The Use of Preferred Equity in Fund Finance

The current “higher for longer” interest rate environment has had a range of consequences for fund finance participants, including the increased focus by private equity sponsors and investors alike on stable and predictable returns and a more stagnant equity market for both private and public companies.

While this shift is likely driven by a combination of factors, it is apparent that the emergence of increased fixed-income yields has coincided with the reduction of traditional equity investing. One trend that has increased with the rise in rates is the use of preferred equity by private equity sponsors. Investors in search of stable returns have grown more comfortable with instruments that offer fixed-income characteristics, as opposed to traditional equity, and preferred equity offers investors the ability to retain some of the rights that they would otherwise have when holding traditional common equity, while holding an instrument that pays a fixed-income yield.

Toward the end of a traditional closed-end fund’s life cycle, investors are often eager to find liquidity and the options for a sponsor for late-stage financing are generally limited. Net Asset Value (NAV) financing has traditionally been the most common solution for private equity funds seeking to finance their portfolio holdings, but NAV financing is not always available. Likewise, funds have raised capital through secondary offerings and continuation funds, but these options typically require the existing investors to exit their stakes in whole or in part.

Given the increased rates and slower equity markets, preferred equity has emerged as a viable alternative source of capital. These issuances address liquidity needs for both private equity fund limited partners (LPs) and fund sponsors. Importantly, preferred equity issuances are also able to generate liquidity while minimizing disruption to existing capital structures and fund economics, without depending on third-party lending from a bank or third-party demand for fund interests.

Structuring and Use of Proceeds

Preferred equity is a hybrid financial instrument that provides the holder with a priority claim on an issuer’s distributions, up to a negotiated multiple of invested capital. It typically ranks between debt and common equity and often exhibits characteristics of both. For instance, a share may carry a fixed or hybrid coupon, be unsecured, and offer more favorable rights than common equity—such as governance rights or control over certain operational matters.

In the context of fund finance, private equity fund general partners (GPs) may issue preferred equity in various structures depending on their objectives. For example, (i) at the fund level, a GP may use the proceeds to make a distribution to existing LPs, allowing them to access liquidity without selling their interests, thereby maintaining exposure to the fund’s upside; and (ii) at the holding vehicle level (typically between the fund and one or more portfolio companies), preferred equity can be used for operational liquidity, deleveraging, or funding follow-on investments. The use of preferred equity may allow a GP to avoid or limit fund-level amendments and/or provide transaction flexibility, which is particularly valuable in today’s environment.

Furthermore, in some cases, preferred equity may serve as a valuable tool in the follow-on financing for one or more (but not all) portfolio companies, akin to a single-asset or limited-asset NAV loan facility. If the preferred equity is issued by a holding vehicle that sits above a smaller subset of portfolio companies, a GP is able to use leverage in a more limited capacity for targeted investments without impacting the entire fund or requiring consent from LPs that may not be affected.

Key Considerations

Despite its flexibility, the issuance of preferred equity raises several considerations, some of which are covered below.

• LP Consent: Issuances of preferred equity at the fund level often require the approval of existing LPs, and may trigger amendments to the fund’s limited partnership agreement. Provisions such as distribution waterfalls usually require supermajority consent, which may be difficult to secure—especially if existing LPs perceive the preferred equity as dilutive or unfavorable to their interests.
• Structural Flexibility: Preferred equity at the holding vehicle level may not require fund-level amendments, increasing transaction certainty. However, GPs must still assess whether such transactions could indirectly trigger provisions in the fund’s governing documents that require LP consent.
• Investor Base: If the issuance is offered to existing LPs, it may represent an attractive reinvestment opportunity. However, some LPs may hesitate to commit additional capital without immediate liquidity. If the issuance is offered to new investors, existing LPs may benefit from liquidity but face subordination in the distribution waterfall, reducing their claim on proceeds. This concern is particularly concerning in a lower-IRR environment and GPs are often required to manage investors and issuances accordingly.
• Preferred Terms and Rights: Preferred equity holders may negotiate enhanced rights, such as approval over “reserved matters” like asset sales, leverage thresholds, or M&A activity. In some cases, they may also receive board or observer seats. These rights can materially impact operations and reduce upside potential for common equity holders.
• Conflict of Interest: If the GP is not a purchaser of the preferred equity, typical GP-led secondary conflicts may be mitigated. However, introducing a preferred return can effectively raise the GP’s hurdle rate for carried interest, creating incentives to delay exits in search of higher valuations. Such conflicts should generally be disclosed, and any related-party provisions in the fund’s documents must be reviewed to determine whether additional approvals are required.

Conclusion

Preferred equity is gaining traction as a flexible, efficient alternative to traditional fund finance strategies. In an environment where equity financing is less attractive and debt provides a high coupon, preferred equity offers a middle ground for investors and sponsors—balancing liquidity needs with structural integrity.

As adoption continues, industry best practices and standardization may emerge, offering clearer frameworks for GPs and LPs alike. Given its adaptability across a range of use cases—from portfolio-level solutions to fund-level liquidity—preferred equity is likely to remain a valuable tool in the evolving fund finance landscape.