Posted on: June 30th, 2023
The saying, “if it walks like a duck and talks like a duck, it must be a duck” is helpful in illuminating when preferred stock is really mezzanine debt. Private equity firms invest in preferred stock and most structure it on a pari passu basis with any rollover equity. This means both parties have the same terms, preferences and rights. If the Private equity investor gets a 6% dividend, the rollover investor also gets a 6% dividend.
If the Company is sold, no party is senior to the other with respect to liquidation preference and realization of sale proceeds. Sometimes, debt oriented private equity firms propose a preferred stock structure where they are senior to the rollover equity with respect to dividend and return of capital. This means the investor gets their accrued dividend back and their principal back before the rollover equity investor gets any return. Any rolled over founder equity is junior to this security whether in a separate class of preferred stock or common equity.
Essentially, this investor preferred stock is senior to the other equity, with a contractual dividend income and redemption rights akin to mezzanine debt. Mezzanine debt is junior to the senior debt but always senior to the equity. In a mezzanine debt structure, the principal is always paid off before the equity holders get any return from a sale. Also, the interest payment, whether it is accrued or paid currently, is always paid before any cash goes to the equity holders. These preferred stock return mechanics have an erosive effect on the any junior rollover equity in several ways.
First, the dividend accrues every year and is added to the principal, giving the investor a contractual return regardless of the underlying equity creation. This means the company must pay off more principal at the time of exit, reducing the value for the other equity holders. This flies in the face of equity risk-return principles where the equity returns are driven by performance. Secondly, the need to pay all of the accumulated dividend and principal back first means they come first in getting out which can bleed the value of the other equity holders. Finally, when all investor equity is structured this way, it means the investors are likely more interested in getting their principal back than in funding the long-term growth of the company. Best to avoid preferred stock that quacks like mezzanine debt when picking your private equity partner.