Preferred Equity: Comparing Alternatives and Managing Legal Risks
This is the second in a three-part series on preferred equity in private capital markets. This Legal Update examines how preferred equity compares to traditional financing alternatives and the principal legal risks that should inform structuring and negotiation. For background on preferred equity features and use cases, see the first installment in this series.
Executive Summary
Preferred equity occupies a unique position in the capital structure, sitting above common equity but below all debt. But unlike senior or mezzanine financing, preferred equity does not carry creditor status, which means it generally lacks the enforcement mechanisms, collateral, and priority protections that debt investors rely on in distress scenarios.
This Legal Update examines how preferred equity compares to senior secured debt, mezzanine debt, and common equity and identifies key legal and bankruptcy risks.
Preferred Equity Compared to Capital Structure Alternatives
Preferred Equity vs. Senior Debt
Senior debt sits at the top of the capital structure, benefiting from collateral, contractual covenants, and creditor enforcement rights, including acceleration and foreclosure. Preferred equity, by contrast, is structurally subordinated to debt and does not carry creditor enforcement rights.
Even where preferred equity includes fixed return obligations or mandatory redemption provisions, failure to make distributions does not typically create the same remedies available to creditors pursuant to applicable statutory and bankruptcy law—preferred equity rights are only enforceable as contractual equity rights.
Other key differences include the following:
- Priority in Bankruptcy: Senior debt sits at the top of the capital structure, while preferred equity ranks junior to all debt. Preferred equity holders remain equity claimants under insolvency law and therefore remain exposed to restructuring outcomes that may not preserve contractual distribution priorities.
- Security: Secured debt benefits from a pledge of collateral, whereas preferred equity generally does not.
- Enforcement: Senior lenders have acceleration, foreclosure, and creditor remedies; preferred equity holders only have contractual remedies.
- Default consequences: Debt defaults can trigger insolvency proceedings and creditor priority, while preferred equity non-payment typically results in rate step-ups, enhanced governance rights, and/or other negotiated remedies.
Preferred Equity vs. Mezzanine Debt
Mezzanine financing occupies a middle ground between senior debt and equity. While subordinated in priority, mezzanine is still debt and typically includes incurrence covenants, events of default, and contractual remedies.
Preferred equity may overlap economically with mezzanine debt in terms of pricing. However, the following key distinctions remain:
- Mezzanine lenders are creditors with defined enforcement rights; preferred equity holders are equity owners with contractual protections.
- Mezzanine interest is generally deductible for tax purposes, whereas preferred distributions are not.
- Mezzanine typically carries a stated maturity, whereas preferred equity may be perpetual or have flexible redemption features.
Preferred Equity vs. Common Equity
Common equity is typically residual in nature: it participates fully in upside value but receives such value only after debt and certain preferred returns have been satisfied.
Preferred equity sits contractually above common equity. It typically receives a preferred return and liquidation preference before common equity participates in remaining value. The relationship between preferred and common equity is defined principally by governing documents, which sets forth any special rights granted to preferred equity holders (i.e., economic, governance, priority).
Key Legal Risks
Lack of Creditor Remedies
As discussed above, remedies available to preferred equity holders upon default are limited to negotiated contractual remedies, such as rate step-ups and enhanced governance rights. Without true “creditor-type” enforcement remedies and collateral protection, preferred equity holders may simply be along for the ride when a downside scenario unfolds.
Structural Subordination and Layering Risk
Since preferred equity is structurally subordinated to debt, it is vulnerable to being “primed” upon the issuance of indebtedness or “diluted” upon the issuance of preferred equity on the same terms.
Therefore, preferred equity investors should carefully consider with counsel the inclusion of appropriate anti-layering protections and meaningful limitations on the incurrence of indebtedness and issuances or sales of securities.
Bankruptcy or Restructuring Scenarios
In a liquidation, preferred equity holders’ contractual preference may provide priority over common equity. In a restructuring or reorganization, however, actual economic outcomes can differ materially from a straightforward liquidation waterfall. Because preferred equity holders remain equity claimants under insolvency laws, they are exposed to restructuring outcomes that may not honor—or preserve—their contractual distribution priorities.
Fiduciary Duties
Fiduciary duty implications depend significantly on entity type in Delaware.
For Delaware corporations, directors owe fiduciary duties of care and loyalty to the corporation and its common stockholders. These duties typically require directors to make informed, honest decisions in the corporation’s best interest, free from self-dealing. In contrast, directors typically do not owe such fiduciary duties to preferred stockholders. This is because Delaware courts typically treat preferred stock rights as contractual in nature. While those contractual rights will be enforced according to their terms, fiduciary doctrine generally does not expand protections beyond the contractual bargain, and boards frequently evaluate decisions with preference to common stockholders as residual claimants.
For Delaware limited liability companies, fiduciary duties may be expanded, restricted, or eliminated by contract, subject only to the implied covenant of good faith and fair dealing. In many private equity structures, operating agreements significantly modify or waive traditional fiduciary duties. Where that occurs, investor protection depends almost entirely on contractual rights.
Next Steps
Preferred equity is an instrument defined principally by contract and structural placement. Compared to traditional debt, it offers flexibility but lacks creditor remedies and collateral priority. Compared to common equity, it provides contractual economic seniority but remains subject to governance dynamics and structural subordination.
For investors, the effectiveness of preferred equity depends on careful drafting, thoughtful structural positioning, and a clear understanding of enforcement and priority. With fewer exits for assets in recent years creating pressure to find alternative sources of capital, preferred equity has emerged as a versatile solution for sponsors navigating valuation uncertainty and a challenging exit environment. The third installment in this series will address tax considerations relevant to preferred equity transactions.
For additional information on preferred equity transactions, please see the following Legal Updates:
