Structured equity offers path to safer late cycle financing

Debt managers are moving down the capital structure to enhance risk-adjusted returns, while private equity players move up to protect risk.

When Paymentsense, a fast-growing fintech company, wanted to finance a minority stakeholder buyout, it turned to structured equity to find affordable capital that was not dilutive to the founder’s equity stake. Borrowers like Paymentsense usually consider two routes when seeking structured equity financing: holding company vehicles or preferred securities.

“We provided [Paymentsense with] unitranche funding at the [operating company] level, and then we provided a [holding company debt instrument with paid-in-kind interest] at the level above,” EQT’s US credit head Stephen Escudier told Private Debt Investor. “For the founder, it’s cheaper than the cost of equity, and they took 100 percent control after buying out the minority shareholder.”

The Paymentsense transaction is partially the result of both private credit and private equity managers converging to the middle of the capital structure, though for different reasons.

“You have credit funds coming down the cap structure and equity funds going up,” said Heather Smith,  structured equity advisor at advisory firm Houlihan Lokey. Private equity firms are raising structured equity funds to reduce equity risk, she added, while credit managers like EQT seek to enhance their yield.

Even as capital markets continue to saturate with issuer-friendly credit, Smith and Escudier see many borrowers like Paymentsense approaching leverage with caution for myriad reasons, including rising rates, covenant avoidance, regulatory prudence or tax concerns.

Consequently, leverage-shy borrowers are turning to structured equity options – or what Smith called “senior equity”– to finance M&A activity, recapitalisations, growth and rescue needs. “This [structured] equity industry has matured in the last three to four years,” Smith noted.

HoldCo PIKs and preferred equity are ways to “enhance [the private equity] sponsor returns, preserve sponsor capital and more broadly approach unusual situations in much more creative ways”, Escudier explained.

Returns for preferred securities and HoldCo PIKs can range from 11-20 percent, depending on the manager’s risk tolerance.

“Preferred equity deserves a premium of at least 200-300 basis points over a HoldCo PIK, given lack of maturity and typically looser documentation,” Escudier added.

Maturing industry

The structured market is bearing multiple signs of maturation, including an influx of participants.

“Now, there are more and more players active in the structured space,” said Tony Marsh, TA Associates’ head of credit. “Five or six years ago it seemed like there were only four to five players that I could call to [arrange structured equity deals]. I’d say that there are four to five times that figure whom I would be comfortable calling.”

Naturally, competition plays a key role in moving capital providers into new areas of the capital structure.

“I see traditional mezzanine managers feeling the heat of competition from the senior debt and unitranche providers,” valuation specialist Mark Emrich of Murray Devine said. Senior debt providers are moving down the capital stack, doing deals involving junior liens, mezzanine or preferred shares, which all rank under “plain vanilla senior secured deals”, he explained.

Emrich recently met with a private equity firm that is pivoting to credit, successfully raising a fund on the premise that “the more attractive risk-reward attachment point might be a structured equity position or in a more senior portion of the capital structure”

Structured equity deals often involve raising late stage equity for clients, according to Houlihan Lokey’s Smith. “We typically raise $40 million-$300 million in structured equity per transaction.”

Size remains a competitive advantage in the bid to win these borrowers, according to Marsh. “Most of the structured equity players can write checks of $500 million or more,” he said.

Deal flow continues

EQT recently provided two HoldCo PIKs to finance an education company that wanted to fund two recapitalisations: a minority stake buyout and a dividend recap.

“The beauty of [the HoldCo] instrument is that it’s almost equity for senior lenders. It has no cash leakage. It’s all PIK interest compounded up,” EQT’s Escudier said. The education-industry borrower needed to appear under-levered for business purposes at the operating company level, so it issued debt at the holding company level.

If structured correctly, HoldCo vehicles avoid hard covenant triggers and provide the potential to improve funding costs if ratings from the agencies improve at the OpCo level. Also, “the OpCo may not even know that the HoldCo is there,” said Escudier.

Preferred securities represent the second path that borrowers, seeking minimal debt covenants and no maturity issues, could walk down.

“The most prevalent equity structure used to be convertible preferred securities,” Smith said. “[Today] these structured equity deals involve preferred securities with [separate] warrants, providing investors more downside protection in exchange for some of the upside return.”