Private Credit Funds Turn to ‘Racy’ Equity Investments in Europe

(Bloomberg) -- There’s a sliver of cash slipping quietly into financings for European buyouts. It’s equity but it’s dressed a bit like debt, and it comes from the opaque world of private credit.

So-called ‘preferred equity’ is increasingly filling the funding gap when private equity firms stretch to pay a high price for a company and can’t make the sums add up. Where the combination of traditional debt and their own money won’t reach far enough to meet the acquisition price, sponsors need another source of funding.

One option is to turn to providers of private credit. These investors have huge funds to deploy and are used to taking on higher risk assets in the pursuit of rich returns.

A slice of preferred equity can allow a buyout to happen that might otherwise fail, but it carries inherent risks for the investor. Companies with multiple layers of debt and equity featured in some of the complex restructurings of the last crisis that saw everything wiped out but the senior debt.

“On the one hand, you could see it as a sort of racy investment, and so systemically a sign of a risky market for investors,” said Jacob Durkin, a senior associate with law firm Proskauer Rose LLP, which has worked on a number of deals with preferred equity portions. But, he adds, it’s also a symptom of a more conservative approach by banks who arrange and underwrite leveraged loans.

While the debt portions of today’s buyout financings usually have fewer layers than they did 12 years ago, investors such as pension and insurance firms have moved into the private credit market that grew up since the financial crisis. In their hunt for yield, some are pushing deeper into capital structure by buying into preferred equity.

Typical features of preferred equity
Preferred equity ranks behind all debt but ahead of ordinary equity, and can include features similar to payment-in-kind (PIK) debt such as:
  • Yield step-ups to encourage repayment
  • Some financial covenants
  • Mandatory redemption rights
  • Preference in the case of liquidation 

Filling a Gap

It’s often on buyouts for high-growth companies that the funding gap appears, where a sponsor might pay as much as 20 times Ebitda and provide about half the cost from their own equity. But arrangers of leveraged loans can be unwilling to go above six times Ebitda, partly because regulators discourage them from stretching further. So preferred equity might be used to make up the shortfall.

“There’s a win-win solution in preferred equity, and that’s in a way a natural development of what’s happening in the market, with very large, very high quality companies being bought with large equity checks,” Robin Doumar, founder and managing partner of Park Square Capital, said at a conference in London this week.

The appeal of preferred equity lies in its rich returns, as an investor might earn a yield in the low- to mid-teens. That’s by taking a position in the capital structure that is--in theory--well-cushioned by the sponsor’s equity, which sits lower in the pecking order in the case of a restructuring.

Private Credit Funds Turn to ‘Racy’ Equity Investments in Europe

But as with true equity, if the value of the business falls then the preferred equity investor’s position can quickly become far more risky and becomes vulnerable to being wiped out.

“An increasing number of sponsor-backed transactions” are using this instrument and there’s every reason to expect this to continue in 2019, Proskauer said in a report that’s yet to be published.

This expansion is happening at a time when global growth has been sliding. With little visibility on what comes next for debt markets, Proskauer noted in its report that some are raising questions.

“With a decade having passed since the global financial crisis, the question that many commentators are asking is whether this development is another example of the ingenuity of the financial sector or a symptom perhaps of a wider credit bubble?” the firm writes.

For managers active in the asset class, it’s the relative value against other opportunities that counts rather than the debt or equity label.

“We are flexible in our approach to preferred equity opportunities,” said Christopher Bone, a partner and head of private debt, Europe at Partners Group. “For it to make sense, we need the instrument to offer attractive risk-adjusted returns. We ask ourselves, ‘Is this an interesting relative value play?’”

©2019 Bloomberg L.P.