Pref equity - ELI5
Gents / ladies / they thems,
Apologies for getting lost in this side of the forum. I don't work in PE clearly but could someone smarter explain or share an "L"BO model / simple workings with pref equity on sponsor entry and mgmt r/o and associated returns vs common equity to each respective contributor. Use any figures for illustration. Would I show returns to pref equity holders first (splitting that to mgmt and sponsor) separately or just deduct in EV to eqv. bridge as debt like item? I am aware this is a stupid question for a lot / all of you but I am here to learn and my brain is limited in capacity. Thank you in advance.
Add as debt like item in TEV to EqV bridge. Reason being that preferred equity is “Preferred” relative to “Common” equity because it gets paid in full (incl. liquidity preference, PIK accretion, min. MOIC, etc.) prior to the common getting anything (just like debt). Debt is paid in full prior to the pref.
If thinking about waterfall, repayment priority is below debt and above common equity.
Feel free to PM me if helpful.
Thank you! DMd
Assume you buy company for $300, using $100 debt, $100 pref, and $100 common (this doesn’t happen really but just assume).
Assume pref has a 10% PIK and a 1.5x Liquidation preference - this means at exit, after the debt is paid off, pref holders get either 1.5x their money back, or whatever the value of their pref is assuming 10% compounding, whichever is higher.
Scenario 1:
In year 5, assume you sell company for $1,000 EV. Pay off $100 of debt, leaving $900 remaining. The pref is now worth $160ish after 10% annual compounding. This is higher than their 1.5x liquidity pref, so they get their $160 back. $740 remaining goes to common and/or management.
Scenario 2:
In year 3, assume you sell for $250. Pay off $100 debt, you have $150 left. The pref balance is $133, because you only compounded 10% for 3 years. This is less than the 1.5x liquidity pref. So preferred equity gets $150 back. Common equity gets nothing
Scenario 3:
In year 5, you sell for $150. Pay $100 debt. Remaining $50 goes to pref equity
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