Quasi-equity when structuring a deal

CAPEXecutive's picture
Rank: Monkey | 49

Dear all,

Just trying to understand, when considering an LBO deal :
1 - Why would a sponsor invest in quasi-equity (convertible bonds, preferred shares, etc) on top of ordinary shares when doing an LBO ? What would he gain from investing the same amount in ordianry equity ?

2 - How are amount and form of this investment chosen ? I guess maximizing profit is the ultimate goal but are there other considerations (ManPack is the only thing that comes to my mind right now)

Also v. interested if you have some reading materials about this

Many thanks !

Comments (12)

Feb 3, 2019

Bump

Feb 3, 2019

What is your question? Why would an investor want pref stock or convertibles?

If so, simple answer. Downside protection.

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Feb 4, 2019
LeonTree:

What is your question? Why would an investor want pref stock or convertibles?

If so, simple answer. Downside protection.

Is there a good book or article we can read more about the various instruments and when to use them? Thank you.

Feb 5, 2019

Also interested

Feb 5, 2019

None that come to mind, most of it I learned on the job really. Hear of something --> Google.

Most of the definitions and examples will likely live in venture capital books/articles. Although, "when to use them" comes down to negotiations. If a competing investor will come in at the same price with commons then all your knowledge of participating preference shares is useless.

Feb 4, 2019

Management package usually includes over-representation of the management team in the ordinary equity, and under-representation on the fixed rate quasi-equity instruments. As a result their returns are boosted when the deal yields a return higher than the quasi-equity fixed rate. It also gives management higher than pro-rata ordinary voting rights.

Depending on countries and jurisdictions there may be ways of using them in the structuring to be more tax efficient (use the entire interest tax shield allowance, shift between capital gains and interest income, etc.).

PS - Obviously this is referring to when Funds invest both in Equity and quasi-equity in the same deal, which is purely a structuring and MEP decision. When you are just deciding, from a commercial point of view, if you want to invest EITHER in equity or in quasi equity, the answer is just the classic risk-return that you expect from the deal, and the probability distribution of expected returns. For example, a biotech with one product in Phase 3 that could either be worth billions or zero requires an equity investment, as using quasi-equity you would give away a huge upside for a statistically irrelevant downside protection.

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Feb 5, 2019

Feel like I haven't made myself clear, v sorry for that :)

Let's say a fund invests 70% ordinary equity and 30% convertibles in a target, as part of a LBO

Why not 100% ordinary equity ? And how is that ratio determined ?

Feb 5, 2019

This is how you create "sweet equity" for managers to incentivize them

Example
If you buy a firm with 1bn EV and have 500m of debt, equity will be 500. Managers have 5m to invest in total. Equity doubles in value at exit:
1. Only common equity: managers will have 1% of equity and receive 1% of the 1000 equity at exit = 10m (100% return)
2. If you use a mix of 90% preferred (10% PIK return) and 10% common, managers have 10% of common equity with that same investment. After 5 years the pref shares will be worth c. 724 (90%500m1.10^5), leaving c. 276 for the fund+management team. 10% = 27.6m for managers is a 452% return on same investment.

If company value remains the same, managers will actually lose their investment because the prefs keep on earning 10% return that has to be paid at exit.

Feb 5, 2019

Sometimes "senior common" or non-coupon paying preferred shares are used in a deal to prioritize the sponsor's claim ahead of management's equity. This is purely for the purpose of downside protection and I would say is more often than not used as a lever in negotiating key deal terms, i.e. I'll go up a half a turn if my equity is given senior priority.

Feb 5, 2019

So basically we got :
1 - For ManPack purposes
2 - Downside protection
3 - Give priority to Sponsor's equity

Any other thoughts ?

Feb 5, 2019

2 and 3 are really the same imo. If your equity has priority you get your money back first in a downside case. Obviously if there is a chunk of debt from an LBO on the business, in a nuclear case it doesn't matter anyways. That's why you typically hear of the fun structures in venture/growth case more often.

Feb 5, 2019
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