Beware the Private Equity Trap


It sounds glib but not all forms of equity investment are equal. One particular example, already widely in use for many years, is an instrument portrayed as equity but behaving as a mixture of debt and equity; preference shares.  

Many (private equity) firms inject funding in this form and it behaves in the following manner. The preference shares rank ahead of ordinary equity in the sense that the first money that will be paid out of a sale will go to the preference shares holder, ahead of the ordinary equity holders. The ranking of distributions upon a sale is not a concern if things have gone well and there are sufficient funds for debt providers to get their money back and all equity holders to make a return. 

However, in cases where returns are less than 1x investment (excluding any interest), it is always the debt providers who are paid out first and the balance of proceeds then split among the equity holders. In the case of preference shares, these are paid out in their entirety before any of the other equity holders receive a penny. That’s the equity side of preference shares but in addition they also attract an interest rate (typically anywhere from 4% to 10% p.a) which the company is often required to service on a regular basis, usually monthly. This means it is debt which could well be in addition to any bank debt. Priority of debt servicing will usually always go to the bank first and there are many cases in which the interest repayment on the preference shares can be deferred but it ultimately will need to be paid. 

In good times, when trading is buoyant, many businesses may cope perfectly well with the cost of servicing their debt, including that carried in the preference shares. But in tougher trading environments – like now – many businesses will struggle to generate free cash flow given profits are siphoned off by onerous debt obligations.  

Other than the obvious, the practical implications of this is that the company can be deprived of sufficient working capital, particularly in cases when it is intending to reinvest. What results is an unhealthy environment where management feels trapped and view their effort as simply serving obligations to the bank and the private equity firm. Understandably, many management teams loathe situations like this but there may be little they can do – other than to seek re-finance or vote with their feet. Negotiation is usually the best way out of this as long as both sides remain pragmatic. 

The debt and financial structuring of an investment in the business can, without proper scrutiny and controls, leave management in a worse state than before – not making enough money to re-invest in the business and unable to raise more, or sell. 

Our business is to invest in mid-sized companies, and so we do not – and never will – inject equity in the form of preference shares. Debt is a valuable instrument when used judiciously and when everyone understands the rules of the game. We prefer to invest in businesses where we believe our operational experience will help the management team turn a company around or take it to the next level, allowing profits from the company to be re-invested and deliver growth. 

We call this “Entrepreneurial Investment”; investing in businesses on the basis of the value we help create by contributing with our own experience, expertise and skills. It is not just about money and, whilst everyone usually says this, not many can back it up with extensive operational expertise. Wheeling in a few non-execs or private equity professionals to the board does not qualify as operational expertise. We always work closely with management teams and want one another to succeed, which is also why we tend to give higher equity stakes to the managers of our portfolio businesses than is the industry norm. 

We are all living through difficult times and I understand one does not always have the benefit of being selective about the strings attached with new funding but it is always worth a closer look. We are a new class of investors having real operational knowledge with sufficient success and mettle to invest their own funds rather than those raised from third party sources by bankers and private equity professionals. In our own experience, this has made a huge difference in the performance of a company.

Rami Cassis
15th July 2020