United States: Will 2023 Be The Year Of The Structured Security?

As part of our Global PE Trends Webinar Series, Morrison Foerster recently hosted a webinar entitled Structures and Solutions in a Challenging Market, moderated by New York corporate partner Mitchell Presser. The webinar asked the question: Will 2023 be the year of the structured security? The panelists discussed the drivers behind demand for bespoke financing solutions and key considerations in structuring the related securities. Since that session, the demand for these solutions has continued to grow.

What Are Structured Securities?

Structured securities are bespoke financial instruments that are customized to the specific situation of the issuing entity, frequently combining equity and debt-like features in a minority investment. They are generally characterized by lower downside risk to the investor with the potential of increased upside if the asset does well.

Examples of structured securities include (but are not limited to) convertible preferred, convertible debt and preferred stock with warrants. The key is that structured securities are often highly structured in terms of economic returns, seniority, and governance, placing them higher in the capital structure, with preferred minimum returns.

Structured securities become popular when traditional financing is scarce, and the current environment ought to result in increased interest from both the supply (investors) and the demand (issuers) side for this type of solution.

What Is Driving Their Appeal?

There are a number of factors that have been driving increased interest in these securities, including: tightening credit markets, investors reduced comfort with risk, and valuations trending down.

The Investor Side

The possibility of a higher guaranteed return on a minority investment, with a significant amount of protections and governance is attractive to a broader spectrum of investors. While these types of securities were historically the domain of a small pool of dedicated funds, they are now within the purview of a variety of financial investors, including alternative capital providers, credit funds, opportunistic private equity funds and special situations funds. Flexibility is the name of the game.

For investors in the issuer, these securities can also function as a bridge to a further liquidity event. Using a structured investment to provide a bridge to IPO when equity markets are tight is common. These days, we are seeing financial investors also use these securities as a bridge to exit; this allows some capital to be returned to existing investors, while providing a constructive valuation mark for a future sales or fundraising process.

The Issuer Side

On the issuer side, structured securities can help bridge valuation expectations. Companies maintain an attractive valuation upon conversion, while providing investors with a more secure return profile. For startups, this can be particularly powerful in avoiding the complications of a down-round (including on management incentives). For VC-backed companies, in particular, an equity or debt solution that does not require lowering the value of their existing investors' stakes can be highly attractive.

But structured securities can also be attractive to more mature companies seeking cash to deploy for growth. In fact, structured securities have been a feature of the growth equity market for years. The breadth of companies looking for growth equity-like solutions has expanded in this environment to capture businesses that may not have sought alternative sources of capital or liquidity in different times.

What to Keep in Mind?

In structuring these types of securities, there are a few key themes that the MoFo panel participants highlighted for investors and issuers:

• Bespoke and Varied – Because these are bespoke securities, their terms vary greatly. A structured security for a performing business that is opportunistically raising capital will be inherently on different terms than a distressed or last resort type funding structure. But in all cases, this typically is not cheap capital for the issuer. The flexibility that they offer often comes at a cost.
• Keep an Eye on Governance– Minority investors will generally require some measure of control over the policies and direction of the issuing company to protect their investment. The right governance package, whether it be board seats, information rights, negative control, or rights relating to exits, is critical. For investors dealing with founders or family-owned businesses, in particular, this can be an important tool in building the right alignment of economics and governance that gets a deal done.
• Need for Alignment – Alignment is critical in finding the right terms. This applies not only to designing the right return and the right protections for the new investors, but also in contingency planning so that alignment is maintained over the life of the investment. Keeping an eye on whether expectations, business goals and incentives are aligned, and when they could become misaligned, is important for both investors and issuers.