When investment bankers look at quick and dirty enterprise value calculations, they generally think:
EV = Net Debt (Debt – Cash) + Equity
In corporate finance theory, enterprise value includes all levels of the capital stack including preferred shares (‘prefs”).
Preferred shares are securities that are senior to common equity and generally pay out a dividend at certain intervals as contractually outlined. Depending on the prospectus for the preferred shares, they may be perpetual capital (no maturity) with fixed dividends – although coupon/dividend provisions may vary. There may be a fixed coupon, a floating coupon (varies with an underlying interest rate), or rate reset coupon (fixed for certain periods of time based on a floating benchmark interest rate).
Are Preferred Shares Equity?
Now what are preferred shares? Depending on what is taught in accounting class, preferred equity is equity that ranks above shareholder’s equity. It is accounted for (usually) in the shareholder’s equity portion of Liabilities and Shareholder’s Equity section of the balance sheet or statement of financial position.
Preferred dividends are not tax deductible unlike interest on debt and can be eligible dividends for Canadian investors.
Dividends also can be deferred or not paid at all, provided that common shareholders that are subordinate to preferred shareholders in the capital stack are also not paid dividends during the same period. This is (without a waiver or an event of default) not possible with debt.
Preferred shares are also permanent capital (although they can often be taken out via redemption provisions by holders of preferred shares or called by the issuers) – debt generally is seen as less temporary capital than equity, with the longest term notes generally not exceeding 30 years (although there certainly are 40, 50, 100 and even perpetual bonds).
Preferred shares are also covered by the equity capital markets division of the investment bank.
Are Preferred Shares Debt?
Now from an investment banker’s perspective, and for what is theoretically in the interest of the company (the investment banker’s client) the only capital tranche that matters is common equity, or what is available to common shareholders. A company’s fiduciary duty is to the common shareholders, not the preferred shareholders.
Likewise, the net income line that equity analysts and stock investors care about is net income available to common shareholders – which is net income after preferred dividends.
Like debt, preferred shares do not get any upside from good financial performance in the underlying firm. The dividends are fixed, and the firm is never going to reward preferred shareholders with a dividend raise like common shareholders get. As such, investors in preferred shares already know what they are going to get paid on a best case basis with only downside from there (unless they are betting on interest rates with a rate reset or floating rate pref).
Preferred shares are sometimes considered debt by credit rating agencies if they exceed a certain % of the firm’s total capital. From their payment schedule and principal, they have debt like cash flows.
Although common shares technically have different classes with different voting rights (although not necessarily normal), common equity represents percentage ownership of a firm. Preferred shares for the same corporate can be in several different series (Series A preferred shares, Series C, Series E) – all of which have different characteristics such as dividend.
Preferred Shares in Equity Capital Markets
So are preferred shares debt or equity? The answer is that it is neither – it is a hybrid instrument with elements of both debt and equity (but not to be confused with hybrid debt, which is what investment bankers usually mean when they talk about “hybrids”).
So when and why do firms reach out to investment bankers to tap into the equity capital markets for preferred share issuance? Theoretically, debt is the cheapest cost of capital so companies should fund with debt when available – however, the cost of debt can go above the optimal cost of capital when the firm is too levered (and financial distress costs start to come into effect). The answer in practice is more nuanced.
Issuing Preferred Shares When Unable to Access Debt Capital Markets
For whatever reason, companies may be unable to access DCM or not want to. Issuing equity can be too punitive, especially if the company perceives its equity to be cheap (after a big fall in the stock price) and may not want to dilute existing shareholders. Prefs can be a happy medium in this instance.
Sometimes, debt capital markets are available but bond indentures (contracts) for the company’s outstanding bonds may not permit additional debt through their maintenance or incurrence covenants. Preferred shares can be a way around that and are treated as equity for the purposes of covenant calculation.
Debtholders generally consider preferred shares to be equity because of this key component – the dividend does not have to be paid, nor does it have to be redeemed. As such, if the preferred shares are contractually written to not be obligated to pay a dividend or mature unless with bondholder consent, this can be a great fix – especially if they count as equity for Debt/Capitalization covenant calculations.
Preferred Shares for Credit Rating Protection
Sometimes investment grade companies with ample access to capital markets have to fund an acquisition or capex program or take out/refinance existing debt. However, as a result of this corporate action they may be breaching credit thresholds for S&P and Moody’s if they were to issue all debt.
Credit rating agencies generally treat preferred shares as hybrids and will offer 50% debt and 50% equity treatment for the capital (and 50% treatment as interest and 50% treatment as dividend for any distributions) until they feel that the prefs become too big of a part of their capital structure.
Opportunistic/Cheap Cost of Capital with Preferred Shares
Now prefs are generally more expensive than debt (they are lower in the capital stack) and also are not advantaged by tax savings on interest. However, if there is enough demand for prefs, the rate can be very cheap without the more onerous obligations of debt.
The debt investing field is considered “smart money” while prefs and common equity is considered “dumb money”. Smart money is institutional money – how many of your friends do you know trade or hold individual bonds?
My experience on the buy side can assure you that there is plenty of dumb money in institutions, but I digress. Nonetheless, prefs are a favored vehicle for many retail (mom and pop) investors because of the high yields and corporates may see frothy demand (issue size is multiple times covered) at very attractive rates. A CFO or treasurer should opportunitstically issue prefs as a funding source if they can if this is the case.
Marketing Preferred Shares
As a sweetener for investors, preferred shares similar to debt can be loaded with various embedded options such as conversion options, payment-in-kind interest and equity warrants attached to the preferreds to entice investors to invest – possibly accepting a lower coupon for the options included.
So do not be surprised to see more structured products such as mandatory convertible preferred shares, floating PIK preferred shares and preferred shares with 50 cent warrants.
Interestingly, fees for underwriting preferred share issuances are in the middle between issuing debt and equity for the investment bankers.