Hybrid Capital: Structuring for Downside Protection and Upside Participation

Introduction

It is rumoured that the growth of hybrid capital into a core tool in the toolbox of sponsors and investors has been driven by debt lawyers, frustrated by years of the confining framework of the LMA, finally throwing off the shackles of their precedent documents and diving into the exciting world of equity transactions. However, at least based on our discussions with our finance colleagues, such rumours seem to be misguided. The real reasons for the growth of preferred equity and hybrid capital have been to allow for more nuanced solutions to the needs of investee companies, optimising capital structures by bridging the gap between traditional financing and equity structures.

Hybrid capital is not a stop-gap that will disappear; slower exits and contested valuations have made it a permanent part of the private capital toolkit. Consolidators are increasingly turning to preferred equity to fund acquisitions as high rates restrict traditional sources of funding. The instrument, however, is only as good as its plumbing, which is the theme that runs through the rest of this article.

As the fourth in our series, this article focuses on the UK and European markets. Stay tuned for how that differs in United States, and the similarities that span both.

The Hybrid Capital Spectrum

Hybrid capital covers the full range of investments between pure debt and pure ordinary equity (covering everything from mezzanine and PIK structures to convertible loans, to preferred ordinary equity structures) with the risk and return profiles for such instruments typically covering the same horizon (i.e., the closer the capital sits to a classic debt structure, the greater the investor protections and the lower the returns, and vice versa).

Hybrid capital is not a single instrument, and its returns come from a combination of protection and upside participation that neither private equity nor private credit typically delivers on its own. Preferred equity, the instrument most often mislabelled, is best understood not as debt in disguise but as equity enhanced through contractual priority and structured economic rights. It ranks ahead of ordinary equity and behind all indebtedness, delivering priority economics without creditor status. Where it sits also matters: the same right has very different value at operating company, holding company or fund level, and fund-level preferred is increasingly combined with NAV financing in back-leverage structures in which the NAV provider takes security over part of the preferred stake.

In addition, depending on the investee company in question, structural, regulatory and tax considerations (e.g., the need for a particular kind of capital treatment or to minimise debt on the company’s balance sheet), can guide the investment structure towards one kind of instrument or another.

All of this creates a melting pot of potential structures and outcomes which have resulted in an ever growing market for "structured equity" solutions which combine a wide variety of attributes across different instruments in order to provide truly tailored solutions to deal with these requirements and restrictions. As such, there is no one size fits all concept of hybrid instruments, But, as explained below, there are certain common threads and "non negotiables" which unite all of these instruments.

Key Characteristics

Downside protection

Given the understandable desire of the majority investors not to lose their capital, hybrid structures will inevitably contain a greater or lesser degree of downside protection via a set of mechanisms which work in combination. The baseline matters: outside debt-style instruments, a missed preferred distribution does not give the holder a right to accelerate or enforce, and without carefully negotiated remedies the investor may simply be along for the ride when a downside scenario unfolds. Often (but not always) these mechanisms will include the following:

• Financial covenants and step in rights: Whilst true finance-style security packages are less common outside of PIK and mezzanine structures, most hybrid structures will include financial covenants and step-in rights. Given the investor will inevitably be in a minority position and, potentially, a long way from the investee companies asset base the ability to monitor the investment, to see if things are going south and to step in at the appropriate time are crucial. As such, these rights are the iron fist inside the velvet glove of information and monitoring rights which will allow the hybrid investor to closely monitor any early warning signs and to engage in early dialogue with its investee company if things start to go awry.

  Given that hybrid capital will typically be sitting behind (at the very least) some form of senior secured financing and away from the operating group, ensuring the correct ‘plumbing’ of these rights is crucial. For example, the covenants will need to be set with a reasonable buffer over those in the senior financing (as trying to take the keys after the secured lender is generally considered ineffective), and step-in rights will need to work down through the group to ensure effective governance control upon exercise and the enforceability of these rights should be carefully tested on the way in.

  The increasing use of private capital as a means of allowing a route to liquidity for founders and non-institutional owners also means that step-in rights may be required in order to ensure liquidity, given that hybrid instruments will often not carry a fixed maturity date. Though these rights are heavily negotiated and bespoke, they will often include rights to require an exit or liquidity event and drag rights in order to ensure the liquidity event can be delivered within the hybrid investor’s expected investment period. These typically sit alongside issuer call rights after a non-call period, time- or event-based mandatory redemption, and redemption premiums that protect the investor’s yield on an early take-out.

• Liquidation preference: The preferred return to the investor will be some form of liquidation preference (which may be a money-on-money return, annual coupon, or both) which will sit ahead of the investee company’s ordinary equity/other classes of equity. Generally, unlike ratchet or upside-sharing mechanisms, these returns are not linked to performance, and returns will usually be cumulative and paid on the occurrence of a liquidity event in order to protect cashflow, rather than cash pay, though certain structures will contain elements of both. Once again, the liquidation preference does not stand alone, but will be protected via consent rights in favour of the hybrid investor (including, crucially, protections against layering, leverage incurrence, and asset-level hijinks which may undermine the liquidation preference), restrictions on distributions to ordinary equity, and a waterfall that preserves the priority as value moves through the structure. Investors should also remember that a preference designed only for a liquidation is designed for the scenario least likely to occur: in a restructuring, outcomes can differ materially from the contractual waterfall because preferred holders remain equity claimants.
• Anti-dilution protection: Anti-dilution protection can take various forms and will have greater or lesser significance depending on where in the spectrum the hybrid capital sits. Because preferred equity ranks behind all debt, it can be primed by new indebtedness and diluted by new preferred issued on equal terms, so anti-layering protection is core rather than optional. Where the investor is not in a protected preference position (where new money can only come in behind it without its consent), it would be expected to require pre-emption protection and potentially other anti-dilution protection to its economic position (e.g., through down-round protection or economic ring-fencing where capital needs to be injected due to underperformance etc.).
• Governance protections: Outside of step-in rights and similar ‘positive’ protections, hybrid investments will include an array of ‘negative’ consent rights against certain acts by the investee company. Regardless of cheque size, the "non-negotiable" rights which are common in all investments include protections against adverse changes to the economic rights attaching to the relevant instruments, adverse changes to the rights personal to the hybrid investor, protections against related-party transactions, and (subject to fiduciary outs) protections against the winding-up, liquidation, or similar by the investee company. Depending on the structure and size of the investment, other rights are common, including consent rights over debt incurrence, layering, M&A, amendments to constitutional documents, distributions to ordinary equity, and other non-ordinary course activities, together with information rights and, in some cases, board or observer seats. More recently, in the most bespoke structures, these rights also include additional protections over LME-type activities by investee companies.

Upside Participation

Often the trade off between the size of the coupon on an instrument and the suite of protections which it enjoys will be upside participation, allowing the holder to share in residual proceeds alongside ordinary equity holders (either via an equity kicker or co-investment). This can be achieved in a number of ways (e.g., a stub-equity subscription, warrants, conversion rights, etc.) depending on the structuring objectives and constraints of the particular investment. More complicated structures may also feature upwards or downwards-ratchet participation or stepped participation depending on the overall performance of the investee company.

Legal Structuring Considerations

Given how hybrid structures interlink with existing debt and equity packages, effective alignment across documents is key (as we put it, getting the plumbing right), and requires input across corporate, debt, and restructuring in order to make sure investor protections not only look nice on paper, but will work as intended when called upon.

In addition, ensuring correct tax and accounting treatment of the instrument is key and regulatory considerations also need to be carefully analysed (e.g., whether the proposed investment structure or rights may trip change of control, antitrust or FDI approvals).

Commercial Negotiation Points

The negotiation between sponsor and preferred investor centres on the economic trade-offs mentioned above. Return expectations are weighed against control and governance (including the breadth of reserved matters, board representation, if any, and default rights). Exit timing is fought over through redemption dates, longstops, mandatory sale triggers, and step in rights, with sponsors and investee companies resisting anything that might force a premature sale, and investors resisting open-ended lock-ins.

Enforcement, finally, addresses what happens on a breach or non-payment, where investors seek meaningful remedies such as coupon step-ups, ratchets, board swamping or accelerated redemption rights. The most productive negotiations start from the scenario rather than the clause: agree what happens if the exit is two years late or the senior lenders block a distribution, then draft backwards.

Underlying all of this is the need for these instruments to dovetail with other stakeholders, because a too-heavy preference stack is no different to excessive leverage, leaving ordinary equity underwater or reducing returns to a level which would make the instrument unappealing for sponsors and management equity holders.

Practical Takeaways

On both sides of the fence, it’s key to spend time and effort getting the structure right at the outset, getting the right advisers into term sheet discussions early to make sure that problems are avoided down the road and then making sure that the eventual legal documents reflect that structure and will work with future changes (e.g., on a refinancing, an add-on acquisition, a NAV or back-leverage financing layered on later, or following a partial liquidity event). Every downside protection should be tested against a restructuring, not just a liquidation, and cross-border issues should be resolved before the economics are fixed.

Discover more insights in our Capital Solutions series