Why would a multi-fund PE fund launch a fund dedicated to investing in preferred equity? What is the benefit, and what is the value prop to target companies as opposed to traditional PE?
The title says all, need to understand why a multi-fund PE firm would launch a preferred equity dedicated fund. Thank you.
I don't know - Probably because the underlying business is riskier, maybe its turnaround type of situation and you want downside protection. Maybe you want to screw the common shareholders or previous investors with participating preferred shares (or maybe if you are just a shark and really good at negotiating great terms). Participating preferred structure can also allow you to bid up for a deal by giving a much bigger 'headline' figure.
There's a lot of reasons but in minority or growth type investments there's always downside risk to not having control/paying a growth multiple and then having the business plateau/crash so you want to get paid out first and protect your basis.
For target companies, preferred equity may be the only financing option available. Are you going to invest in a risky, early-stage company as a common shareholder? No way. If the business fails and we need to sell off the assets, I want to get paid first before the guys who ran it into the ground.
Can you clarify what you mean by "Participating preferred structure can also allow you to bid up for a deal by giving a much bigger 'headline' figure"?
How does it allow you to bid up for a deal?
To make sure we are on the same page, let's define the participating preferred structure. This means that I, as the investor, am entitled to my investment amount back AND my pro-rata common ownership in the business. So, in the example below, on the full sale of the business, I get my $1mm back AND whatever % ownership of the remaining proceeds.
Example: let's say you are investing $1m of equity, it is a secondary share purchase, and I want to 3x it. We value said target at $10mm, so we own 10%, and to get a 3x we need to sell the target at $30mm (if we are all common shares).
But, it's a cruel world and there are other buyers bidding as well. So, let's say this is an extremely egotistical founder who needs to beat his chest to his friends on "how much my business is worth" and is only focused on making a splash on the front page of the WSJ (or TechCrunch) with a nice juicy article saying the business was "valued at $10mm". He doesn't care about the capital structure, all he cares about is being the BSD. Lucky for us we have a crystal ball and we know that business will sell for $30mm down the road. Now we can use the preferred equity structure to give him a bigger headline valuation than the $10mm he was originally seeking.
Now using some Excel wizardry (i.e., the goal seek function) we can figure out how to increase our valuation while still maintaining a 3x return at the same $30mm exit value. We will invest $1mm of equity at a valuation of $14.5mm (6.9% common ownership), but with a 1x liquidation participating preferred terms. Here's how the math works: our exit valuation is $30mm and we get our 1x liquidation back first (so we pocket $1mm and the remaining proceeds are $29mm [$30mm-$1mm]). We still have 6.9% ownership and are entitled to our share of the remaining proceeds, so 6.9% x $29mm = another $2mm into our pockets.
And there you have it, a 3x cash-on-cash return. The founder feels good because he got a bigger valuation and gave up less ownership upfront. If we gave him the $14.5mm valuation with the same $1mm investment (6.9% ownership) with the same $30mm exit - we only ~2.1x our investment.
This is more pertinent to VC firms seeking to do non-dilute “equity” financing. Any insight on mature stage companies? Pref. at a mature stage is kind of frustrating: you’re subordinated to all the bank debt and mezz above you and you have no control. You’re super cove-lite aside from change of control put right or redemption right, so you can’t even limit the amount of incremental debt layered senior to you. You also face the fear of getting PIK’d/accrued instead of getting your preferred cash dividend. There’s literally no structuring at all.
that said, I’ve seen some PE firms use pref financing with creative structures, sometimes in unison with investing in other parts of the cap structure. Main equity kicker being the upside convertible / call option.
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