Structured Preferred Equity: Documentation, Protective Covenants, Tax Treatment, Use in Debt Restructuring

Description

Increasingly, fund sponsors are turning to third-party preferred equity as a financing tool. Preferred equity financings can be attractive to alternative credit providers because they are priced to provide higher returns than traditional debt investments. Still, counsel must be aware of the legal and structural differences between preferred equity and traditional debt investments.

A key feature of preferred equity financings is that there is typically no stated maturity date and no mandatory redemptions or put rights unless there is a change of control or IPO. The uncertain exit timing should be considered by prospective investors, especially fund investors with limited lives.

Investors may negotiate certain rights to effect an exit, such as the right to appoint directors or demand a sale of the issuer after the anticipated investment period has run. They will not have the same rights to enforce payment as holders of debt, the benefit of collateral or guarantees, or the ability to act as a creditor in a troubled situation. Prospective investors must be sensitive to how their interests may differ from the lenders and structure the covenant package accordingly.

Investors should consider whether the coupon on the preferred equity investment will generate phantom income. The tax status of the issuer, the specific terms of the preferred equity, and the nature of the investor and its owners will figure into structuring from a tax perspective.

Listen as our authoritative panel discusses the structuring nuances of preferred equity investments. The panel will also discuss the use of preferred equity in certain workout scenarios, including a debt for equity swap to right-size the balance sheet or to hand over control to the lender.