Preferred Equity vs. Sub Debt


Under what situation (s) typically, would a PE sponsor want to structure its investment in the company in the form of preferred and common (as opposed to subordinated debt and common) assuming there’s room for the company to take on the sub and no leverage covenant will be breached? Confused because in principle the pref and sub-debt sound the same (junior, unsecured, and targeting mid-teen returns). If the sponsor can invest in the form of sub-debt and get the coupon payments deductible for tax purposes, why won’t it? Its’ dividends as holders of pref won’t be tax-deductible, and so going with sub debt will help the portco lower its overall tax bill yet allow the sponsor to benefit.

 

Bc no one will lend them sub debt. Also the sub debt may restrict them paying themselves a dividend, doing M&A or investing in the business through Capex. The sub debt would ultimately let them do those things, but not until they open the credit agreement and pay an amendment fee. The company's view is why should I pay you to spend my money. So in summary two scenarios: they have no other choice but preferred equity or the company thinks the terms on the sub debt will be too restrictive. I'm sure there's other reasons, but these are the two that most down the fairway in my mind.

 

You're literally describing an LBO then. Of course they'll take as much debt as a lender is willing to give them bc it enhances their returns from the leverage they are getting on their equity. Really dumb question. Every sponsor is going to take as much debt as they can get without overburdening FCF. Further, in a scenario where the company gets sideways then you have conflicting interests as a debt holder and equity holder so it's not practical to invest in debt and equity out of the same fund. Even more messy when LPs own both the debt and the equity. It's not practical. You didn't just discover fire with your question, don't bite the hand that's trying to help.

 
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