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Shubham Saharan

Companies saddled with too much debt — including the likes of Radiology Partners and Equinox — are increasingly turning to preferred equity to provide more breathing room.

Pref equity investments have been popular for some time with early-stage venture capital focused investors and select distressed credits. Now, use of the instrument is becoming more prevalent amid upheaval in leveraged finance markets.

Investors that have the ability to do prefs have plenty of dry powder and are willing to take on more risk to get higher returns, and there are plenty of struggling companies that can make use of this capital to right-size their capital structures, bankers and investors told 9fin.

Use-cases range from: riskier companies hoping to extend their lifelines; existing shareholders seeking liquidity; lenders wanting to de-risk their positions via a subordinate capital injection; and healthier companies trying to push deals across the finish line in tough market conditions.

"There has been a lot of calls for [preferred equity injections] going on for nine months,” said Ray Costa, a managing director at Benefit Street Partners, in an interview with 9fin. “We've seen an increase across the board of people willing to look for that type of solution if there's a story for the equity."

The introduction of preferred equity onto a balance sheet is often pitched as a win-win situation for borrowers and investors alike.

For providers of preferred equity, there are juicier returns compared with a regular debt investment. Investors can often push for bespoke terms such as a dividend enhancement, a forced sale process, or certain governance rights.

For borrowers, such instruments often don’t require cash interest payments (as coupons can be structured as payment-in-kind) and do not show up as debt on a company’s balance sheet, allowing them to pay down outstanding loans.

As a result, raising preferred equity can be a first step towards helping companies raise new debt at a lower interest rate — which may be necessary if the company is facing a liquidity crunch.

Preferred equity can also be structured to help improve credit ratings, for example by using perpetual maturities, or by converting junior debt into preferred equity.

"Preferred equity has evolved now to sit anywhere between the most senior debt to common equity,” said Augusto Sasso, managing director and global head of capital markets at Moelis. "We're coming across companies with maturity profiles looking out two years that need to be addressed, and there'll be more demand for hybrid capital, which can be customized to companies.”

Case in point: physician-owned medical imaging provider Radiology Partners recently agreed a debt extension deal that included $720m of preferred equity from existing sponsors and new investors, surpassing its initial goal of raising $300m of funding.

Preferred equity is especially appealing in this case because it doesn’t dilute the ownership stake of existing common shareholders, which include many of the company’s staff, said sources familiar with the situation.

Elsewhere, luxury gym chain Equinox is seeking around $400m in preferred equity — and getting good demand for it — in addition to a roughly $1.3bn new loan to address its upcoming maturities, as 9fin reported earlier this month.

Membership at the company’s gyms have yet to rebound to pre-pandemic levels, and the company is not generating strong enough earnings to cover its sizeable interest burden, according to a Moody’s note published in November.

“The scenarios in which preferred equity is needed have gotten bigger because of elements of distress, whether it’s upcoming maturities or liquidity [needs],” said Ryan Cox, a partner at Akin Gump, noting that there has been an uptick in pref activity over the past 12-18 months.

The stage is set for more stress across the leverage credit markets, whether public or private. According to Lincoln International’s data on prviate credit, for example, interest coverage ratios have dropped to a “slimmer than ever” figure of 1.07x.

This is likely to further boost demand among borrowers for preferred equity financing, sources said.

Cash to fund a preferred equity structure for a struggling company can either come from a private equity sponsor injecting its own capital, or from a third party — or both.

One situation that involved both putting the cash in was Consolidated Precision Products, in a deal that closed in December. Ares Management and CPP’s private equity owner Warburg Pincus provided $750m of preferred equity with a roughly 15% yield, while a group of direct lenders provided more than a $1bn loan, according to a Bloomberg report and 9fin sources.

Proceeds were intended to help the aerospace parts supplier extend its debt maturities and improve its liquidity position, sources said. Representatives at CPP and Warburg didn’t respond to requests for comment, and Ares declined to comment.

The long running saga of Finastra’s debt financing is another example of a sponsor putting in funds through a pref deal.

Vista Equity Partners opted to pump $1bn of preferred equity into the portfolio company to push a tricky debt refinancing over the finish line, which first explored the BSL option, before going to private credit lenders. Vista drew its capital from a NAV loan provided by Goldman Sachs, which is backed against the private equity firm’s portfolio of assets.

Ultimately, demand for such deals comes down to the sponsors and investors’ belief that the company will be able to grow into its debt stack.

Unlike debtholders, preferred equity holders do not have collateral to seize and cannot accelerate debt repayment in the event of a default. And in the case of a bankruptcy, preferred holders are behind creditors in the repayment line.

"It's really about how much conviction the sponsor has in the business," said one source at a large asset manager. “If you're not so sure, but you want to buy some time, you'll give up [equity] instead of dealing with a bankruptcy and a restructuring.”

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Pref equity gains steam as troubled credits seek respite

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