Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How LBO Firms Are Financing Deals With Preferred Equity
Transcript
- Lucas: So we talk a lot about how deals get done — the pitch, the negotiation, the integration. But there's a quiet change happening in how those deals are actually financed, and it's reshaping the math behind a lot of LBOs. Luna: You're talking about preferred equity, aren't you? Lucas: Exactly. Over the last twelve to eighteen months, preferred equity has gone from being a niche instrument — something you'd see in distressed situations or very specific growth-equity rounds — to a near-standard layer in middle-market LBOs. And I want to drill into one deal to explain why. Luna: Good. Let's get specific. Which deal? Lucas: A $1.4 billion take-private of a specialty chemical company — I'll call it ChemCorp for simplicity — by a middle-market private equity firm. The deal closed in February of this year, and the capital structure is really instructive. Roughly 40 percent senior debt, 20 percent preferred equity, and 40 percent common equity. Luna: Twenty percent preferred — that's significant. A few years ago, that layer would've been maybe 5 percent, if it existed at all. Lucas: Right. And it's not because the banks or direct lenders pulled back completely — they're still lending. But the terms got tighter. Spreads widened, covenants got stricter, and the amounts available for senior debt shrank relative to purchase prices. So sponsors started looking for ways to fill the gap without diluting their own equity returns. Luna: And preferred equity fills that gap because it sits between debt and common equity in the capital structure. It's riskier than debt, so it yields more, but it's senior to common, so it doesn't dilute the sponsor's upside the same way. Lucas: Exactly right. In the ChemCorp deal, the preferred carried a cumulative dividend of 12 percent, paid-in-kind for the first three years, with a liquidation preference of 1x. And it had conversion rights tied to a 2x MOIC threshold. Luna: So the preferred investors get 12 percent annually, compounded if not paid, and if the deal does well, they can convert into common equity to capture more upside. But if it goes south, they get their money back before the common holders see a dime. Lucas: Precisely. And that structure allowed the sponsor to bid a higher purchase price — roughly 11 times EBITDA — without putting in more common equity. The seller got their number, the sponsor preserved its internal rate of return profile, and the preferred investors got a fat yield with downside protection. Luna: But isn't this just a sign that the market is stretched? I mean, 11 times EBITDA for a mid-market chemical company — that's rich. And using preferred to bridge the gap feels like kicking the can. Lucas: It's a fair critique. And in some deals, that's exactly what's happening. But in this case, I'd argue it's more about structural innovation than desperation. The sponsor had a clear operational plan — consolidating the fragmented chemical distribution space, adding bolt-on acquisitions — and the preferred equity gave them the firepower to execute. Luna: So they're using preferred as a tool to take a longer view. The PIK dividend means they don't have to cash-flow the coupon early, which buys time to integrate acquisitions. Lucas: Exactly. And that's the key insight: preferred equity is letting sponsors do deals they couldn't do with traditional debt alone, without selling more common equity. It's a third leg of the stool. Luna: But who's buying this preferred? I assume it's not your average retail investor. Lucas: No, it's mostly institutional — pension funds, insurance companies, and dedicated credit funds that have a mandate for higher-yielding, structured products. There's been a real proliferation of 'private credit' vehicles that specifically target preferred equity in sponsor-backed deals. Luna: So basically, the same pools of capital that used to buy high-yield bonds or mezzanine debt are now buying preferred equity. But the risk profile is different. Lucas: It is. Preferred equity sits below unsecured debt in bankruptcy, so it's genuinely riskier. But the yields are correspondingly higher. And in a low-default environment like we've had, those yields look very attractive. Luna: Low-default environment — that's a key caveat. What happens when defaults pick up? The cumulative dividends can really stack up, and the liquidation preference might not mean much if enterprise value erodes. Lucas: That's the billion-dollar question. In a downturn, preferred equity can turn toxic fast. If a portfolio company struggles, the sponsor might find themselves with a huge preferred dividend overhang that drains any cash flow. And if the company needs a rescue capital injection, the preferred holders have to be dealt with first. Luna: So there's a real tension: preferred equity facilitates deals now, but it could complicate restructurings later. Are sponsors aware of that, or is it just 'yield now, worry later'? Lucas: I think the good sponsors are very aware. They're modeling downside scenarios, they're making sure the PIK toggle doesn't trigger for at least three years, and they're keeping a buffer of liquidity. But there's no question that some deals are being done with optimistic assumptions. Luna: Let's go back to the ChemCorp deal. How did the preferred equity actually get placed? Was it a club deal, a syndication? Lucas: It was a club deal — three large credit funds each took a third of the $280 million preferred tranche. The sponsor didn't want to syndicate it broadly because they valued the relationship with these specific investors. They're long-term partners. Luna: That makes sense. Club deals give the sponsor more flexibility on terms and avoid the hassle of a full marketing process. But it also means fewer checks on pricing. Lucas: Right. And the pricing was negotiated bilaterally. The 12 percent coupon was set relative to the yield on bb rated bonds at the time, which were around 7 percent. So the preferred offered a 500-basis-point premium for the subordination and the PIK feature. Luna: Five hundred basis points — that's a big spread. It suggests the market is pricing in significant risk, or at least demanding compensation for illiquidity. Lucas: Both, I think. Preferred equity is inherently illiquid — there's no secondary market to speak of. And the risk is real, as we discussed. But for the investors in this deal, they know the sponsor well, they've worked with them before, and they're comfortable with the business plan. Luna: So relationship lending, but in equity form. It's almost a return to an older style of financing, where trust and track record mattered more than a rating agency's opinion. Lucas: Exactly. And I think that's part of the attraction for sponsors. They can bypass the volatility of the syndicated loan market and secure committed capital from partners who understand their strategy. It's more expensive, but it's more reliable. Luna: Let me play devil's advocate. If preferred equity becomes too common, doesn't it start to crowd out traditional debt? And if that happens, the overall cost of capital for LBOs goes up, making it harder to generate the returns that LPs expect. Lucas: That's a valid concern. But I'd argue that preferred equity is complementing debt, not replacing it. In most deals, the senior debt layer is still the largest piece. Preferred is filling the gap where mezzanine debt used to sit. And mezzanine debt was often more expensive and more restrictive. Luna: Fair point. Mezzanine typically had coupons in the 12 to 15 percent range anyway, plus warrants. So preferred equity at 12 percent with a conversion feature is actually comparable, if not cheaper in some cases. Lucas: And the structure is cleaner. Preferred equity doesn't have the same covenant complexity as mezzanine. You have a liquidation preference, a dividend rate, maybe conversion rights — that's about it. It's simpler to negotiate and simpler to administer. Luna: Simpler is good, but simplicity often means less protection for the preferred holder. If things go wrong, they don't have the same acceleration rights as a lender. Lucas: True. A lender can call a default and force a restructuring. A preferred holder generally can't. They can vote on certain matters, like changes to the charter or additional issuances, but they don't have the same leverage. Luna: So the preferred holder is really relying on the sponsor's good faith and the hope that the business performs. That's a big leap of faith for a 12 percent yield. Lucas: It is. And that's why these placements are happening with repeat relationships. The credit funds doing these deals have teams dedicated to monitoring their preferred investments, and they have board observer rights or even board seats in some cases. Luna: Let's zoom out. In May 2026, are we at peak preferred equity in LBOs, or is this just the beginning? Lucas: I think we're still in the adoption phase. I've seen estimates that preferred equity now accounts for 10 to 15 percent of total financing in middle-market LBOs, up from maybe 2 or 3 percent five years ago. I expect that number to keep growing, especially as more institutional capital flows into private credit. Luna: But if defaults rise, that growth could reverse quickly. Preferred equity is the first to get hit in a downturn, and if a few high-profile deals go sour, investors might flee. Lucas: No doubt. But I think the structure is here to stay in some form. It's too useful a tool for both sponsors and investors. The key will be how it's used — as a bridge for sensible growth, or as a crutch for overpaying. Luna: And that brings us back to the ChemCorp deal. How's it performing so far? Lucas: Early days — it closed only three months ago. But the sponsor has already announced two bolt-on acquisitions, funded partly with additional preferred equity from the same group of investors. So the strategy is executing. Luna: Interesting. So the preferred equity facility is being used as a kind of acquisition line. That's a creative use. Lucas: It is. And it shows how the instrument is evolving. We're seeing more 'preferred equity lines' structured similarly to delayed-draw term loans, where the sponsor can draw down additional capital for add-on acquisitions under pre-agreed terms. Luna: That's a significant innovation. It gives sponsors certainty of capital for their roll-up strategy without having to go back to the market each time. Lucas: Exactly. And it aligns incentives: the preferred investors get to deploy more capital with the same sponsor, deepening their relationship and their potential upside. Luna: So the takeaway is that preferred equity is reshaping LBO financing in a structural way — not just a cyclical fad. But it brings new risks that investors need to understand. Lucas: That's my view. For operators and investors listening, I'd say: understand the terms of the preferred in any deal you're evaluating. The cumulative dividend, the PIK feature, the conversion rights — they all matter. And ask yourself: is this preferred financing a sign of discipline, or a mask for overpaying? Luna: And for sponsors, the message is: don't abuse it. A few bad deals could poison the well for everyone. Lucas: Right. So that's the state of play in May 2026. Preferred equity has arrived as a core financing tool in LBOs. Whether it becomes a permanent fixture or a cautionary tale depends on how wisely it's used. Luna: I suspect we'll revisit this topic in a year or two, once the cycle turns. Lucas: I hope we do. That will be the real test.