- Sophie Gioanni
WHAT PREFERRED EQUITY MEANS FOR BOTH GPs AND LPs IN SECONDARY TRANSACTIONS
Secondary transactions have gained popularity in recent years. Private equity is inherently illiquid, but structures have been put in place in order to satisfy the short- or medium-term liquidity needs of either LPs (looking to exit a fund) or GPs (looking for additional funding for their entire fund or a few individual assets). Preferred equity is one of the solutions offered by secondary fund managers.
What is a preferred equity transaction?
Preferred equity has been around for a long time, offering an instrument which sits in between debt and equity. In the secondary market, the preferred equity provider (a secondary fund manager) provides a set amount of cash in return for an equity instrument. This equity instrument has a preferred return over one, several assets, or the entire portfolio of a fund. When only one or a few assets are used for the preferred return, a new vehicle or SPV is created and will be the one issuing the preferred equity instrument to the secondary player, rather than the fund itself.
What is the cash used for in a preferred equity transaction?
Cash provided by the secondary manager can be used for one or both of the following reasons: 1) provide liquidity for LPs without having to sell the entire position in the fund. The LP avoids taking a discount which might not get approved by the investment committee, and at the same time can retain some upside in the fund once the preferred return has been satisfied; 2) provide liquidity to the GP who can use it for other underlying portfolio assets, and avoid, for example, a capital call from the LPs. GPs can also combine the two and receive some financing for their assets/fund while at the same time, provide liquidity to LPs. In this case, LPs may be offered the options to participate in the preferred equity, keep their position unchanged, or sell down their stake.
Why would a GP use a preferred equity deal?
In general, preferred equity is a much more flexible solution for the manager. It is an instrument closer to equity rather than debt, but still with priority in the waterfall over LP’s equity. Importantly, there is no fixed term for repayment, covenants are limited and a GP can raise cash as little as 20% or as much as 65% of the underlying portfolio value. Preferred equity is, however, in general more expensive than other financing solutions offered by secondary players such as NAV financing. It also requires engagement with LPs, and sometimes their authorisation.
What are the key points of a preferred equity deal?
One of the important considerations of a preferred equity instrument will be the protections for the secondary fund manager providing the preferred equity. Typical ones include mandatory redemption, consent rights, board or observer seats, or Loan To Value covenants. Consideration around the waterfall distribution, taxes and conflict of interest will also need to be addressed.
If you are looking to use preferred equity in your funds and want to discuss potential solutions or just interested in more information, please reach out to us.