Convertible preferred issuances

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GENERAL

Preferred securities feature both equity-like and debt-like characteristics. Because issuers' credit ratings are heavily dependent on ratings agencies' classifications of their capital-raising, many issuers expressly condition their willingness to undertake a preferred issuance on ratings agencies providing an indication that such preferred issuance will receive at least 50% equity credit.

In terms of equity characteristics, preferred securities generally stand "behind" debt in the capital structure, do not have a maturity date, generally cannot force mandatory distributions (instead receiving distributions as and when declared), sometimes have voting rights on an "as-converted basis" and sometimes provide the buyer with board observer or director appointment rights.

In terms of debt characteristics, preferred securities stand "in front of" other equity in the capital structure, generally do not have many class voting rights and have a specified distribution rate (which accrues until payment if not paid when due), which may include a payment-in-kind option during negotiated periods. It is these preferences over other more junior classes of equity that entice investors and give the preferred security its name.

PRICING

Pricing is one of two primary economic features of a preferred issuance, and is a feature with which both issuers and buyers struggle frequently. Preferred securities of public issuers are often priced above the current trading price of the issuer's publicly traded common security due to their advantageous features (including distribution and, in most cases, liquidation preferences), but in some instances are priced below the current trading price. Because the issue price is so important, however, it is often "locked in" at the term sheet stage, which leaves uncertain the relationship the issue price will bear to the common security trading price at closing. Pricing preferred securities of pre-public issuers is more complicated and may be based on a variety of relevant factors, including the potential price if the issuer does go public.

DISTRIBUTION RATE

The quintessential characteristic of a preferred security is a preference on distributions made by the issuer. While distributions typically are not mandatory-they are usually paid only when declared by the issuer-they almost always must be paid in full (together with any arrearages) prior to any distributions being paid to junior security holders (and in some cases, prior to or at least pro rata with distributions being paid to pari passu security holders). Distribution rates are heavily negotiated and vary significantly among issuers. For example, EnLink's preferred investors are entitled to an initial 8.5% annual distribution rate, while American Midstream's preferred investors are entitled to a nearly 11.8% annual distribution rate. Sometimes, convertible preferred security holders are entitled to receive distributions on the issuers' common securities on an as-converted basis. The lower the distribution rate, the more comparatively expensive other debt or equity becomes, which may cause the issuer to retire other capital first. Alternatively, a higher distribution rate may cause the issuer to retire preferred securities before other capital.

COMPOUNDING DIVIDENDS

Another term that often is subject to negotiation is whether unpaid distributions on preferred securities are subject to compounding. Issuers are often very resistant to including compounding features in preferred securities, while investors frequently insist on compounding as a critical economic feature. Serious negotiation of compounding is sometimes preempted, however, by ratings agencies' apparent hesitation to give at least 50% equity credit to preferred securities that have compounding features. It bears noting, however, that payment of distributions in-kind (described further below) has a similar economic effect to "traditional" compounding during the payment in-kind period.

PAYMENT-IN-KIND

Issuers are often interested in negotiating the right to pay in-kind distributions (e.g., by dividending additional preferred securities instead of cash or by increasing the liquidation preference of already-issued preferred securities) to preferred investors in order to maintain maximum liquidity. By contrast, preferred investors, recognizing that they have no right to force distributions, generally want to be treated like other equity holders and receive cash distributions.

One way in which issuers and investors often compromise on this issue is to permit in-kind distributions of additional preferred securities during a prescribed initial period, with later distributions made solely in cash. For example, Plains and Crestwood each have the option to "PIK" their preferred security for a specified number of years.

BLOCKING RIGHTS

Preferred securities often include specific blocking rights that investors view as essential to their ability to protect their investment against dilution and other adverse changes. For example, preferred securities commonly prohibit the issuance of more "senior" equity securities and place significant limitations (or outright prohibitions) on the issuance of "parity" equity securities by the issuer.

It is also common for the terms of preferred securities to prohibit the issuer from taking any action that adversely affects the rights, preferences or privileges of such preferred securities or amends or modifies any of their negotiated terms without the express approval of the preferred investors by majority (or higher) vote, voting separately as a class. Less common are blocking rights in respect of the incurrence of indebtedness, material transactions and other similar matters, but investors (particularly those whose preferred investments represent significant positions on an as-converted basis) sometimes successfully negotiate for such consent rights.

ANTI-DILUTION PROTECTIONS

Preferred securities typically include anti-dilution protections in respect of splits, conversions and other similar changes to the underlying common securities. In most recent transactions, however, preferred securities do not include anti-dilution adjustments for subsequent "downround" common security issuances, on the logic that preferred investors should stand shoulder-to-shoulder with other existing investors in respect of fluctuating common security pricing. However, some investors have pushed for preemptive rights in order to protect themselves from such downrounds by buying additional securities, while others have even pushed for downround protection through volume-weighted average or full ratchet conversion price adjustments.

CONVERSION/REDEMPTION

Preferred securities need not be convertible or redeemable, but because investors often prioritize liquidity and issuers often prioritize flexibility, conversion and sometimes redemption have become customary terms of preferred issuances that are typically available to each party after a period of time or upon certain triggering events, such as liquidation. While not universal, it is common for investors to agree to volume thresholds and frequency limitations in return for an option to convert less than all preferred securities they own. It is also common for any issuer option to be exercisable only in respect of all outstanding preferred securities and only if the current trading price is over a certain threshold.

Investors, in particular, are often very focused on issues involving conversion/redemption because such issues pertain not only to investors' ability to liquidate their investment, but also to the preservation of the preferential terms for which they have negotiated so heavily. Investors and issuers are wise to focus on various potential conversion scenarios so that they properly understand what happens to a particular quarterly distribution upon a conversion in the middle thereof, as well as to ensure that any conversion feature does not run afoul of stock exchange rules that require shareholder approval of any issuance that could result in the investor obtaining 20% or more of the issuer's securities (on an as-converted basis).

CHANGE OF CONTROL

Investors are often wary of risks associated with an issuer change of control and are typically successful at negotiating certain protections in such events. Because changes of control can have multiple permutations, such protections often assume various forms, depending on the specific circumstances of the change of control transaction.

For example, in the case where the issuer is acquired by a third party, investors often attempt to negotiate certain rights, such as an option to require the third-party acquirer either to provide it with a substantially similar preferred security or to redeem the preferred securities at a specified premium. As another example, where the issuer merges with a subsidiary of an acquirer and survives the merger, investors regularly attempt to negotiate other rights, including an option to retain the outstanding preferred security without changes or to convert into common equity at a conversion rate superior to the otherwise general conversion rate described above.

BOARD REPRESENTATION/OBSERVER RIGHTS

Another commercial item often central to preferred issuances is whether the investors are entitled to any board representation or observer rights in connection with their investment in the preferred security. Board representation/observer rights are essentially a matter of access and information, although investors will sometimes trade such rights for better pricing or other terms.

This issue is resolved disparately across various precedent transactions, including (i) no board representation or observer rights, (ii) board observer rights only, (iii) one or more directorships initially dedicated to preferred investors and (iv) one or more directorships dedicated to preferred investors only upon the occurrence of certain trigger events, such as failures to pay dividends for a certain number of periods.

In large part, the outcome of negotiations depends on the percentage of the issuer's total equity that the investors will hold; a smaller percentage (as in the MPLX issuance) likely correlates to fewer (or no) representation/observer rights; a larger percentage (as in the EnLink issuance) often correlates to greater rights. Some preferred investors have elected to forgo board or observer seats entirely in order to avoid liquidity concerns arising due to their likely receipt of material non-public information if they have board or observer representation.

REGISTRATION RIGHTS

Registration rights are significant elements of most preferred issuances, the details of which are-unfortunately-often left unaddressed until latter stages of negotiation. Registration rights sit at the crossroads of competing interests-investors want certainty of liquidity and flexibility of exit, while issuers are often focused on avoiding disruption to their business, precedent-setting and flexibility of financing.

Five primary elements characterize most preferred registration rights: (i) which securities are registrable, the preferred security itself or the common equity into which it is convertible, (ii) by when will the issuer be required, or when can the investors require the issuer, to register the subject equity, (iii) whether the issuer will be required to pay specified liquidated damages in connection with any delay in successfully completing or maintaining registration, (iv) which investors will have "piggyback" rights to participate in a primary equity offering by the issuer or registered secondary offerings by other equity holders and (v) which investors will have the right to require the issuer to engage underwriters to conduct an underwritten public offering of such investors' securities. Registration rights vary widely among preferred issuances depending on the particular concerns of the investors.

When contemplating an issuance of preferred securities, investors and issuers should carefully consider the many key terms of such issuance and their impact upon the more-obvious commercial terms of the potential transaction. When structured correctly, issuances of preferred securities can provide significant benefits to both investors and issuers that are often more advantageous than other transactions, such as the issuance of common stock, the incurrence of debt or the undertaking of other more custom transactions.

ABOUT THE AUTHORS

Cliff Vrielink is co-leader of the global energy practice of Sidley Austin LLP and based in Houston. He is a member of the firm's Private Equity and M&A teams and primarily advises private equity groups and public and private companies engaged in the energy industry.

Tim Chandler is a private equity and M&A lawyer in the Houston office of Sidley Austin where he represents clients in domestic and international private equity investments, mergers, joint ventures and project development.

Ryan Scofield is an associate in the Dallas office of Sidley Austin where he advises clients on complex corporate and transactional matters, primarily focusing on M&A, dispositions and private equity transactions.