Modeling Preferred Equity in M&A Financing
Preferred equity comes before equity but, after all the debt when it comes to receiving dividends or money from a sale or liquidation.
Preferred equity is capital contributed towards a company, where in exchange, the provider gets a security that has priority over common equity but is surpassed by debt in case of the sale or liquidation of the company.
This type of equity provides the users a hybrid combination of debt and equity, a priority position above the common equityholders. Apart from the priority, they are also entitled to PIK dividends (a form of dividend payment where the payment can be in the form of additional shares or increasing the liquidation preference).
PIK or Payment-In-Kind is a type of payment feature that is often described as a negotiated feature that lets borrowers to delay the cash payments with the unpaid balance amount accruing. This feature serves as a strategic tool that is utilized primarily to fund highly leveraged deals. PIKs are generally used to protect the cash flows or to optimize the overall capital structure.
Companies can pay their dividends in cash or in kind, and, in the leveraged deals, it is often structured to pay in kind. This is then added to the outstanding balance, increasing the payout of the investor.
What Is Preferred Equity?
Preferred equity is a source of capital, a hybrid of debt and equity. Companies pay dividends for their contribution towards the capital and preference over the common equity shareholders in the event of liquidation. Preferred equity sits between debt and common equity in the capital structure.
Lenders get paid first, preferred equity holders are second, and common shareholders last. However, preferred shareholders do not get the voting rights, and owners can raise capital without giving up as much control as they would by selling common shares. Many deals add consent rights that claw some of that back.
And, in some instances, only if the preferred shares are convertible, the investor can swap them into common shares at a set price. That dilutes existing owners and can shift control if enough convert.
Additionally, if the investor opt for convertible preferred shares, there is the added risk that the investors might seek to convert their preferred equity into stock, which would lead to a dilution of current shares and change the control structure of the company.
Preferred shareholders can have some kind “veto” on the decisions. This can hinder the speed and effectiveness at which companies make decisions. Furthermore, dividends that investors get from the company may add up, which would result in a serious financial burden.
It is also important to note that preferred equity investors are at less risk in case of a sale of the company. This is due to the fact that preferred equity investors often have priority over common equity investors when it comes to cashing in their investments.
- Preferred equity comes before equity but, after all the debt when it comes to receiving dividends or money from a sale or liquidation.
- Preferred share capital is typically used to close a transaction’s funding gap without adding debt or issuing more common equity, as the preferred equity is a hybrid financial instrument, sharing the features of debt and equity.
- The money an investor gets mostly comes from a set dividend. This dividend is given as cash or, as goods or services. When it is given as goods or services the amount that is not paid in cash is added to the balance. This total balance grows over time. Keeps increasing until the investor decides to leave or take their money out.
- Main advantages of preferred equity are access to capital without additional debt, reducing immediate dilution of the control structure, and flexible payment structures;
- Main disadvantages are potential higher cost of preferred equity over debt. PIK can grow quickly over time, and in some cases, the investors may have veto or conversion rights.
What Is M&A?
Mergers and acquisitions (M&A) are the processes, where two or more companies combine through transactions such as acquisitions, mergers, joint ventures, and strategic alliances. Organizations use M&A to accelerate growth, acquire talent, technology, enter new markets, and strengthen competitive positioning faster than organic growth.
M&A is one of the main ways companies grow faster than they could on their own. A number of domains are engaged in M&A activities. For example, investment banks advise on the deals, corporate development teams lead them, and private equity firms and lenders bridge the gap in funding.
Often, companies find that they need more money to perform the large transactions needed for M&A. To perform those transactions, firms that engage in M&A have to secure capital. The most common way in which firms have secured capital over the years is through debt financing.
How M&A Deals Are Financed
Acquisitions are usually paid for using layers of money and these layers build up based on their position, in the order. Debt is the layer then any preferred shares, then regular shares. The way money is arranged in a buying or merging deal is divided into the following parts:
- Debt
- Preferred Equity
- Common equity
Debt In M&A
Debt sits at the top of the capital structure. Lenders are paid before anyone else, and what they're owed is contractual: interest and principal come due whether the business performs well or not. In this category, we can find sources of funding such as:
- Term loans
- Revolving credit facilities
- Senior notes and high-yield bonds
- Second-lien loans
- Mezzanine debt
- Recurring Revenue Lending (practiced when companies depend on revenues in the form of subscriptions)
While there are many more categories of debt, these are the most common ones that we’ll find in the M&A scene.
Who Provides Debt?
Post the 2008 Financial Crisis, stringent bank capital rules have directed the banks to avoid leveraged lending, and private credit funds have stepped in. The estimates of market size vary with definition, ranging between $1.7 trillion to $3.5 trillion.
Some of the main investors are:
- Banks,
- Private credit funds,
- Institutional investors in bonds
- Colletaralized Loan Obligations,
- Mezzanine funds
- Private debt (credit) companies
Preferred Equity In M&A
Preferred equity is used when a buyer needs capital to complete a transaction but wants to avoid taking on more debt or issuing common equity. It helps fill funding gaps reduces pressure from debt limits the dilution for existing owners, and can make the deal more attractive to investors. It also allows companies with cash flow to free up their financial resources.
In mergers and acquisitions financing, preferred equity is often favored over equity because it acts as an effective capital bridging mechanism when a company has already used its senior debt capacity. Common equity can be very costly or highly dilutive especially when the business is already stretched thin. Preferred equity sits in between debt and common equity in terms of risk and return making it a balanced option, for financing.
Common Equity in M&A
Common Equity (or equity shares) is the ownership funds representing the ownership interest in the organization. Holders of these shares are the absolute owners, the holders of greatest risk and reward. They are at the bottom layer of the capital structure.
Regardless of the context, M&A or Corporate Finance, the equity shareholders aren’t guaranteed any fixed or variable payment, not even a liquidation preference. They are known to capture the financial upside, or absorb primary losses in the financial transaction.
Example Of Debt Financing
Suppose Business A needs $100 million to buy a company, Business B. A loan at 6% costs $6 million a year in interest with the principal coming back at maturity. Over five years that's $30 million in interest and $130 million in cash out, and every payment is due whether A performs well or not.
Now fund the $100 million with preferred equity paying an assumed 10% dividend, all in kind. No cash leaves the company. The balance compounds: $100 million × 1.10⁵ comes to, about $161 million after five years, and that amount comes out of exit proceeds before common holders see anything. The dividend also generally can't be deducted the way loan interest can. (The 10% is illustrative. Actual rates vary by deal.)
What Is A Financial model?
A financial model is a set of linked calculations in a workbook that shows how a company or a deal will do financially. This set is usually built in an Excel Workbook. The process begins with financial data taken from financial statements and then adds assumptions, about growth, margins, spending, and financing.
Based on this premise, the model builds the income statement, balance sheet, statement of cash flows, and supporting schedules that fill for projections ahead based on historicals.
Company’s management can then use the model to predict which kind of performance will give the most optimal outcome and to act accordingly. However, sloppy models can create problems. As such, many organizations send their models to third parties to validate the financial model.
Elements of a Financial Model
Institutions that financial models are sent to for verification can vary, as this practice is done by banks, private institutions, project promoters, and corporations seeking funds. For a model to function, a model needs to have assumptions, as no model can account for all scenarios. Additionally, the model requires the following data:
- Income statement
- Balance sheet
- Cash flow statement
- Valuations
- Sensitivity analysis
- Graphs
- Charts
How To Model Preferred Equity?
There are many ways to model preferred equity. However, in the context of this article, we will look at how preferred equity will be modeled in Mergers & Acquisitions. A potential model has to be based on the capital structure of a company. As such, preferred equity has to be fitted into the model in such a way that it accurately represents the seniority that debt and equity have.
In this case, to properly model the distribution of funds among the capital structure, we will need to use a waterfall model. This would accurately show the distribution of the cashout of the company and the repayment of the different obligations. In this case, we need to look at what sources of funding we assume.
Let's look at the following example:
| Acquisition details | Value in millions of $ |
|---|---|
| Purchase price / Enterprise Value | 500 |
| Fees & expenses | 20 |
| Total uses | 520 |
| Capital structure | |
| Senior debt | 250 |
| Preferred equity | 100 |
| Common equity | 170 |
| Debt & Equity | 520 |
In this scenario, let's assume that the preferred equity is 100, with a PIK of 10% over a period of 5 years with a liquidation preference of 1.0x. As such, the value of the preferred equity investment will evolve over the following period of 5 years:
| Time since investment of preferred equity (in years) | preferred equity + PIK Interest (in millions of dollars) |
|---|---|
| 0 | 100 |
| 1 | 110 |
| 2 | 121 |
| 3 | 133.1 |
| 4 | 146.4 |
| 5 | 161.1 |
Table 2: Evolution of preferred equity with PIK Interest over a period of 5 years
We now assume that 5 years after the M&A, the company decides to sell, for a new value of 800 million dollars. We consider that during this time, the firm has paid part of its debt and only has around 100 million dollars of debt left to satisfy. Putting that into a table, we have:
| Total Enterprise Value at exit | 800.0 |
|---|---|
| Capital structure - Exit Payment (in millions of $) | |
| ⇒ Debt outstanding | 100.0 |
| ⇒ Preferred Equity, incl. PIK | 161.1 |
| ⇒ Common Equity residual | 538.9 |
Table 3: Waterfall representation of a company sale at 800 million dollars
In this table, we see that all the different lenders have been paid out. However, this is not always the case. Consider that, instead of a valuation of 800 million dollars, the company would have lost value and sold at a market valuation of 250 million dollars. In this scenario, the distribution of funds shifts drastically. In this scenario, the waterfall model looks something like this:
| Total Enterprise Value at exit | 250 |
|---|---|
| Capital structure - Exit Payment (in millions of $) | |
| ⇒ Debt outstanding | 100 |
| ⇒ Preferred Equity, incl. PIK | 150 |
| ⇒ Common Equity residual | 0 |
Table 4: Waterfall representation of company cashout at 250 million dollars
In this case, debtors get their full payout, while preferred equity investors are still owed around 11 million dollars. Furthermore, the common equity investors, who have invested around 170 million dollars, do not receive a payout, as there are no funds left to distribute.
Of course, it is worth mentioning that the preferred equity model is a small part of the broader M&A model. Besides, the demonstration of these scenarios up here would be undertaken through a financial model built in Excel.
How Preferred Equity Factors Into The Broader M&A Model
Preferred shares can be treated as either a liability or equity, and the choice depends on the terms of the shares. Under US GAAP ASC 480 says that preferred shares the issuer must redeem at a date or event must be treated as a liability. Other instruments can also be classified as liabilities depending on their features.
Some SEC registrants show preferred shares outside of permanent equity treating them as temporary equity instead. IFRS through IAS 32 uses a test to determine classification. I have found that in modeling the choice, between liability and equity really matters. When the instrument is treated as a liability the dividend usually shows up in the income statement as interest expense.
When the instrument is treated as equity the dividend is seen as a distribution that reduces earnings to common shareholders. Cash dividends appear in the financing section of the cash flow statement. PIK dividends or dividends paid in kind do not involve cash and are -cash items—they just increase the balance. It is important to note that the book classification does not affect tax deductibility. Tax treatment is an issue and must be considered separately.
Examples Of Preferred Equity Transactions In M&A
Heinz (2013): Berkshire Hathaway and 3G bought Heinz for $23 billion for the shares. Berkshire contributed $8 billion of stock that gives a 9% cumulative dividend, plus warrants on roughly 46 million shares along with common equity from both buyers and debt, for the remaining amount.
Wrigley (2008): Mars bought Wrigley for $23 billion. Berkshire supplied $2.1 billion of Wrigley preferred stock that paid 5%. The redemption amount for this stock was linked to future earnings. Berkshire also provided $4.4 billion in 11.45% subordinated notes in 2018. Goldman Sachs and JPMorgan provided financing, for the deal.
Occidental–Anadarko (2019): Occidental issued ten billion dollars of stock to Berkshire Hathaway to help buy Anadarko. Occidental set an eight percent dividend that could be paid in cash or, in shares depending on what Occidental chooses. The agreement also gave warrants for eighty million shares. Occidental could buy back the preferred stock after ten years at one hundred five percent of the liquidation preference. In each of the three deals Berkshire supplied the shares.
Modeling Preferred Equity In M&A Financing FAQs
Preferred equity is used when a buyer needs the bridging capital in order to complete a transaction but does not want to undertake more debt or common equity. It can fill the funding gap, reduce interest and debt influence, and limit equity dilution. It can also free up the cash flow when the company is tight on capital.
A preferred return is a priority distribution rule where the cash flows to investors are promised at a minimum specified return rate before any common equity holders or sponsors receive a share of the profits.
Preferred equity in M&A financing is preferred over common equity as it functions as an efficient “gap-filler” when the organization has utilized senior debt to its limits while common equity may prove to be extremely dilutive or expensive. This type of equity sits between senior debt and common equity.
A waterfall model in M&A Financing is a distribution framework that is legal and mathematical. It dictates how the exit may proceed, asset sale, or operating cash flows, and how they can be carved up to facilitate the distribution among lenders, preferred investors, sponsors, and common shareholders.
Conclusion
Preferred equity in M&A is important because it is one of the few capital solutions that help companies reach the required capital level. As such, it is an important part of the broader M&A model, especially when it comes to the payout structure and the waterfall model.
Preferred equity is often modeled as part of the larger capital structure that defines the M&A deal structure. Classification changes how the dividend and the balance appear in the statements and how leverage looks, but the payout to each layer follows from the contract terms.
Overall, preferred equity is an important component of M&A modeling because it influences both financing and returns. Since mistakes in classification or payout priority can materially affect the model, any model involving preferred equity should be carefully reviewed and peer-checked before being used for decision-making.
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