Establishing Your Position in the Capital Structure
Downside risk has always been inherent to the structured equity and growth markets. To mitigate the risk, structured equity and growth investors traditionally avoid using ordinary (common) equity and instead rely on other legal instruments. These alternative instruments are not as commonly used by mainstream private equity teams, but they can be useful to them at times when risk pervades the entire market. We have provided the following “menu” of available options, from the most junior instrument in the capital structure to the most senior, with a view to helping private equity investors balance the risks and rewards of their investments.
- Preferred Equity: Preferred equity, which is senior to ordinary shares but junior to all debt instruments, is the traditional way of making growth investments. Preferred equity comes in two principal flavors: “participating preferred” (for which, upon a “liquidation event”, the relevant equity investor is entitled to its preference amount plus the amount that the equity investor would have received as an ordinary shareholder), and “non-participating preferred” (for which the equity investor is entitled to the higher of its preference amount or the amount it would have received as an ordinary shareholder). Many other varieties of preferred equity exist, including preferences with a multiple (where the investor is entitled to recover a multiple of its original investment), capped preferences, and “pari passu” preferences (pari passu with other preferred equity instruments, as opposed to senior to other preferred). In recent years, the market standard for growth investments in competitive processes has been a 1x non-participating senior preference, but with a change in the market toward more investor-friendly terms because of increased liquidity demands, we expect to see more “participating” shares, similar to the instruments used after the last financial crisis. We may also see a renewed focus on preferred dividends (payable in kind during the life of the investment or at least until the cash flow situation of the company stabilizes) as a way of bridging valuation gaps between companies expecting to receive the “price of yesterday” and new equity investors expecting to pay a discounted price.
- Convertible Loans: Convertible debt is junior to senior secured debt and trade debt, but senior to all equity, including preferred equity. Historically, growth investors have used convertible loans to provide bridge liquidity to companies until their next financing round (usually defined as a “Qualified Financing Round”), allowing the parties to defer valuation negotiations until the next equity raise. In the current market, where valuations are in flux, we expect convertible loans to be widely used and popular as they allow companies to access the liquidity they need while deferring valuation discussions. Convertible loans are typically unsecured and come in different forms, depending on their interest rates, the type of interest payment (cash, pay-in-kind, PIK toggle, pay-if-you-can etc.), repayment provisions, the definition of “Qualified Financing Round” that triggers a conversion into equity, the conversion price and discounts, and the shares into which they convert (which can be senior to all equity, or pari passu with the equity issued in the “Qualified Financing Round”). Particularly in challenging times, we expect the conversion price to be a focus issue, with investors insisting on large discounts to the price used in the “Qualified Financing Round”, and on caps on the conversion price.
- Holdco PIK Debt (+ Warrants): Alongside convertible debt, “Holdco PIK” debt sits in a deeply structurally subordinated position in the capital structure, being junior to senior secured debt but senior to equity, including preferred equity. Holdco PIK debt is often used in situations where it is not possible to incur additional leverage at more senior levels of the capital structure. In times of financial stress, this deeply subordinated position may be the most senior position in which it is possible to inject funds without breaching the terms of prior-ranking debt instruments. Holdco PIK debt is typically unsecured (although occasionally a share pledge may be granted) and does not benefit from cash-pay interest during its life, with interest capitalizing over the life of the investment. Structured equity investors also commonly ask to invest in warrants alongside their Holdco PIK debt to capture a larger share of the upside.
- Second Lien Debt and Senior Secured Debt: Second lien debt and senior secured debt would typically be provided by banks or specialist debt funds, rather than mainstream private equity or growth funds. Senior secured debt is typically the prime-ranking element of any capital structure, ranking ahead of all creditors and investors other than any super senior debt that may be present (typically where rescue financing has previously been provided, or a revolving credit facility has been provided on a super senior basis). Second lien debt is close to senior secured debt in terms of character and terms, often replicating the covenants and other provisions of the senior debt documents and benefiting from the same security package, but ranking behind senior secured debt, having additional headroom included on financial covenants and being subjected to limitations/standstill periods when taking enforcement action. To the extent that the senior secured debt documents permit additional debt incurrence at the second lien tier of the capital structure, second lien debt may present an opportunity to inject additional capital into the structure on a secured (albeit subordinated) basis.
- Super Senior Rescue Financing: In situations of severe financial distress where the various stakeholders are negotiating a consensual restructuring but the borrower is facing an immediate liquidity crisis, it may be possible to obtain consent from sufficient senior lenders to enable an injection of short-term rescue financing into the capital structure on a super senior basis to bridge short-term liquidity needs. In such circumstances, the debt will be advanced on bespoke, highly restrictive terms tailored to the relevant circumstances and capital structure on a first-ranking basis ahead of existing senior debt. The provision of such debt is rarely viewed as a standalone investment opportunity and is more likely to form a part of a broader strategy with respect to the financial restructuring of a distressed asset.
Maintaining Your Position and Preserving Your Upside
As a private equity investor, establishing your position in the capital structure is only the first step: Once it is established, how do you ensure that you not only maintain your position during the life of your investment but also preserve your upside? In their equity or quasi-equity investments, structured and growth funds routinely use a combination of strategies that other private equity investors can emulate.
- Anti-dilution and Veto Rights: The most basic and common way for an equity or quasi-equity investor to preserve its upside and avoid dilution is to include pre-emptive rights in the shareholder agreement, allowing the investor to participate in further issuances of securities pro rata.
Pre-emptive rights are an imperfect tool, however, in that they require the investor to inject more money at the price determined by the company at a given time. In addition, pre-emptive rights provide only limited protection against further issuances of senior instruments, exposing the investor to the risk of falling behind in the capital structure. This is why structured equity and growth funds routinely seek additional protections, including (i) veto rights on further equity raises that are at a lower price than the price paid by the equity investor, (ii) veto rights on further issuances of senior or pari passu instruments, including debt instruments, and (iii) “weighted average” or, less often, “full ratchet” anti-dilution protections, which work by adjusting the conversion ratio of preferred shares to take into account the price of new shares issued in a later capital raise.
- Minimum Return on Exit: To preserve its upside, an equity or quasi-equity investor would be well advised to include minimum return provisions in the shareholder agreement, preventing an IPO or a full sale of the business unless the investor receives a multiple of its original investment. These minimum return provisions are often seen as “blocking rights” on IPOs and drag-along provisions, which can make them unappealing to the founders and other incumbent shareholders of the company. This is why structured equity and growth funds have recently been including “ratchet” provisions, allowing the founders and other incumbent shareholders to bypass an investor’s blocking rights, so long as the investor is made whole and receives its minimum return in the form of additional shares (in the case of an exit through an IPO) or a disproportionate share of the exit proceeds (in the case of a sale of the business). A new equity investor would also try to ensure that incumbent shareholders do not benefit from minimum return rights or blocking rights that would jeopardize the new investor’s exit strategy, and would typically request a “governance clean-up” as part of its investment.
- Redemption, Exit Demand Rights and Put Rights: To preserve its economic position, an equity or quasi-equity investor would also be well advised to ask for a right to request an exit (either on its own, or together with other investors that have the same investment horizon). This right can take many forms, including (i) an exit demand right, entitling the investor to force a sale or IPO process of the company, (ii) a redemption right, allowing the investor to force the company to buy back, or “redeem”, its shares, or (iii) a put right, allowing the investor to force certain of the other shareholders to buy its shares at a pre-defined price in certain circumstances. While exit demand rights have remained a common feature of growth markets over the years, redemption or put rights have been much less prevalent. This situation may change in a downturn, with investors focusing more closely on their ability to take their money out and exit their investments. To ensure that they are effective, redemption rights should be coupled with “refinancing demand rights” (allowing the investor to take the reins in a refinancing, to ensure that the company has enough cash available to redeem the investor’s shares) or broader “springing governance rights” (allowing the investor to appoint additional members of the board or to replace managers if the company underperforms or breaches certain covenants).
This is a short, simplified and non-exhaustive list. In practice, the legal instruments that private equity investors use are driven by a range of factors, including the company’s pre-existing capital structure and shareholder arrangements, the relevant jurisdiction and tax considerations. If you have questions about how to structure a capital injection or you have questions about this article, please contact the Sidley lawyer with whom you usually work or any member of our European Private Equity team.