United States: How To Raise Energy Capital In Tough Times

The energy industry is particularly capital intensive, meaning that access to the equity and debt markets is critical to the survival and growth of companies in this sector. While the current economic climate has only exacerbated the need for access to liquidity—as reduced revenue resulting from historically low energy prices have required energy companies to seek additional capital—energy companies are looking beyond traditional offerings of straight debt or common equity.

Considering their present stock prices, energy companies are reticent to issue common equity securities because low trading prices mean equity issuances would be significantly dilutive. Further, energy companies have found it difficult to obtain debt financing on commercial terms when their balance sheets are already stressed due to market conditions.

Therefore, energy companies have looked to preferred stock as an alternative financing source for their existing operations and future capex. Preferred stock can provide maximum flexibility for both the company and the investor.

To assist energy companies in their capital raising strategies, in this article, Gibson Dunn & Crutcher summarizes the key terms of preferred securities, highlights potential benefits and pitfalls for companies and investors to consider when negotiating these terms, and provides market data regarding key terms of preferred stock. This article also shares the firm's expectations, based on experience and discussions with investment bankers in the space, for future developments with respect to the preferred private placement market in the energy industry.

What is preferred equity?

Preferred equity is a separate class of equity securities that entitles holders thereof to certain rights and preferences over common equity. The terms of the preferred stock can be tailored to the needs of the company and the investment goals of the purchasers. Common features include dividends, liquidation preferences, redemption rights, conversion rights, voting powers and, occasionally, preemptive rights. These preferences are heavily negotiated between companies and investors and result in bespoke terms from issuance to issuance.

What are the benefits of preferred equity?

The tailored nature of preferred stock offers companies with the flexibility to determine the scope of the rights and preferences to be offered to the investors. Depending on the circumstances and funding needs of the company, the rights of preferred stockholders may be narrow or broad. These preferences vary on a case-by-case basis as parties make accommodations to meet their ultimate investment goals.

In the current climate, many companies believe their common stock is temporarily undervalued and the issuance of additional common stock would be significantly dilutive. These companies can raise capital by issuing preferred stock and avoiding immediate dilution. The extent to which the company minimizes the risk of dilution depends on whether, when and under what circumstances the company or the holder can convert the preferred stock to common stock.

Also in the current climate, companies are concerned about leverage or the impact of issuing debt on their credit ratings. These companies can carefully tailor the terms of the preferred stock to attract fixed income investors but still receive partial or full equity treatment under their credit agreement or from the rating agencies.

From the investor's perspective, preferred stock can be an attractive investment as it can provide both debt-like returns and equity upside. The convertible nature of many preferred stock allows the investor to share in the upside returns alongside common stockholders, including in a change of control. If cash dividends are required to be paid on the preferred stock, then the investor will receive a debt-like instrument with interest payments. Further, while preferred stock is generally subordinate to debt claims, preferred stock may provide superior downside protection for equity investors due to being senior in priority in the capital structure in the event of bankruptcy or liquidation.

Another benefit to bespoke preferred stock is the private nature of the transaction. First, the negotiation process between the company and the investors as to the terms of the preferred security is more efficient. Rather than negotiating with a representative of potential investors, the company can negotiate directly with the investor to tailor the terms of the preferred security to provide the suite of economic and governance rights desired by the investor while being satisfactory to the company. Second, the deal timeline can be more condensed than in a public offering. The growth and maturity of the private placement market has resulted in increased standardization of documentation and terms, which has expedited the length of negotiations between companies and investors. Further, placing preferred stock with a previous or current sponsor eliminates any time delay resulting from the investor needing to complete certain due diligence prior to making the investment.

What are the key provisions of preferred stock?

As previously mentioned, one of the primary benefits of preferred stock, particularly when issued in a private placement, is the ability of the parties to customize the terms of the security. The most common customized terms relate to dividends, liquidation preferences, conversion rights, redemption rights, voting powers and board representation rights.

Dividends: Although dividend payments on preferred stock are conceptually similar to interest payments on debt securities, preferred stock generally provides for a higher return to compensate the investors for their junior position in the capital structure as compared to the debtholders. Further, dividends generally must be paid to holders of preferred stock prior to payment of a dividend to holders of common stock, eliminating some of the risk of payment. Other points of negotiation relating to dividends include (a) whether the dividend rate is fixed or floating, (b) the frequency and form of payment, (c) whether the dividends are cumulative or noncumulative and (d) any restrictions on payment.

The dividend rate on preferred stock may be fixed or floating. A fixed rate dividend is generally a percentage of the initial purchase price, but it can also be based on the liquidation preference or another predetermined metric. This rate may increase or be adjusted after a certain period of time. A floating rate is adjustable and is typically tied to a predetermined formula that fluctuates with interest rates.

Dividends on preferred stock are commonly paid on a quarterly basis, although the parties may instead negotiate for semiannual or annual payments. Dividends may be paid in cash, payment-in-kind (PIK) of company securities or a combination. A PIK option is attractive to a company that is prohibited from issuing cash dividends by debt covenants in its outstanding debt or that has limited liquidity.

Dividends may be cumulative or noncumulative. A cumulative dividend will accrue over time until paid, rather than being lost. Companies are restricted from paying dividends on junior stock so long as accumulated dividends remain unpaid. Noncumulative dividends are lost if not paid by the company and will not be made up at a later time.

The majority of the recent preferred private placements in the energy industry were fixed rate securities that paid quarterly dividends with a combined cash/PIK payment option. However, the precise terms of payment varied widely. For example, one company's preferred stock provided that no dividends would be payable in the first year, but dividends would be payable thereafter at a fixed rate of 10% of the purchase price. Another company's preferred stock provided for an initial fixed dividend rate, but a representative of a majority of holders of the preferred security could elect to convert the fixed rate into a variable rate after the five-year anniversary.

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.