Clifford Chance

MC

Hello and welcome to today's podcast where we're going to be speaking to you about hybrid capital solutions. My name is Melissa Coakley, and I'm a partner in the restructuring team here in London. And I'm joined today by my partner, Neil Evans and my partner, Matt Dunn, handing over to you, Neil and Matt to introduce yourselves please.

NE

Thanks, Melissa, I'm Neil Evans. I'm a partner in our private equity team in London. I've been seeing a lot of activity in the preferred equity space and I'm here today to explain my recent experience and why we're seeing this product in the market.

MD

Hi and I'm Matt Dunn. I work in the global financial markets practice and I'm going to talk about what we've seen on HoldCo debt on leverage and infrastructure finance transactions.

MC

And bringing it all together, I will add my views around downside risks for these particular instruments. So, jumping straight to it, Neil, if I can ask you what's driving the requirement in the market for alternative financing solutions, what have you been seeing?

NE

Thanks, Melissa, the reality is, if you said to me, you know, six months ago whether we'd be spending a lot of time talking to our clients and other contacts in the market about these types of financing solutions frankly, I would have been quite surprised and it's a really exciting area that we're working at the moment for a lot of innovation and really highly bespoke solutions. The key really is to develop a really good toolkit for approaching any of these financing solutions so that so that you know, whatever the scenario, we can absolutely optimise the terms for our clients. What's driving it though? I mean, a whole range of things really and Matt will talk about some of those in a minute, but I guess in like headline terms, a lot of the kind of traditional debt solutions that would be available to business owners just aren't available at the moment for reasons that everybody is aware of, equally the kind of the financial investor market is a bit clogged up, right and the availability of new equity to be put into these businesses is also severely limited and on top of that, right, other kind of normal corporate events that would get you some liquidity such as selling assets or divisions also not very attractive at the moment given the pricing environment, so actually all of these reasons together have created issues for people who own businesses, they're looking at it from the perspective of how do we raise this new finance, but also opportunities for investors to invest in these kind of creative financing solutions and the right opportunity to make a very healthy return and what's interesting in particular is a lot of market participants wear both hats they both own businesses which need these kind of alternative finance solutions, but they also see the opportunity in the investments.  So, they need to flip between the two.  So, Matt it would be good to understand what you've been seeing in the HoldCo debt marketplace.

MD

Sure, yeah as you say, different types of structures and different scenarios. So, you could have a different type of HoldCo debt at different points in their life cycle. So, you could have a private equity sponsor they've owned a business they're looking to exit, but they're not able to do so by way of a sale or an IPO and so a means of bridging those returns back to their LP's is raising HoldCo debt and upstreaming the proceeds to their limited partners. So, that's one use for HoldCo debt. You might also see it on a new acquisition where the nature of the target means that you can't apply as much debt to the target as you might intend, perhaps for regulatory reasons, if it's in a sector such as utilities or another regulated sector but there is an ability to service more debt and therefore, you can have HoldCo debt with no recourse to the target as a means of increasing the total leverage of the structure, so, as I say, different types of HoldCo debt for different times in an investment life cycle or different types of assets, Melissa anything to add?

MC

Yeah, so many of the same factors in the stressed space, obviously due to the market conditions and continued fear of a downturn, traditional bank lenders are perhaps slightly more reluctant to lend in the current climate and provide the kind of solutions that we would usually see. so HoldCo finance in particular is coming across my desk and into structures I'm working on within restructuring deals more and more. And that's broadly driven by the same factors that both, Neil and Matt talked about Balance sheet and deleveraging considerations but we're also seeing it more and more being used as an emergency liquidity tool for sponsors to put money in and essentially buy some more time to try to fix troubled capital structures. Moving on, shall we focus on the specifics of the alternative financing solutions that we're seeing in the market starting with preferred equity.  Neil, shall I hand over to you to sort of go through some of the fundamentals?

NE

Yeah, thanks, Melissa, listen, I think when people think about preferred equity, most investors certainly within the kind of private equity community think about either kind of frankly a kind of tranche of shares to give you a bit of downside protection on any investment or failing that, perhaps in a kind of growth equity context where perhaps you've taken some convertible preferred shares in either a you know an early stage or maybe late stage growth company which enable you to have downside protection, but also kind of plug into the equity upside of that company as well, whereas this product, when we're talking about preferred equity at the moment, it's really a credit investment on the cash flows of the issuer.  So, just by way of example, it's very rare that in these instruments at the moment we're seeing the preferred equity have a conversion feature so that it converts to ordinary equity. Much more common if an investor wishes to plug into the equity story of the issuer then it will either take a slice of ordinary shares, or perhaps more commonly, at the moment we're seeing warrants issued alongside the preferred equity.

Really the key point though on this new type of preferred equity, which as I mentioned is a credit investment principally, is that investors need to get their head around the idea that the product really must be equity for accounting purposes.

A lot of the debt features that investors are used to in credit products simply aren't available.  Now, that's not to say that they should feel uncomfortable with the product, but I would say that a deeper understanding of the sector in which the issuer operates and its business perhaps comes more into focus than it would for a normal credit investment.

MC

That might be a good time to segue into what are the potential downside risks of this product. So, obviously it's an incredibly attractive product, very useful in various scenarios, but it's always good to think about what could be the impact if things don't necessarily go to plan. So, clearly any equity investment is potentially at risk if the underlying business becomes distressed because as we all know, in the worse case scenario of insolvency, debt is repaid before equity and this means to state the obvious that attractive preferred equity features like preferred dividends, liquidation preference or conversion rights are only relevant to the extent value actually remains in the HoldCo equity.  So, what are the key risks?  I mean, putting it simply, these arise primarily from the structural subordination factors. If the distress is really fundamental, there are scenarios where preferred equity holders can be left out in the cold if the business is close to insolvency and a restructuring deal is done at the OpCo level that involves a change in ownership or a material write down of liabilities across the capital structure, but clearly, however, the business will need to be in a pretty bad way for these types of scenarios to be on the table, but obviously as with any structurally subordinated product, that's something that investors need to be aware of.  So, we've talked about preferred equity, let's talk about HoldCo debt and some of the distinguishing features HoldCo debt hasMatt, can I hand over to you please?

MD

Yeah, sure there are different types of HoldCo debt, you can have the traditional high yield notes, which is structurally subordinated, but still has some second ranking recourse into an OpCo group where there are also senior secured creditors or you know the more true HoldCo debt where there's no recourse to a target operating group and interest may not be cash pay but may payment in kind, (PIK)  and there's an ability to toggle between cash and PIK interest and there are some similarities with the preferred equity product and some differences.  So, in terms of the similarities, if you're a creditor, you want to try and fix the group structure and make sure there's no scope for what we call layering. So, no scope for other creditors to come in ahead of you in the capital structure as it exists at inception and you'll also likely want to try and control additional debt incurrence, security and fundamental transactions like acquisitions and disposals and mergers happening below the level of the HoldCo debt in the structure, because that can be diluted or reduce likely recoveries for the HoldCo debt creditors and then there are some differences with the preferred equity product. So HoldCo debt will have a fixed maturity, it, will have security and therefore, it is a traditional debt product and those features are not necessarily always available for preferred equity because of the requirement to seek equity accounting and you might also have maintenance financial covenants, so some early warning sign on underperformance of the business and potentially a seat at the table in an event of default. So those are differences that make the HoldCo debt product more familiar to traditional credit investors.

NE

Yeah, it's interesting Matt, one of the questions we get most commonly when talking to clients about these various hybrid products is why to consider preferred equity ahead of Holdco debt, given the advantages that you just described. The way I would explain it is as follows;  the preferred equity has a much more significant return than the HoldCo debt, and that's the key commercial driver here.  The pricing of the preferred equitywe are seeing is an upfront fee at around 1% coupled with a coupon that compounds.  The coupon in most instances we're seeing it in the range of 14% to 16%, subject to step ups., however,during the course of the investment, which can be triggered by a whole range of factors and again just kind of plays into this point we were making that these products are very highly bespoke and the step ups of the coupon are really key parts of that.

Together with that on redemption of the preferred repayment, there's usually some kind of MOIC ("Multiple on Invested Capital") hurdle to be satisfied, regardless of the coupon, so really the return can be very attractive.  The preferred equity obviously ranks higher than other classes of equity securities of the issuer.  There's no conversion right as we discussed before.  There's some good negotiations we had around governance rights, not really in relation to the operations of the company on a day-to-day basis, but really, to kind of provide some fundamental economic protections.

There really are a number of bespoke features that can be included within a preferred equity product which are very worthy of discussion in more detail.

MC

This is probably a good juncture again to go back to the gloomy side and talk about what the downsides are with HoldCo debt and what investors need to be aware of should things again not go to plan. So similar to preferred equity, HoldCo debt is structurally subordinated, so will be less in the driving seat in the distress situation compared to senior lenders who have lent, much, much closer to the assets. Typically, lenders under HoldCo facilities can only accelerate under and upon a cross acceleration triggered by an OpCo payment default or an insolvency event, and because there tends to be no intercreditor arrangements in place in relation to HoldCo debt, it means that the usual embedded intercreditor value protections, vis a vis steps that the OpCo lenders can take to recover their debt, to try to protect any surplus recoveries for the benefit of the HoldCo lenders are not typically there.  There are some scenarios where HoldCo lenders can have more of a seat at the table e.g. if the HoldCo equity pledge has being granted and the group needs to avoid a change of control in the near term, but generally in a distress situation in much the same way as for preferred equity HoldCo lenders can be vulnerable to being left behind if the lenders at the OpCo level, decide to use restructuring or enforcement or insolvency solutions to try to take over the business.

So, to recap, we've covered the need for hybrid capital solutions and what's driving this in the current market conditions. We've also been through the key features of both products, before we conclude, Matt, Neil, are there any further key thoughts that you would like to overlay?

MD

Thanks, Melissa one point, I'd make is that for HoldCo debt preferred equity, there are no standard terms across the whole range of transactions we see, they're always highly negotiated and bespoke to the particular situation we are looking at, so depending on whether it's distressed or not, depending what the sector is and who the parties involved are and what they're trying to achieve. So, we may see more use in certain sectors, such as real estate or infrastructure, but by no means are the terms common in different sectors and everything is up for negotiation and that's what we've seen and we'd like to share here.

NE

Yeah, one thing I'd really like to share with anyone listening to this podcast is that we've picked up a lot of experience in the last few months with a lot of transactions involving HoldCo debt and preferred equity. Some pretty high profile in the market and the interest from the investor community has been huge. The reaction to listening to what we have to say has been really noteworthy, and that ranges across sovereign wealth funds, Hedge Funds, private equity and as a result, you know we've produced a really quite in-depth PowerPoint presentation, which among other things has some really great comparison tables showing the differences between different types of equity, different types of debt and also comparing the different features of these hybrid capital products we've been talking about today, so to the extent anybody is interested in hearing any more of that, please get in touch, we'd be delighted to share our presentation and also key learnings from all this experience we've obtained in the past few months.

MC

Thank you for listening. That's a wrap.