Expensive debt, cheap equity. Increasingly, the age-old distinctions between the two are blurring as there is now a growing expectation that there will be a greater presence of preferred equity instruments on both sides of the Atlantic.
Preferred equity is not new. And it’s not unknown for credit funds to operate on the other side of the border, with many providing financing in the form of PIK notes. However, there is increasing pressure for credit funds to deploy capital and it is through preferred equity that they are finding the opportunities. US department store Nordstrom, for example, is reportedly speaking to asset managers and institutional investors about a preferred equity financing.
The enormous amounts of dry powder that both private equity firms and private debt funds are sitting on means competition for assets is fierce. Borrowers have the option to finely tune the terms to suit their needs and it’s pushing debt funds to be as adaptable as they can.
If the senior and subordinated debt positions are already occupied, but the company wants additional financing then preferred equity makes sense. Fewer rights and no interest payments allow extra room for the company to manoeuvre, while maintaining an ownership of the company. For credit funds, the 12-15 percent margin is attractive at a time when spreads on senior debt continue to tighten around mid-single digits.
PIK notes are covered by some fund’s LP agreements. The instrument, however, contains undertakings and could potentially be captured by the European Central Bank’s guidelines on leveraged lending due to take effect in November. Banks holding the senior position will push back against attempts to add any debt that should see them fall foul of the regulations, hence the move to preferred equity. A similar trend took place in the US following the introduction of guidelines in 2013.
Where the tensions may lie is with the underlying investors. Credit investments offer security following a downturn in a company’s fortune and loans offer a maturity date of repayment. A preferred equity financing means the fund will be behind the debt holders in the capital structure and there is an uncertainty over the exit. Furthermore, institutional investors may have to worry about the weighting of their private equity exposure should credit firms go further down this road.
It’s not just credit funds that are heading down the capital structure, many private equity firms are looking more closely at offering preferred equity, as well as launching their own private credit strategy (Thoma Bravo, Onex for instance) as they look to head in the opposite direction.
Ultimately, meanings can be bent, but not broken. And while credit firms may argue that they are responding to changing market conditions serving as one-stop shops for corporates, some investors may question the discipline.