investor has received a certain multiple on its invested capital and/or a minimum internal rate of return. Unlike debt, there is no stated maturity or repayment date, but rather, upon achievement of such financial metrics, the preferred equity security would typically liquidate, although certain fund-level preferred deals will provide for the Investor’s participation in further upside. The Fund’s use of proceeds would generally be to support incremental investment in an agreed portfolio company, but the proceeds could also be used by the Fund for myriad other purposes – e.g., a distribution to limited partners, portfolio company deleveraging (including an equity cure for a pending covenant breach or the repurchase of debt obligations of a portfolio company) or financing portfolio company M&A and other add-on strategies.
The attractiveness of a fund-level preferred equity solution is magnified in these trying times for a handful of reasons, including:
- Valuation: By making an investment into the Fund rather than an individual portfolio company, the Investor and the private equity sponsor of the Fund do not need to reach an agreement on a particular portfolio company’s valuation. This is especially important at this time, when the effects of COVID-19 on a portfolio company and its prospects will be difficult to quantify or unknowable and we are seeing, and expect to continue to see, large valuation gaps between buyers and sellers.
- Dilution: If an investment is structured such that the preferred instrument liquidates upon a multiple of invested capital and/or IRR hurdle, the Fund’s limited partners will not suffer uncapped dilution as a result of the Fund-level preferred equity and, in that sense, is akin to a debt instrument.
- Limited Supply of Other Viable Financing Options: Portfolio companies that have tapped their credit lines – particularly those operating in industries disproportionately negatively impacted by COVID-19 – may struggle to find financing on terms – particularly duration and loan-to-value ratios – that would be acceptable to the private equity sponsor that controls the portfolio company. By issuing a preferred equity security that is collateralized by a more diversified pool of assets, the private equity fund and, in turn the portfolio company, can access financing on more favorable terms – often with no or minimal covenants and without a stated maturity – and use that capital defensively to preserve liquidity or de-lever or offensively to make follow-on acquisitions in a market where pricing will be more favorable to the buy-side.
- Flexibility and Creativity: Preferred equity has long been a favored tool for private equity investors because of its flexibility and ability to create a structure that satisfies the needs of both the issuer and the investor. Fund-level preferred equity is no different. As compared to preferred equity issued in growth equity financings, there is less of an established “market” for fund-level preferred equity, which makes these transactions even more ripe for creativity and bespoke solutions – like capital being drawn over time on an as-needed basis – to satisfy a particular financing need.
- Deal Execution and Timing: Over the last few years, we’ve observed a robust expansion of capital committed to investors whose principal objective is to provide liquidity and financing solutions to private equity limited partners, private equity sponsors, private equity funds and their portfolio companies – it is these “secondary” funds, along with other alternative asset investors (including sovereign investors), that have been the principal source of fund-level preferred equity financing. These institutional “secondary” investors are able to write sizeable checks ($500mm is not unheard of), experienced investing through cycles, highly efficient and oftentimes, as limited partners in the underlying private equity funds or co-investors in certain portfolio companies, have deep insight into the pool of portfolio companies that will ultimately serve as the “collateral” for their preferred equity investment, thus increasing their ability to move with speed and eschew some of the processes that would typically be involved in underwriting but are expected to be impossible or meaningfully more cumbersome in light of COVID-19 (e.g., on-site due diligence). These institutional “secondary” investors have also shown increased creativity and flexibility as competition for investments have grown. These deals can get done with alacrity (in roughly one month), with the key gating issue on timing being any required consents of limited partners (as described further below).
A fund-level preferred equity financing – on a clear day or in these difficult times – requires careful consideration of the following items:
- Limited Partner Consents: To the extent that the preferred equity is structured in a manner such that it is viewed as an issuance of equity interests under a Fund’s governing agreement, it will likely require an amendment to such agreement’s distribution provisions. Sponsors should review their amendment provisions carefully to determine whether such an amendment, if required, can be made by obtaining the “default” consent percentage; many funds require a higher threshold vote for modifications of provisions impacting distributions. To the extent that the preferred equity is structured in a way as to be deemed debt for purposes of a Fund’s governing agreement, a Fund’s borrowing provisions – including limitations as to the amount, duration and permitted uses of borrowings – must be scrutinized and necessary amendments may similarly need to be obtained from LPs.
- Structuring: In certain circumstances, it may make sense to interpose a subsidiary between the Fund and the portfolio company that is expected to benefit from the proceeds received by the Fund in exchange for the issuance of the preferred equity security. While this will allow a sponsor to avoid an overhaul of its Fund documents, depending on the facts and terms of the deal, it may in fact still be viewed as part of the “Fund” and therefore may still require the same consents as would be required if the governing agreement itself were being amended to introduce the preferred equity structure. Alternatively, if the facts allow or require the new subsidiary to be viewed as a portfolio company, sponsors should be mindful of any diversification covenants or restrictions on cross collateralization in the Fund documents that may require an amendment or waiver.
- Conflicts of Interest and Risk Disclosure: To the extent that preferred equity is issued directly to a “secondary” investor, many of the conflicts inherent in a traditional “GP led” secondary will not be present, as the sponsor will not be on both sides of the transaction (i.e., controlling and being compensated by a fund vehicle that will hold the new equity). That said, in soliciting consent to any required amendments, it is critical that sponsors evaluate the transaction to identify all actual or potential risks and conflicts of interests that may arise specific to the preferred equity. For example, there may be situations where an investment performs poorly and the ultimate exit only provides returns to the holders of preferred equity, and not to limited partners of the Fund. Further, the existence of preferred equity, particularly one requiring a specific multiple to be met, may create an incentive for a sponsor to hold onto a portfolio company longer and take more risk than it otherwise would have in order to attempt to achieve an exit at a higher valuation, since the preferred equity will make it more difficult for a sponsor to clear the IRR hurdle in the distribution waterfall necessary to receive carried interest distributions. In addition, to the extent the sponsor is required by the preferred equity holder to acquire a portion of the preferred equity, this will create additional conflicts of interest requiring disclosure and (potentially) consent. Each transaction should be scrutinized to determine whether any aspects of the transaction, particularly in respect of any conflicts of interest, require advisory committee consent under the Fund’s governing documents.
- Impact on Other Fund-level Financing: It is important a sponsor review any existing credit facility documents to confirm that the issuance of preferred equity will not cause a covenant breach with respect to the facility’s credit agreement. Funds may be required to seek a waiver or amendment to their existing facility in order to issue preferred equity. In addition, sponsors should pay attention to any procedural covenants and be sure they comply with obligations to provide notice to lenders of new equity holders, amendments to governing documents, etc.
- Tax Considerations:
- A tax analysis of the entire package of rights and obligations of the Fund and the Investor is essential to determine the proper characterization of the preferred investment as either debt or equity for U.S. federal income tax purposes.
- Equity treatment for U.S. federal income tax purposes is typically sought in order to avoid potential negative tax consequences (i.e., UBTI/UDFI) to existing U.S. tax exempt investors in the Fund. In addition, a preferred equity investment that is characterized as equity would not be subject to interest deduction limitations that could otherwise be applicable to a debt issuance by the Fund.
- The structure of the preferred equity investment will likely need to take account of the tax profile and tax structuring needs of the preferred investor (e.g., U.S. tax exempt, U.S. taxable, non-U.S. or a combination thereof) as the Investor will participate in the returns of the Fund on a flow-through basis absent special structuring.
Liquidity issues caused by COVID-19 at portfolio companies along with pullback from traditional debt financing sources will present more opportunities for bespoke and creative financing arrangements to solve the needs of private equity funds and their portfolio companies. We expect to see an uptick in fund-level preferred equity solutions, benefiting all stakeholders including sponsors, existing investors and secondary investors, as we come out on the other side of this difficult period.
- As we’ve witnessed in the wake of prior bear markets, we also expect to see a proliferation of side-cars, top-up funds, annex funds and similar vehicles created to make further investments to support existing portfolio companies in situations where the existing fund may not be able to make such investment due to concentration limits, lack of available capital commitments or other constraints.
- Please keep in mind there are numerous important considerations, including tax matters, when repurchasing portfolio company debt. View Weil’s Alert on “Debt Buybacks— A Familiar Tool for New Circumstances.”