Convertible and Participating Preferred Security Modeling
So despite not having any real deal experience, you somehow manage to convince a handful of senior private equity people during on-cycle recruiting that you’re an excellent modeler.
You breathe a sigh of relief and calmly wait for two years to pass.
When you finally hit the desk, you realize you have no idea how to model preferred securities, which you soon learn is going to be an important part of your job in private equity. You were excited by the prospect of making several hundred thousand dollars at a top fund, but you didn't realize you'd have to know financial modeling.
This article is for you. And if you don't want to read, you can download the Excel breakdown of Convertible vs. Preferred securities here.
The Preferred Security is an important financing tool that blends elements of both debt and equity.
Preferred Securities sit above Common Equity but below Debt in a company’s capital structure. They tend to be popular in private equity because they can provide an attractive yield to the private equity firm without the management having to give up control of the business.
Preferred Securities typically pay dividends, which can either be in the form of cash or PIK interest.
Companies may choose to issue preferred securities because:
Less Dilution than Common Equity: Preferred securities typically dilute total equity ownership less than common equity. Only common shares have voting rights and direct ownership of the business.
Non-Cash Interest: Preferred securities generally have PIK (non-cash) interest, meaning there is no ongoing cash expense associated with them. Debt typically comes with cash interest. A fast growing or cash negative company may have difficulty issuing debt without a strong cash flow profile and may turn to preferred stock instead.
Get Around Covenants / Leverage Ratios: Preferred securities don’t always count as debt in the eyes of rating agencies. Many companies have strict covenants that prevent them from raising traditional debt above a certain level. Issuing preferred stock can be a creative way to avoid these covenants.
Investors may be attracted to preferred securities because:
Downside Protection: They offer greater downside protection than common equity because they issue dividends, are higher in the capital structure, and often have a “liquidation preference”. A liquidation preference means that the preferred stock may guarantee a certain level of return before any common equity is paid out. For example, if you have a 1.5x liquidation preference, you are guaranteed to get 1.5x before the common gets anything.
More Upside than Debt: Preferred securities are often convertible into common equity at a certain point (i.e. after a certain amount of time, above a certain dollar amount, or in the event of a company sale). This gives the investor the downside protection of debt and the upside of equity.
Perpetual: Unlike debt, preferred securities are typically perpetual, meaning that they do not expire after a certain time.
If you're interested in learning how to model convertible preferreds in more detail, you can check out our Private Equity Recruiting Course, which also includes detail on LBO models and case studies.
There are two main kinds of preferred securities: the Convertible Preferred and the Participating Preferred. They have relatively similar conversion mechanics.
If you invest in a Convertible Preferred, you can get EITHER 1) the converted value of the common shares OR 2) the preferred value of the security.
As the investor, you’re picking between the greater of two calculated values. This gives us downside protection as our minimum value is the preferred value, but we can still participate in the company’s upside via common equity.
The table below illustrates how this would play out across a range of exit proceeds. The free Excel is here. Exit proceeds refers to how much money we would receive in an exit situation. We use this terminology instead of "enterprise value" because we don't want to think about other debt instruments right now.
Assume we are making an investment of $100mm, which can convert into 25% of the total common equity. For simplicity, we assume no PIK interest. With preferred securities, it’s important to understand how received proceeds to the PE firm changes over the range of exit proceeds.
We can see that until we reach exit proceeds of $400mm, we would choose to take the preferred amount over the common. $400mm x 25% ownership = $100mm so it makes sense that this is the break-even point where both the Preferred and Common values are equivalent.
In a Participating Preferred, we receive BOTH 1) the converted value of common shares AND 2) the preferred value of the security. We get our downside protection and we also get to participate in the common equity value. Yes, it's a lot better.
All else being equal, this is going to result in a much higher value than a Convertible Preferred, because you’re getting BOTH values. If you hold all inputs the same (PIK rate, ownership %, investment amount), the Participating Preferred is going to be much more profitable than a Convertible Preferred.
Below, you can see a Participating Preferred across a range of exit proceeds. We invest at a $100mm preferred value that can also convert into 25% of common.
We get BOTH the $100mm of Participating Preferred value and 25% of whatever is left over from the common. We must deduct the preferred amount first because it is ahead of common equity in the capital structure. At $400mm of exit proceeds, we're getting the full $100mm of preferred value and 25% of the common equity for a total of $175mm in proceeds. Again, way better.
Comparing Convertible, Participating and Common Equity
It’s a typical exercise in private equity and investment banking to chart the potential proceeds of an investment across a range of exit values. These preferred securities and structured securities in general behave differently across different exit values, and it can be most helpful to actually chart it out. In contrast, vanilla common equity just accumulates proceeds in a straight line.
Below, let’s compare the investment of a Participating Preferred with Convertible Preferred and with Common Equity. As in the previous examples, assume we invest at a $100mm preferred value, are entitled to receive 25% ownership, and have no PIK rate.
We can see that at the lower amount of exit proceeds (<$100mm), the Preferreds accrue at a much higher value. This is the downside protection of these securities. Thereafter, the Participating Preferred continues to increase in value at the same slope of the Common, because it is getting the ENTIRE downside protection, plus all of the upside.
Participating Preferred Can Result in Higher Valuation
In practice, if a company were debating whether to issue a Convertible or Participating, they would likely issue the Participating with a lower ownership % so the resulting proceeds to both securities would be similar. You can see from our graph that the Participating is way better as is, so you'd have to reduce the ownership % quite a bit to make them more even.
Because Participating Preferred securities are typically given lower ownership %s, they then result in a higher implied equity value. Valuation, particularly for private companies, is often estimated as "Equity Investment / Ownership %", so a lower ownership % results in a higher valuation. This can be a strategy to juice the sticker price of an asset in the public eye. It also serves as a reminder that high valuations can sometimes just be flimsy house of cards, propped up by exotic securities.
Lastly, again note that most preferred securities will typically carry some form of PIK rate, which accrues over time. That means in order to compare the attractiveness of different securities, you would have to chart at different points in time. PIK rates increase the preferred value over time.