It should come as no surprise that the old investment adage about getting what you pay for holds true for preferred stock, too. Despite often being pitched as a bond alternative, especially lately, there are multiple factors beyond dividend yield to consider. Among the features, an investor needs to understand are the liquidity provisions, dividend policy, and preferred shareholder rights. Sponsors tend to get irritable when FactRight stress tests their pro forma model or highlights weak investor protections, dismissing the concerns as implicating scenarios highly unlikely to ever occur. However, sometimes the unlikely or improbable does occur. This post will focus on a real scenario involving several preferred securities that underscores the need for due diligence in these areas.
A cautionary tale
I recently logged into a stock-focused website that I had not visited since late 2020 amid the COVID-19 pandemic. At that time, I had created a watchlist consisting of preferred stocks trading at deep discounts that had been highlighted by various contributors. These stocks—let’s call them “busted preferreds”—were publicly-traded securities trading well below par, and most had double-digit dividend yields based on then-current prices. It was a little eye-opening to revisit the watch list two years later; while a few of the preferreds had rebounded sharply or were redeemed, the majority had remained range-bound, reflecting the issuers’ ongoing business challenges. Not unexpectedly, a few issuers filed for bankruptcy protection.
What piqued my interest was the merger of two small-cap REITs, both focused on grocery-anchored shopping centers along the East Coast, that was completed in August 2022. One of these companies, Company-1, recharacterized several series of preferred stock so that dividends were no longer cumulative and canceled all accrued but unpaid dividends on those series. The other company, Company-2, sold approximately $900 million of its real estate assets to third parties, leaving the RemainCo with a value of approximately $300 million, which in turn was merged into Company-1. However, this RemainCo chose not to redeem its preferred stock; the two series of preferred carried over to the acquiring company and remain outstanding. Both series of preferred stock in Company-2 had traded near $25 dollars (par value $25) prior to the announcement; it was current on its preferred dividends and paid an above-market rate. Subsequent to the completion of the merger, those same preferred shares were trading under $10 per share. This is likely a reflection of concerns about liquidity, lack of preferred stockholder protections, and corporate governance.
While this merger serves as a cautionary tale that cheap shares in the public markets are often cheap for a reason, the episode carries considerable lessons for private market offerings. The preferred stock features embedded in the governing documents that made these actions permissible are the same features that FactRight sometimes encounters in preferred share offerings sold through the BD and RIA channels.
Four key areas of preferred securities
A key part of the due diligence process is identifying potential risks embedded in the structure of the securities. We agree with the assertion of sponsors that the likelihood of the above series of actions occurring is relatively low. However, during a five-year hold period, market conditions can change, management teams can change, and even property-level factors can change. The rapid increases in interest rates in 2022 are contributing to stresses at various alternative investment programs currently regarding acquisition terms, fund level liquidity, and in certain cases, prospective erosion of returns for equity investors. Companies and investment programs that find themselves facing slower-than-expected growth and have little incentive (or ability) to call their preferred securities may seek solutions that are not necessarily in the best interest of investors at different positions within their capital stack.
Investment programs come in a variety of different shapes and sizes because investors have different objectives and priorities. Still, there are several features of all securities that warrant discussion and were at play in the above example:
- Liquidity and redemptions
- Voting rights
- Protective provisions
- Reputational risk
How liquid are they really?
Many of the preferred share offerings that FactRight has reviewed recently provide for redemptions through features such as an issuer call option, a mandatory redemption provision that triggers after a certain number of years, or a change of control provision. These redemption provisions may vary significantly from program to program and be subject to considerable limitations unique to each offering. An investor needs to understand who has the decision-making power, the company or the investor, and what form of consideration the redemption may occur in, namely cash or common stock.
Additionally, there may be monthly, quarterly, or annual redemption limitations that may extend the anticipated investment horizon. Even with a periodic redemption feature, the governing documents often include the phrase “at the sole discretion of the Manager.” A company facing an unfavorable operating environment or weakened finances could choose to halt redemptions indefinitely. For preferred shares with a fixed dividend, inflation would likely eat away at the real return over time.
Restrictions and limitations are typically memorialized in the prospectus, company charter, bylaws, and the articles supplementary. In the merger story highlighted above, Company-2’s documents did have a change of control provision, but also included language indicating that no change of control would trigger if the preferred remained outstanding and the terms were materially unchanged, even in the event of a merger where Company-2 was not the surviving entity.
Preferred voting rights are not standard
Issuers are permitted to not only grant certain rights to preferred shareholders, but also to limit those rights. A typical construction in the offering documents is to first state that preferred shareholders have no voting rights but to then to provide a set of exceptions. The exceptions usually confer rights consistent with laws in the state of domicile. For example, most traded and non-traded REITs are domiciled in Maryland and defer to Maryland's general corporate law when establishing voting rights.
However, issuers have considerable latitude in setting voting rights and may reserve the right to eliminate them altogether. Often times we see provisions allowing the preferred stockholders to have the ability to vote on certain matters, or elect a special director, in the event of a disruption to their preferred distribution; however, this is by no means a standard provision.
How easily may the issuer take away preferred rights?
Among the most common protections conveyed to preferred shareholders are limits on the issuer’s ability to amend the formation and offering documents. Some of these provisions state that the company cannot modify the powers, rights, or preferences in the supplementary articles without a majority vote of the preferred shareholders. Similarly, oftentimes, the charter cannot be amended in a way that is adverse to any particular series of preferred shares with majority approval of the affected series of preferred shares.
Another protection typically conveyed to preferred shareholders, but should still be verified, is a provision that limits the issuer’s ability to issue new preferred shares or other securities that rank senior to the existing share classes without approval from the impacted share classes. There have been instances where the company specifically reserves the right to issue new equity securities that rank senior to existing issues.
Returning to the series of actions referenced earlier in this post, Company-1 canceled the cumulative feature on two of its existing series of preferred shares and erased all undeclared dividends in arrears. Company-1 sought approval from holders of the common equity to change terms of the preferred shares; holders of the preferred shares were granted no voting rights. As a result of, in effect, a cram down, holders of the two preferred series will receive dividends only if and when declared by the board. Unfortunately, the two series of preferred shares have no maturity and are not publicly-listed, leaving investors no ability to exit the shares.
Reputation is important when raising capital
Away from the formation and offering documents, investors may want to consider the sponsor’s reputation risk. A sponsor that has syndicated numerous securities offerings in the market and has plans to offer additional programs in the future tends to generally be more concerned with reputation. This type of sponsor also tends to be more willing to incorporate investor-friendly provisions into the documents at the front end because they see a direct correlation with capital raising success.
In contrast, a company that has built a portfolio of properties with the intent to retain full ownership and manage the assets has less incentive to be investor friendly. Entities with a track record of making decisions that do not benefit investors tend to find it more challenging to raise additional capital. While past actions do not guarantee comparable actions will be taken in the future, they do provide insight into the sponsor’s attitude toward corporate governance and alignment of interests.
Every preferred share is unique
Investing is about assessing both risk and anticipated returns. Whether one is looking through the wreckage of broken preferreds for a deep value play or hunting for a bond alternative with a good rate, the details matter. Each preferred share offering is unique and provides a different level of investor protection. Those protections, or lack thereof, are in the documents. Yes, the language in those documents is there because of the lawyers (as issuers are quick to note). However, the issuer has the ultimate say as to which protections to limit. Investors need to be selective, even with preferreds. FactRight is here to help.