By Balázs Gecse, András Nemesánszky and Kristóf Seres
Like the monochromatic television set, before the 70s, common stock was the only instrument available to GPs in PE and VC when investing in portfolio companies. This rigid capital structure had a vice grip on minority investors by subordinating them and offering intermediate returns only in the form of dividends or share repurchases. Subsequently, the industry transformed with emphasis shifting towards redeemable preferred stocks. This was a solution for investors who demanded to receive their capital as quickly as possible in order to reallocate. As the market became more competitive towards the 80s, convertible preferred stocks became the standard security in PE. Later in the 90s, in reaction to the rise of multiple round investing, GPs began to prefer participating convertible preferred stocks. These issuances offered investors more involvement and security. Over the course of this timeline, investors could tailor equity interests to their liking and protect returns with covenants granting multiple layers of safeguarding.
The greatest advantage of preferred shares relative to common stocks is that preferred shareholders are more senior i.e. they’re repaid first. Redeemable preferred stocks, more specifically, do not convert into equity. Instead, their value originates from the face value plus any additional dividend rights. There is always a pre-negotiated date (typically 5-8 years) when the company will redeem the stock (buy out the issue holder). Redeemable preferred stocks are most often used in combination with common stocks or warrants. In this way, investors can maximize their profits when the company’s value appreciates and take positions of varying maturities. However, this “double-dipping” comes with negative side effects as well. Investors’ returns using the aforementioned combination may be reduced if an IPO is pursued because the market will price the common stocks at a discount due to the existence of the more senior preferred stock – similar to the company being more highly levered. These concerns spurred interest into innovating a new solution.
A decade later, convertible preferred stocks are what followed. These securities allow holders to convert their equity into common stock. Therefore, investors can choose between either higher dividends and seniority or the underlying common equity position. Convertible preferred stocks usually contain a mandatory conversion deadline, which can be adjusted or fixed depending on the contract. This form of equity provides the holders with an option while enabling entrepreneurs to catch-up to investors once they are compensated for their initial investment. Furthermore, the mandatory conversion term gives the right to a company to force investors to convert their shares in the event of an IPO with a pre-negotiated size and price. In order to prevent future dilutive financing, many convertible preferred stocks contain an anti-dilution provision which functions as an automatic adjustment of the conversion ratio (ratio of common shares delivered for each convertible preferred stock).
The structure of convertible preferred stocks raises many concerns for late-round investors who might not have sufficient time to exercise a profitable conversion. It was through this, that in the early 1990s participating convertible preferred stocks emerged. The rise of these new issues gave investors the right to receive the face value as well as the equity participation (as if the stocks were fully converted) in the event of liquidation of a company. This is beneficial for later stage investors and minority shareholders because they either participate in all of the upside or are fully reimbursed. However, such a safety net requires the equities to be priced at a premium.
By using these securities investors can achieve high returns, however it is crucial for them to protect their investments. The most common way to do so is through the use of covenants – agreements between the investor and the company. In turn, the investors can be heavily involved in the financial strategy, which allows them to monitor their investments and achieve high returns.
The covenants have two broader categories: positive and negative. Positive covenants include requirements such as paying taxes and producing reports. Negative covenants, on the other hand, are primarily used to restrict the potential destructive behavior of an entrepreneur. In most cases the super majority of the investors (i.e. greater than 50 percent) is required to approve such actions. Thus, covenants limit the managers from increasing the risk profile of the company. Moreover, a merger or sale of the company can also be confined because there is a reasonable possibility that such events introduce new management and implement a change of strategy. Furthermore, when the investor does not have super majority, covenants can be used to impose control in certain cases. These agreements explicitly specify the number of board members that a PE company can elect and, by extension, obviate any drastic changes through disaccord. In the worst case scenario, when the company does not accrete value to the investors, covenants can enforce mandatory redemption rights. This allows the investors to oblige the firm to repay the face value of the investment at any time. If there are insufficient funds available, the investors can demand an action to create a liquidity event.
All in all, the evolution of PE securities has endowed investors with greater influence over target companies, which guaranteed higher and more timely returns. In addition, the usage of various types of covenants ensure GPs that returns remain safe. As a result of these factors, PE continues to expand its horizon as well as adopt a wider view of the quality of assets in which to invest.
Editor: Eric Peghini
Authors: Balázs Gecse, András Nemesánszky, Kristóf Seres