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Hybrid Capital
Capital between senior debt and equity.
Hybrid capital is appropriate for owners who require quasi-equity capital that does not involve dilution or loss of control. These are situations where the senior lenders have reached their limit, while the equity story is still intact.
Typical scenarios
- A HoldCo, founder or family office which requires liquidity but does not want to sell any assets or give up control
- Quasi-equity capital or pre-IPO capital when sale or dilution at the current valuation is undesirable
- HoldCo loans that are flexible with respect to coupon (PIK or payment-in-kind toggle) because of uncertainty around dividends from operating companies
What we look for
- Downside protection through both the equity valuation and the structure: security, preference, puts or other protections
- An exit strategy within a defined period of time
Instruments
HoldCo loans, PIK loans, mezzanine loans, preferred equity, perpetual loans, convertible loans and loans with warrants.
Questions
01What are hybrid capital instruments?
Hybrid capital combines elements of debt and equity. Some examples of hybrid capital include convertible loans, loans with warrants, mezzanine loans, HoldCo PIK loans, perpetual loans and preference shares (preferred equity). Similar to debt, the instrument has a fixed return and ranks higher than ordinary equity in the capital structure. Similar to equity, the hybrid capital instrument is subordinated to senior debt and the issuer can generally defer payments on the instrument. Therefore, hybrid capital sits between senior debt and ordinary equity in the capital structure.
02How does hybrid capital work?
Hybrid capital is utilised when senior lenders have exhausted their lending capacity while owners are reluctant to dilute their position by issuing additional equity. The hybrid capital investor receives a return which is higher than the senior debt interest, partially or fully deferred and protected by the structure of the instrument such as preferred dividend rights and/or governance rights (e.g. observer seat on the board, veto rights on reserved matters). The instrument is generally repaid through a refinancing, a sale of assets or a conversion into ordinary shares under pre-agreed conditions.
03How does it avoid dilution compared with raising equity?
Equity financing gives the investor a permanent share in the company and in all future proceeds of the company at the current valuation. In contrast, hybrid capital offers investors a fixed return and a predefined term/time horizon (usually 5 years). Even if the hybrid capital contains warrants or conversion options, the amount of dilution will be lower than that of an equity issue at issuance of the hybrid instrument. Therefore, owners of fast-growing businesses or businesses with very stable cash flows often use hybrid capital in lieu of ordinary equity.
04What is a PIK toggle?
A PIK toggle allows the borrower to choose for each interest period to either pay the interest in cash or to capitalise it (payment-in-kind). The PIK toggle suits a holding company where the ability to pay interest depends on dividends received from its operating companies, which may vary each year. Usually, the decision to capitalise the interest will cost the borrower more, for example, via an increased interest rate for this period.