structured preferred equity: documentation, protective
TRANSCRIPT
Structured Preferred Equity: Documentation, Protective Covenants, Tax Treatment, Use in Debt Restructuring
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WEDNESDAY, SEPTEMBER 22, 2021
Presenting a live 90-minute webinar with interactive Q&A
Stephen A. Boyko, Partner, Proskauer Rose, LLP, Boston & New York
David M. Hillman, Partner, Proskauer Rose, LLP, New York
Steven M. Peck, Partner, Proskauer Rose, LLP, Boston
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Structured Preferred Equity: Documentation,
Protective Covenants, Tax Treatment, Use in
Debt Restructuring
Presented by Steve Peck, Steve Boyko and David Hillman of Proskauer Rose, LLP
September 22, 2021
What is Structured Preferred Equity?
• Many names: Preferred Equity; Structured Preferred; Structured Capital
• “Lengthens” the capital structure
• Extends debt financing model to equity side of capital structure
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Structured Preferred Is Here to Stay
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Structured Capital at Proskauer
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Visit: www.proskauer.com/practices/structured-capital
Trends
Why a Market for Structured Preferred Equity?
• Alternative capital providers looking to deploy dry powder
‒ Senior lenders are stretching; pushes the entry point for subordinated capital lower in the
capital structure
‒ Investor and Issuer demand for new product category
• Bridging valuation gaps
‒ High target prices create a hole in the capital structure between funded debt and sponsor
equity
• U.S and international banking regulations
‒ Regulations incentivize banks to lend to companies with lower debt/EBITDA ratios
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Trends (Cont’d)
How Structured Preferred Equity Is Being Utilized
• Buyout financing
• Add-on acquisition financing
• Dividend financing
• Debt reduction / balance sheet management
• PIPE investments
• Debt-for-equity exchanges
• Restructuring workouts
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Trends (Cont’d)
Advantages of Structured Preferred Equity
• For Investors:
‒ Debt-like investment thesis
‒ Higher yield opportunity
‒ Ability to invest in multiple levels of a capital structure
‒ Investments can be coupled with common upside via warrants
‒ Flexible terms – generally remains a bespoke investment
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Trends (Cont’d)
Advantages of Structured Preferred Equity
• For Sponsors/Issuers:
‒ Allows higher leverage (generally treated like equity for covenant, accounting and ratings
agency purposes)
‒ Committed equity financing at signing of acquisitions
‒ Lower cost of capital than traditional equity (in upside scenarios)
‒ Governance rights can be more permissive than large traditional equity investments, and
protective provisions are typically more flexible than debt
‒ Investors have equity holder rights, not creditor rights (can’t foreclose, get a judgment for
payment, etc.)
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Key Features and Terms
• Economics
• Maturity / Exit
• Covenant Package
‒ Senior Equity protections
‒ Debt covenants
‒ Other
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Key Features and Terms (Cont’d)
Economics
• Preferred return
‒ Fixed rate or floating
‒ Often accruing (PIK), but can be bifurcated into cash pay and accruing
‒ Company typically retains cash pay option
• Optionally redeemable by issuer
• Call protection
• No participation with common equity (but investment may include common equity
warrants or quasi common equity upside)
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Key Features and Terms (Cont’d)
Maturity / Exit
• No fixed maturity (i.e. security is “perpetual”)
‒ Having a fixed maturity date or a redemption date tied to senior debt’s maturity may have
impact on equity treatment for covenant, accounting and rating agency purposes
• Alternative approaches to exit in lieu of fixed maturity
‒ Economic incentives to be “optionally” redeemed
o Preferred rate increases after a specified date (e.g. 6 years after issuance), with additional
increases each subsequent year
o Toggle to all cash pay dividend (failure to pay would trigger additional default-based rate
increases)
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Key Features and Terms (Cont’d)
Maturity / Exit (Cont’d)
• Alternative approaches to exit in lieu of fixed maturity (cont’d)
‒ Mandatory redemption triggers
o Upon liquidation or bankruptcy
o Upon change of control or IPO
o (Occasionally) Upon cross-default or cross-acceleration of company debt
o (Occasionally) Upon un-remedied breaches of significant covenants
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Key Features and Terms (Cont’d)
Maturity / Exit (Cont’d)
• Alternative approaches to exit in lieu of fixed maturity (cont’d)
‒ Forced sale right - right to demand sale of company or IPO after a specified date (often 6-10
years after issuance)
‒ Drag right - right to drag all shareholders in sale transaction after a specified date (often 6-10
years after issuance)
‒ Right to take over board control
o If sale/IPO is not consummated after forced sale demand (i.e. within a 6-12 month window)
o (Occasionally) After a specified date, typically equal to or outside of the forced sale right
trigger
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Key Features and Terms (Cont’d)
Covenant Package
• “Senior equity” protections
‒ Restrictions on senior / pari equity
o Sometimes additional pari equity permitted subject to total leverage test and ROFO
‒ Passive holding company covenant
‒ Protections against “leakage” (to ensure true seniority over common)
o No dividends to junior equity
o No redemptions of junior equity (limited exception for management buybacks)
o Limitations on restricted payments
o Limitations on transactions with affiliates (limited exception for management agreement in
sponsor-backed issuers)
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Key Features and Terms (Cont’d)
Covenant Package (Cont’d)
• “Debt-like” covenants
‒ Tracks or incorporates some or all of the covenant package from the company’s most junior
debt security, typically with an additional cushion
‒ Standalone incurrence test
o Typically based on closing date leverage with a cushion
o Limited carve outs (revolver draws, for example)
‒ Common deviations from debt covenant package:
o Maintenance tests are rare
o (Occasionally) No issuance/sale of subsidiary stock
o No guarantor structure (no security interests)
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Key Features and Terms (Cont’d)
Covenant Package (Cont’d)
• Other covenants
‒ Limitations on asset sales
o Repayment/reinvestment rights similar to debt instruments
‒ (Occasionally) Limitations on mergers and other consolidations/restructurings
‒ Information/Reporting rights
o Often includes lender packages and (occasionally) board packages
o (Occasionally) Board observer rights
‒ (Occasionally) Consent over voluntary bankruptcy
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Implementation
• Commitment Letter – “Signing”
‒ Attaches a term sheet with key legal terms; depending on timing sometimes attaches full form
documentation
‒ Fewer “precedent documents” to refer to in commitment papers given relative immaturity of
this market
• Closing Documents
‒ Purchase Agreement
‒ Certificate of Designations (DE Corp.)
o Legally an amendment to the certificate of incorporation
o Contains the economic and other important terms of the preferred equity security
‒ Stockholders Agreement
‒ A&R LLC Agreement (DE LLC)
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Equity v. Debt – Important Legal Distinctions
• Creditor vs. Equity Rights
• Statutory Limitations on Payments
• Fiduciary Duties
• Ultra Vires or Contract Protections
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Equity v. Debt – Important Legal Distinctions (Cont’d)
Creditor vs. Equity Rights
• Preferred equity holders do not have a right to force bankruptcy
‒ Structurally subordinated to all creditors and all equity of subsidiaries
• Junior to all creditor claims
‒ Secured and unsecured
‒ Trade creditors, underfunded pensions, taxes, litigation, etc.
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Equity v. Debt – Important Legal Distinctions (Cont’d)
Statutory Limitations on Payments
• Payments to equity holders limited by statute
‒ Subject to solvency and “funds legally available” tests
‒ Directors may be personally liability for unlawful distributions or redemptions
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Equity v. Debt – Important Legal Distinctions (Cont’d)
Fiduciary Duties
• Board owes fiduciary duties to holders of preferred equity only to the extent their interests
overlap with holders of common.
‒ Hsu Living Trust v. ODN Holdings (2017)
o The board had duty to decide whether it was in the best interests of the common stock to
commit an “efficient breach” of the company’s obligation to the preferred and not take actions to
fund the redemption because doing so diminished the long-term upside potential of the
business
‒ In re Trados Inc. S’holder Litig. (2013)
o The board should have separately evaluated whether the sale was in the best interests of the
common stockholders even if rejecting the sale and continuing to struggle to try to improve the
business made it much less likely that the preferred would ultimately be paid off.
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Equity v. Debt – Important Legal Distinctions (Cont’d)
Ultra Vires
• As holder of preferred equity, may have claim of ultra vires rather than breach of contract
claim against issuer. But:
‒ Courts have held preferred stockholder covenants can, like contracts, be subject to “efficient
breach” if determined to be consistent with fiduciary duties to common equity
‒ Subsidiaries are not parties to documentation, so subsidiary board fiduciary duties trump issuer
covenants and ultra vires claims.
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Key Tax (U.S.) Concepts
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U.S. tax treatment of “preferred” as debt or equity Multiple factor test. Form of the transaction (i.e., calling it
equity) is important but many other factors are relevant.
Issuer’s determination controls withholding and reporting
unless documents agree otherwise.
Loan origination guideline compliance Debt: compliance with fund-level guidelines on origination
required.
Equity: often subject to different, limited and more
permissive fund-level guidelines.
Issuer deductions Debt: Interest generally deductible subject to a 30%
limitation on business interest (Tax Reform change).
Equity: Distributions generally not deductible by U.S.
issuers but dividends paid by pass-through issuers can
shift taxable income to preferred holders.
Dividends received deduction for U.S. corporate
holders
Debt: not available.
Equity: DRD from corporate domestic issuer, participation
exemption from foreign issuer. Many special rules for both
Key Tax Concepts (Cont’d)
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TAX ISSUE EQUITY TREATMENT DEBT TREATMENT
Corporate Issuer:
Holder Tax Treatment
Distributions generally treated as dividends, return of
capital or capital gain (in that order):
Non-U.S. Holder: 30% withholding on dividends
(including phantom dividends) unless reduced by treaty
or special exemption applies (example: SWF exemption)
U.S. Taxable Holder: If dividend is “QDI,” U.S.
individuals benefit from lower capital gains rate.
Some preferred equity terms can create phantom
dividends or trigger special rules for U.S. corporate
holders.
Distributions generally treated as interest:
Non-U.S. Holder: Generally eligible for 0%
withholding (“portfolio interest”) unless (i) linked
to issuer’s income / profits, (ii) holder is a bank,
or (iii) holder owns >10% voting stock.
If not portfolio interest, 30% withholding unless
reduced by treaty or special exemption.
U.S. Taxable Holder: Interest (including PIK
and OID) included on a current basis at full
ordinary rates.
“Flow-Through” Issuer:
Holder Tax Treatment
Income allocated to preferred equity holder whether or
not cash distributed. Tax distributions common but not
required as a matter of law.
Significant UBTI/ECI concerns for non-U.S. and tax-
exempt investors (including SWFs). Blocker/AIV
structure to mitigate adds complexity and drags
economics.
U.S. Tax Reform imposes potential withholding on
sales by non-U.S. holders.
Distributions generally treated as interest,
subject to same basic considerations as above,
except for portfolio interest the inquiry is whether
the holder owns >10% of capital and profits of
issuer (not tied to vote).
Preferred Equity as a Debt Restructuring Tool
Preferred equity is a flexible instrument to facilitate debt restructurings:
• Consideration for Lender Accommodations
‒ In lieu of cash fee
‒ Covenant light (customary equity protections only)
• Debt for Equity Swap to Right-Size the Balance Sheet In lieu of cash fee
‒ Terms often mirror those of debt exchanged
• Preferred Equity to Cede Control
‒ Economics and governance can “flip” to control upon the occurrence of specified events or
milestone failures
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Preferred Equity as a Debt Restructuring Tool
• Preferred Equity as Third Party Financing
‒ Rescue equity allocating rights between new and current equity
‒ Can be new investment from existing sponsor
• Golden Share
‒ Typically non-economic instrument providing governance rights
o Board rights
o Approval over specified actions
o Bankruptcy approval enforceable?
‒ Can be a “Flipping” Golden Share to address governance initially and economics/control upon
trigger events
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Preferred Equity as a Debt Restructuring Tool
Risks of owning both Preferred Equity and Debt
• Out of Court Restructurings:
‒ Lender liability claims
‒ Breach of fiduciary duty claims
• In Court Restructurings:
‒ Equitable Subordination
‒ Recharacterization
‒ Insider Status
‒ Credit Bidding – 363(k) (“for cause” limitation)
‒ No Per Se Prohibition
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Structured Preferred Equity: Documentation,
Protective Covenants, Tax Treatment, Use in
Debt Restructuring
Presented by Steve Peck, Steve Boyko and David Hillman of Proskauer Rose, LLP
September 22, 2021