A more debt-like instrument, such as preferred stock plus warrants, can be used to right-size a company’s leverage, while giving the capital provider downside mitigation over other equity owners.
This downside mitigation is based on the risk level of the provider’s capital—in other words, a higher position in the capital stack. For example, if the capital provider’s last-dollar loan-to-value ratio is 60% of a company’s total enterprise value, 40% of the value could erode from that business, but the capital provider would still get its last dollar out.
In a debt-like investment, most of the capital provider’s return comes from consistent preferred equity dividends, which tend to be higher than those for a more equity-like structured instrument. Meanwhile, the warrants offer some additional upside to the underlying preferred return if the long-term equity story for that business plays out.
This type of debt investment often saves the capital provider and the target company from having to agree on a valuation for the business. This helps facilitate transactions where valuation expectations between the two parties are not aligned.
Alternatively, a capital provider investing in a more equity-like instrument, like a convertible preferred, inherently believes that the underlying equity value of a business will grow materially over the long term. This equity-like investment would have a lower running cost of capital but would generate a higher amount of the overall return from the equity component.
This allows the capital provider to support the company’s growth strategy while participating in its share of the business’s profitability. These types of solutions tend to work well for a misunderstood, dislocated business, where the capital provider and the counterparty roughly agree on where the valuation lives. In other words, structured capital can reduce the market timing risk found in traditional private equity by offering a premium valuation in exchange for downside mitigation.