Podcast: Preferred Equity Financings: Tools for Both Fund Sponsors and Investors
In this Ropes & Gray podcast, asset management partner Isabel Dische is joined by tax partner Dan Kolb and asset management associate Adam Dobson to discuss preferred equity deals in the private funds context. Following a brief explanation of what these deals are, they share why a fund sponsor or an investor may want to pursue a preferred equity financing, and provide details on the structures and certain considerations for these deals that market participants may want to keep in mind.
Isabel Dische: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on topics of interest for asset managers and institutional investors. I’m Isabel Dische, a partner in our asset management group based in New York and co-head of our institutional investor practice. Joining me today are Dan Kolb, a tax partner based in our New York office, and Adam Dobson, a senior asset management associate based in our Boston office. Today, we are going to be talking about preferred equity deals in the private fund context. We’ll start with a brief explanation of what these deals are and why a fund and/or an investor may want to pursue a preferred equity financing. We’ll next discuss typical structures for these deals and certain considerations that funds and preferred equity providers will want to keep in mind. Finally, we’ll quickly cover certain key tax considerations in these transactions. Adam, would you like to kick off our discussion with a quick overview of why a fund or fund investor may want to consider a preferred equity financing?
Adam Dobson: Gladly, Isabel. Preferred equity deals are potential solutions to a number of different fact patterns. They offer a mechanism for GPs in need of liquidity. For example, to support one or more portfolio companies in need of cash for working capital, to pay down debt and/or to make an add on acquisition, in each case where there aren’t sufficient undrawn commitments. These deals allow GPs to obtain a capital infusion while retaining control over the investment and also retaining the upside. Alternatively, they can be used by fund sponsors to generate near-term liquidity for limited partners. Preferred equity structures can also be used by existing limited partners to monetize their holdings in one or more funds – by contributing those fund interests to a new vehicle in which they and the preferred equity provider share future cash flows stemming from the interests. In each case, the preferred equity financing offers an alternative to taking on debt or selling one or more of the underlying assets. Interest in these deals has been heightened in recent months as the recent COVID-19 pandemic has both heightened liquidity needs at many portfolio companies and because the pandemic has temporarily resulted in a suspension of many fund recapitalization transactions due to valuation concerns on the part of both secondary buyers and existing funds. That brings us to the question of how these deals are typically structured.
Isabel Dische: In a typical preferred equity deal, the equity provider is entitled to a disproportionate share of future fund distributions up to an agreed-upon rate of return. Cash flows are subject to a negotiated waterfall. Likewise, the parties negotiate who will be responsible for any uncalled capital commitments and any vehicle expenses. Where a fund sponsor is arranging preferred equity financing for a fund, most typically the preferred equity provider will be admitted as a new limited partner to the fund, with the agreed-upon preferred rights. Where an investor is monetizing holdings, most typically those assets will be contributed to a new special purpose vehicle of which both it and the preferred equity provider will be partners, and the agreed upon economics will be reflected in the terms of that SPV’s partnership agreement.
So why might a fund want to consider a preferred equity deal? Preferred equity financings can offer a less restrictive alternative to traditional debt financing. For example, the covenant protections are often lighter and there typically is no tenor (although many preferred equity providers will include a liquidity mechanism – for example, allowing the preferred equity provider to have a put option whereby it can redeem its interests at an agreed-upon price after an agreed-upon number of years). Because of the limited upside, preferred equity deals also offer cheaper capital than traditional equity. From the perspective of a fund investor, a preferred equity deal can offer a number of different advantages. First, these deals can offer accelerated distributions and allow investors to lock in a higher IRR. Second, preferred financings also offer a way to properly stabilize and/or invest in the portfolio at a lower cost while still allowing the existing investors to share in the continued upside of the underlying assets. Third, existing investors also can avoid an immediate capital account write-down because of a discounted valuation. Dan, do you want to highlight some of the potential tax considerations with these deals?
Dan Kolb: There are a number of tax considerations in these deals and the relative importance varies depending on the facts. In the event proceeds are distributed to the original investors, the parties should consider the possibility that the transaction will be treated as a disguised sale (and the possibility that the sale will trigger withholding obligations). Further, depending on the arrangements, it is possible that there will be a capital shift between the parties either at the time of the investment or in the future. Preferred investors should also consider whether the preferred security will produce guaranteed payments which are treated as ordinary income, and depending on the nature of the underlying income, whether ECI, UBTI or CAI could pass through to the preferred investors. The parties also need to consider similar considerations in the event of a redemption or put of the preferred security in the future and where appropriate plan for those events. There are many other tax considerations, but the forgoing considerations appear in many of the transactions.
Isabel Dische: Needless to say, there’s a lot to consider. Thank you, Adam and Dan, for joining me today for this discussion, and thank you to our listeners. For more information on the topics that we discussed or other topics of interest to the asset management industry, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we discussed, so please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.