Pref Securities

Question 1

What are the two types of pref securites?

Answer 1

Convertible and participating prefs

Question 2

Why do companies like prefs?

Answer 2

Companies might prefer to finance themselves with prefs because

• They are less dilituve to common equity: Most prefs tend do not have direct ownership of the business and therfefore no voting rights
• Non-cash interest: Fast growing firms prefer to not use their funds to service interest payments
• Maximize leverage / get around leverage ratios: Prefs dont always count as debt in the eyes of rating agencies therefore they can raise more debt by going the pref route

Question 3

Why do investors like pref securities?

Answer 3

Investors like prefs because:

• A pref provides more downside protection compared to common equity invesments: A pref is higher in the cap structure, pays a dividend, and often comes with a liquidation preference
• A liquidation preference allows the pref stock holder to get a guaranteed certain level of return before common equity is paid out. For example, if your pref secuirty has a 1.5x liquidation pref you are guaranteed to get 1.5x your money before common gets anything
• More upside than debt: Prefs are often covnertible to common.
• Perpetual: Unlike debt, prefs do not expire after a certain time

Question 4

How does a convertible pref invetment convert at exit?

Answer 4

If you invest in a convertible pref:

You can get either:

The pref value or the converted value of the common shares.

As the investor you are picking between the greater of the two therefore you have downside protection as your min return is the pref value but can participate in the upside via the common shares

Question 5

Assume we are making a convertible pref investment of $100mm, which can convert into 25% of the total common equity at exit.

For simplicity, assume no PIK interest.

How do how received proceeds to the PE firm change over a range of exit proceeds?

Answer 5

If I invest $100mm for a 25% equity stake in a company that means that we value the firm at $400mm.

Given that I’ve set the firm value at $400mm my exit proceeds need to exceed $400mm before proceeds to common exceed the value of the pref.

Question 6

How does a participating pref work?

Answer 6

In a participating pref the investor receives both 1) the pref security value + 2) the converted value of the common shares

Participating prefs are much better deal to investors than convertible prefs because you get downside protection via the pref and upside via common equity ownership

Question 7

How do convertible prefs compare to participating prefs? Which one produces higher returns to investors?

Answer 7