Preferred equity: Last in, first out

VC investors have deployed nearly $85 billion in China over the past six years. It remains to be seen how much of this money comes out, and how soon. Technology sector realizations since 2015 stand at $32 billion, according to AVCJ Research. A further $40 billion has come from IPO proceeds, but renminbi-denominated listings on mainland exchanges account for over one-third of the total raised and three-quarters of the offerings. And IPOs in every market have slowed in the last 12 months.

The ramp-up in the number of private funding rounds at progressively higher valuations – include growth-stage tech deals and the total invested reaches $165 billion – has left venture capital managers sitting on portfolios that look great on paper, yet many have delivered little or nothing in terms of exits. Those needing to show distributions in order to shore up future fundraising activity are exploring secondary solutions.

For funds that are too young for a full restructuring, two other options are beginning to appear on the menu in Asia: selling a strip off a portfolio into a vehicle backed by new investors, but often managed by the incumbent GP; and issuing preferred equity. In the latter case, incoming investors receive the lion’s share of all distributions from future exits until they have recouped their principal plus an agreed return, and also often enjoy a smaller portion of the equity returns thereafter.

“We’ve seen some strip sales in Asia, and these have highlighted the opportunity. What might start as a strip sale conversation flips to a preferred equity solution because there isn’t an alignment on price. With preferred equity, you are hiding a bit of the discount through the preferred return,” says Tim Flower, a managing director with HarbourVest Partners. “What you might end up with is a combination of preferred equity and standard secondary in order to get the desired return.”

While there is growing interest in preferred equity for VC, investors and advisors have yet to see it translate into actual deal flow. There are two reasons for this. First, these structures often become an option because investors refuse to underwrite a standard equity deal at the GP’s desired valuation – in other words, they are willing to bridge the pricing gap, but only if they get paid out first. This raises questions about the general reliability of valuations in China.

Second, even if an investor is comfortable that a current net asset value (NAV) of 3x cost can be realized, the rule of thumb for preferred equity is that it works best with diversified portfolios that generate predictable cash flows and have some visibility on exits. Only a reasonably mature VC fund would likely meet these criteria. VC funds often fall short.

“Right now, everyone in Asia is waiting for fourth quarter valuations. A big chunk of money has gone into China unicorns and it will be interesting to see how the valuations come out,” says Lucian Wu, a managing director with HQ Capital. “Given valuations have been going up and exits have been slow, securitization might be attractive, but the structuring only makes sense if you can underwrite some short-term exits. It all depends on the individual portfolio.”

Nascent market

Preferred equity is sufficiently established in the US and Europe that the likes of Whitehorse Capital and 17Capital can raise funds dedicated to the strategy. Immanuel Rubin, a partner with Campbell Lutyens, observes that these structures are frequently used to bridge valuation gaps. They can also help increase leverage on deals. A secondary investor acquires a portfolio and opts for preferred equity instead of bank financing because it often provides higher loan-to-value ratios (LTVs).

In a VC context, managers opt for this structure when, for example, a fund has run out of undrawn commitments and needs more runway to develop a portfolio. “You can raise a top-up fund, but maybe investors aren’t willing to provide new capital,” Rubin says. “Preferred equity provides an alternative source of new capital in such instances.”

Discussions in Asia are still largely confined to hypotheticals because recent transaction history is sparse. AVCJ has found evidence of just two preferred equity deals in the last two years, neither of them that large. In each case, extenuating circumstances made them a good fit for this structure.

In 2017, Olympus Capital Asia issued a preferred equity security to Canada Pension Plan Investment Board (CPPIB), specifically to take out existing debt. According to sources familiar with the situation, the debt comprised a note held by the Overseas Private Investment Corporation (OPIC), a US development finance institution that typically structures investments in debt rather than equity, and financing secured by Olympus against the portfolio to make distributions to LPs.

The second transaction concerned a fund raised by FengHe Fund Management under Singapore’s Global Investor Program (GIP). This scheme, which enables foreigners to apply for permanent residency in the city state if they invest at least S$2.5 million ($1.9 million) in a GIP fund, prompted a spate of fundraising activity by local managers. The investors are high net worth individuals whose top priority is not financial returns, so the structures are said to be looser than for typical PE funds.

Committed Advisors backed a GP-led restructuring of an earlier FengHe vehicle – a complex process that involved taking the offer to each of the high net worth LPs. When a similar opportunity came up with another fund, FengHe and Committed Advisors opted for a preferred equity structure instead. It allowed the GP to accept a secondary investment and make distributions without the protracted pain of dozens of individual negotiations. Committed Advisors declined to comment on the deals.

Preferred equity typically sits in a special purpose vehicle between the fund and the assets, or it can be wrapped around the assets synthetically and secured through a contract with the fund. If new equity were introduced at the fund level, modifications would have to be made to the limited partnership agreement (LPA). But avoiding that doesn’t mean LPs can be excluded from the decision – much rests on the wording of the LPA and how aggressively lawyers seek to interpret it.

“You have to look at borrowing limitations and there are some tricky issues around fiduciary duties and whether you disclosed to investors when they committed to the fund that you might engage in a transaction like that,” says Damien Jacobs, a partner at Kirkland & Ellis, who focuses on fund formation and secondary transactions. “It is not necessarily a silver bullet.”

Common ground

If consultation with the entire LP base is required, it might be enough to dissuade a GP from proceeding. Jacobs contrasts the approval process for preferred equity with that for a fund recapitalization, which involves asking the advisory board to clear a potential conflict of interest situation. “You are not putting a new document in front of the whole investor group and asking them to make amendments,” he observes.

Moreover, there is no guarantee that investors will respond favorably to preferred equity. Some see it as a mechanism that does nothing more than pay out a dividend by leveraging up their position, while the exits picture is unchanged. Others might not be philosophically opposed, but they are already receiving more than enough distributions from elsewhere in their private equity programs and are struggling to redeploy the capital.

“If a manager utilizes technology like preferred equity to create some liquidity, investors don’t necessarily welcome that. They prefer the portfolio to fully develop and exit,” says Rubin of Campbell Lutyens. “However, if the market changes and we are suddenly in a crisis, the number of trades might increase because liquidity becomes more important and returning money to investors is essential to getting them to recommit to a fund.”

It is also possible to find common ground by taking advantage of the flexibility offered by preferred equity. There are various scenarios whereby cash flows and sliced and diced to give certain investors preferential treatment in return for taking on a different level of risk. From a secondary investor’s perspective, it is often a question of how far they would shift from 100% priority in order to make a deal palatable to the GP and existing LPs. Valuations and path to exit are key considerations.            

Among GPs, greater familiarity with the secondaries market can help get deals done. But the amount of pressure they are under to deliver realizations – especially in the venture capital space – and a recognition of the impact structured solutions can make on headline performance might turn more of the current round of prospective discussions into real activity.

“Preferred equity helps you stop the clock, which is really important,” says Jason Sambanju, founder of Foundation Private Equity, who has seen several preferred equity deals proposed in Asia, notably in China and India. “You might give up some multiple but at least your IRR is preserved. In the ideal scenario, you do a sufficiently large piece of preferred equity that not only do you return capital, but you stop your preferred return clock completely.”

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Greater China
• GPs
• LPs
• Secondaries
• Portfolio management
• China
• Exit
• Venture
• HarbourVest Partners
• HQ Capital
• Campbell Lutyens
• Foundation Private Equity