Preferred equity as a portfolio-wide liquidity option

Potential liquidity concerns are dominating private equity managers’ contingency planning for their portfolio investments. Flexible funding solutions provided on a fund-wide basis have emerged as a means for managers to tap additional capital as needed in order to finance working capital or additional equity for their investee companies.

A range of preferred equity providers, including funds dedicated to the strategy, traditional secondary players and investment banks, have identified the current COVID-19 hit market-place as a window of opportunity to design bespoke funding solutions for managers seeking to rapidly plug liquidity gaps and add extra ballast to their portfolio company balance sheets.

Here we provide a snapshot of the key legal and commercial points to be considered when putting in place preferred equity instruments. Our market-leading private equity team, encompassing funds, M&A, finance, tax and regulatory expertise, is uniquely placed to assist with the structuring and execution of the whole range of liquidity and financing structures increasingly being employed at fund level.

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Preferred equity - representative key terms

Pros and cons for preferred equity

Liquidity solutions at the fund level can now take many forms, including NAV-based debt facilities or portfolio or strip sales to continuation vehicles or secondary buyers.

How does preferred equity compare to other liquidity options?

Common structuring questions

Preferred equity deals are typically simplest to structure where the instrument is issued by a common holdco or aggregator vehicle which is interposed between the fund vehicle(s) and the underlying portfolio assets. Any transfer of a fund’s interests in its portfolio assets to a new holdco will require careful analysis of any transfer or change of control provisions in the underlying equity or debt arrangements relating to each portfolio asset. Tax advice will also be needed in order to ensure tax charges are not inadvertently triggered.

The terms of the relevant fund documents, in particular in relation to any relevant borrowing/leverage restrictions or caps, controls relating to the transfer of portfolio assets and any restrictions on portfolio assets effectively cross-collateralising other assets in the fund’s portfolio should all be considered carefully in determining if LP consent (and at what threshold) is required and/or desirable from an IR perspective. Some preferred equity structures can be executed without requiring any formal LP consents.

The precise terms of management incentivisation packages in place at the portfolio asset level should be analysed to determine if the liquidity event represented by the preferred equity transaction could constitute an ‘exit’ or other relevant trigger for rights of management teams of each portfolio asset and/or related tax charges. In some cases, preferred equity instruments can be put in place without affecting existing management arrangements.

Amongst other regulatory considerations, careful thought should be given to whether the relevant transaction could affect a fund’s status as a non-leveraged fund for AIFMD purposes (and the status of the manager as a manager only of non-leveraged funds) and any potential impact of moving to leveraged fund status in terms of: (1) the compliance requirements applicable to the manager; (2) reporting to regulators and investors; and (3) any impact of a change in status on investors’ own capital or solvency treatment of their interest in the fund.

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