Rising Interest in Preferred Equity: Opportunities Amid Market Uncertainty

In recent months, the investment landscape has seen a notable shift towards preferred equity as investors pursue higher yields amidst a challenging economic environment characterized by a scarcity of high-quality assets. Preferred equity, which includes preference shares in the UK and preferred interests in the US, has traditionally been utilized by private equity firms in buyout structures. However, it is increasingly recognized as an asset class in its own right, attracting a diverse range of investors, including private equity firms, private credit funds, and specialized investment vehicles.

According to Peter Banks, Partner at Allen & Overy in London, "The surge in interest for preferred equity instruments can be attributed to their debt-like features, such as fixed or floating dividend rates, which offer higher returns compared to traditional debt securities. These instruments also provide governance rights and distribution waterfalls, which prioritize claims on assets and earnings, thereby offering some downside risk protection."

The increasing appeal of preferred equity can be traced back to various factors, including economic and geopolitical uncertainties that have led to a decrease in the availability of quality assets. This trend has resulted in heightened competition among credit funds, pushing sponsors to diversify their offerings to attract fresh investments. As stated by Kfir Abutbul, Partner at Allen & Overy in New York, "For investment-grade issuers that cannot take on more debt without jeopardizing their credit rating, preferred equity serves as an effective capital injection option, incentivizing existing shareholders to participate."

Preferred equity can be issued in various contexts, such as to facilitate M&A transactions, provide liquidity to current shareholders, or finance new joint ventures. The terms surrounding these securities are often heavily negotiated, reflecting the associated risk levels. Factors such as transferability and investment grade obligations are crucial in defining typical preferred security terms.

In the current market, there is a notable increase in preferred equity linked to debt offered by credit funds, especially in large acquisition financings across the US and Europe. This trend is particularly pronounced in situations involving 'fallen angel' investments and special situations, which further explains the growing interest from investors globally. According to Karen McMaster, Partner at Allen & Overy in London, "In emerging markets, private equity sponsors and sovereign wealth funds are shifting from traditional growth equity investments to preferred equity structures that resemble loan-style financing due to persistent macroeconomic challenges."

The ongoing popularity of preferred equity highlights the need for investors to carefully structure these instruments to ensure they are classified as equity by ratings agencies, as excessive debt-like features could lead to downgrades. Furthermore, exit strategies have become a focal point in negotiations, with investors often seeking 'drag' rights that allow them to initiate a sale process if their stake is not redeemed by a predetermined date.

As preferred equity continues to gain traction, it is essential for investors to remain informed about the evolving dynamics and to negotiate terms that align with their risk tolerance and investment goals. The implications of this trend extend beyond individual investors, as it reflects broader shifts in market behavior and investment strategies in response to economic pressures and uncertainties.