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Convertible vs. Participating Preferred Stock Returns

Understand Convertible and Participating Preferred Stock Returns

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Convertible vs. Participating Preferred Stock Returns

In This Article
  • What are the two options available to an investor holding convertible preferred stock?
  • How is “participating” preferred stock different from “non-participating”?
  • Which type of feature tends to have higher returns: convertible or participating preferred?
  • What is a “capped” participating liquidation preference?

Convertible vs Participating Preferred Stock Types

Like common stock, preferred stock is a class of ownership in the issuing company.

These securities sit above common equity in the capital structure, in terms of the priority at which security holders are entitled to a portion of the company’s profits.

Still, preferred stock is of lower priority than all tranches of debt, including the riskier types of debt such as mezzanine financing.

The risk/return profile of preferred stock tends to appeal most to institutional investors attempting to maximize the potential upside while limiting the downside.

In the case of convertible preferred stock, the holder is granted the right to receive either:

  • 1) The Preferred Proceeds or
  • 2) The Post-Conversion Equity Value

For the latter option, whichever is of greater value and brings higher returns to the investment firm is chosen.

On the other hand, for participating preferred stock, the firm receives the preferred proceeds amount (i.e., the cash dividends or accrued value), as well as a portion of the residual proceeds for common equity shareholders – so, the investor gets to “double-dip” in the exit proceeds.

For more commentary on the differences between common and preferred stock, review the following post:

Common Shares vs. Preferred Shares

Preferred Stock Returns Calculator – Excel Template

The focus of this article will be on understanding the mechanics of modeling convertible and participating preferred returns.

Before we get started, download the template using the form below to follow along with the tutorial:

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Preferred Stock Returns – Model Assumptions

Here, in our hypothetical scenario, we will use the following investment assumptions:

  • A firm has decided to invest $100mm for a 20% ownership stake in the target company
  • The company holds zero debt on its balance sheet (i.e., 100% preferred and common equity) from the date of initial purchase to the date of exit
  • Upon dividing the $100mm of capital invested by the 20% ownership, the implied total equity value of the target is $500mm
  • As a placeholder, the exit proceeds (i.e., the exit equity valuation) is $1bn

Investment Assumptions

Convertible Preferred Stock Returns Calculation

Now, we will begin setting up the calculation for the convertible preferred stock returns given the stated scenario.

First, the preferred value formula contains a “MIN” function that links to the original $100mm capital investment and the value of the exit proceeds. The reason for this is that if the exit equity value is less than the preferred investment, the investors cannot receive the initial amount back in full (i.e., incurred a net loss).

Preferred Value Formula

Next, we calculate the convertible value, which is equal to the implied ownership multiplied by the exit proceeds.

Convertible Value Formula

Since the convertible preferred stock chooses the higher value, we use the “MAX” function between the preferred value and convertible value. Here, the convertible value of $200mm is selected as it is the greater of the two compared to the $100mm in preferred value.

Under a $1bn exit proceeds scenario, the convertible value comes out to $200mm.

Convertible Preferred Formula

Conversion Ratio and Convertible Price

In practice, convertible preferred stock comes with a pre-negotiated conversion ratio, which determines the number of common shares received per preferred share upon conversion.

After multiplying the number of preferred shares by the conversion ratio, we can calculate the number of convertible common shares.

Then, the conversion price can be calculated by dividing the par value of the convertible preferred stock by the number of common shares that could be received.

Moving on, the assumption here is that the $100mm preferred investment can be converted into 20% of the total common equity.

Since we have the entry valuation, we can deduce that the inflection point where the convertible value exceeds the preferred value will be an exit valuation in excess of $500mm (i.e., 5x initial).

Once past the break-even point, the convertible shares are considered to be “in-the-money” and profitable to convert.

As an example, say the exit value falls to $50mm from the initial valuation of $500mm. That would mean the valuation has fallen 90%. By multiplying the $50mm in exit proceeds by 20%, we get $10mm as the convertible value.

The convertible value is $10mm while the preferred value is $50mm; hence, the preferred value is chosen. This $50mm in proceeds reflects the downside protection of preferred stock.

And after calculating the proceeds, we can back out the multiple on invested capital (“MOIC”) by dividing the proceeds received by the initial investment. For instance, if the exit proceeds are $1bn, the convertible value is $200mm, which represents a 2.0x MOIC ($200mm ÷ $100mm).

Convertible Preferred

Participating Preferred Stock Returns Calculation

The “participating” portion of participating preferred stock refers to being able to share in the residual shares left for common shareholders after receiving the preferred value.

In contrast, for “non-participating” preferred equity, the investment firm receives just the preferred value without being entitled to any of the common proceeds – the exception being if there is a convertible feature attached.

Preferred equity typically pays out dividends in either cash or paid-in-kind (“PIK”), but we are neglecting them here for purposes of simplicity.

For the calculation, the first step is to deduct the value of the preferred equity from the exit proceeds, as well as wrap a “MAX” function around the formula to ensure the value does not dip below zero.

Again, the preferred equity holders are above common equity holders in terms of the order of priority in which they are paid out – thus, in certain unfavorable exit scenarios, the common equity holders may be left with nothing (i.e. zero).

While the common equity holders could be left with nothing, they would typically not be in a scenario where they would owe anything to the company (i.e. negative proceeds).

The treatment of preferred equity when calculating the remaining proceeds to common equity holders is debt-like, in the sense that the preferred equity holders get paid out first before the common equity holders are entitled to any proceeds.

Participating Preferred Formula 1

We arrive at the preferred value is shown, which is the first source of proceeds for the investor. Similar to how we calculated the convertible preferred, the “MIN” function will be used here. If we set the exit proceeds to $50mm again, then the proceeds to the investment firm would be $50mm as intended.

Since this is participating preferred, the investor has a 20% share of the residual common equity value. From the example below, we see the $900mm in common equity proceeds being multiplied by 20% to get $180mm.

Participating Preferred Value

Lastly, the two are summed together to arrive at $280mm as the proceeds received with participating preferred stock (and resulting in a 2.8x MOIC).

Participating Preferred

Preferred Stock Returns Summary

In the two grey sensitivity tables below, we can see the proceeds to the firm and the MOIC based on different exit proceeds.

Preferred Stock Returns

Most of the time, the returns from participating preferred outpace that of convertible preferred investments.

For that reason, companies limit the % share that preferred investors have in the proceeds attributable to common shareholders, and/or place a liquidation preference cap on the return multiple to prevent the investor from generating returns beyond a certain level.

Such provisions help protect existing common shareholders from dilution.

In closing, we benchmark the two returns against one another in the graph below, depicting how the convertible value remains constant at $100mm until the exit proceeds reach $500mm.

Convertible vs. Participating Preferred Returns

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