Convertible Preferred Stock in Leveraged Buyouts: Full Guide + Excel Examples

Convertible Preferred Stock Definition: In a leveraged buyout, Convertible Preferred Stock gives the investors downside protection plus potential equity upside by giving them the option to convert into common shares in the exit if the deal performs well enough – or stay in Preferred and earn back a higher balance by the end.

Convertible Preferred Stock is common in many situations, ranging from standalone company operations to venture capital deals, but this article focuses on its uses in leveraged buyouts.

It’s easiest to illustrate the mechanics with a simple example: Suppose a company acquired in a leveraged buyout has issued Convertible Preferred Stock with a 12% coupon rate attached.

If the internal rate of rate (IRR) to the Common Equity investors (i.e., the private equity firm) in the deal is 5%, the Convertible Preferred investors will stay in Preferred and earn a 12% IRR in the exit due to the 12% coupon rate.

But if the Common Equity IRR is 25%, the Convertible Preferred investors will convert into common shares in the exit and earn this 25% IRR.

There are some limitations to the downside protection and the amount of Convertible Preferred that may be used to fund deals, but it is still useful in many deals.

Files & Resources:

• Convertible Preferred Stock in LBO Models (XL)
• Convertible Preferred Stock in LBO Models – Slides (PDF)

Convertible Preferred Stock Mechanics in a Simple LBO Model

Setting up Convertible Preferred Stock in a simple LBO model requires initial assumptions, modifications to the 3 financial statements (or cash flow projections), and changes to the exit calculations.

The first two parts are straightforward, but the last one is tricky:

Convertible Preferred Stock, Part 1: Assumptions

First, you make assumptions about the Convertible Preferred Stock used in the deal, the Conversion Price, and the number of Potential Shares it represents.

The traditional Debt used in an LBO is typically based on a leverage ratio, or multiple of EBITDA, and so is the Convertible Preferred.

This model uses 4.0x EBITDA for the traditional Debt and 1.0x for the Convertible Preferred:

The Conversion Price is normally based on the Offer Price per Share in the initial deal, which equals the Purchase Equity Value / Pre-Deal Share Count, or $10.00 here.

The Potential Shares equal the Convertible Preferred Balance / Conversion Price, or $50 million / $10.00 = 5.0 million.

You also assume a coupon rate on the Convertible Preferred Stock, such as 12% here.

This is normally accrued or Paid-in-Kind (PIK), meaning the company does not pay these Preferred Dividends in Cash; instead, they increase the Convertible Preferred balance each year.

You can also plot the fully diluted ownership in the Sources & Uses schedule:

Convertible Preferred Stock, Part 2: LBO Model Flow

In the cash flow projections, Convertible Preferred Stock with 100% Accrued Dividends makes no net impact because the Preferred Dividends are non-cash and not tax-deductible.

So, you deduct them on the Income Statement under the “Net Income” line to calculate “Net Income to Common” and then add them back on the Cash Flow Statement.

These Dividends then increase the Convertible Preferred Stock on the Balance Sheet each year:

Convertible Preferred Stock, Part 3: Exit Calculations

The trickiest part of this model setup is the exit because many formulas must change.

Also, Convertible Preferred Stock creates a circular reference, and you need a special setup to avoid it with an approximation.

You can start by changing the Enterprise Value / Equity Value bridge so there are separate lines for Cash, Non-Convertible Debt, and the Convertible Preferred treated as either Debt or Equity (depending on the deal results):

You can leave the “Convert to Common” line blank for now and calculate the Common Share Price by dividing the Exit Equity Value by the Diluted Share Count in the exit:

The Convertible Preferred Share Count is based on the 5.0 million shares times this “Convert to Common” switch, which may be 1 or 0 (it’s still blank for now, which effectively means 0).

Next, you compare the “Accrued Value” of the Convertible Preferred to its Value as Common Shares, which is based on the 5.0 million shares * Common Share Price in Exit:

The “Convert to Common” switch is 1 if the Convertible Preferred is worth more as Common Shares and 0 if it’s worth more as Debt (the “Accrued Value”).

This creates a circular reference because the Diluted Share count in the exit depends on the conversion decision, but the conversion decision also depends on the Diluted Share count!

There are some tricks to get around this (see below), but it’s a common issue with Convertible Preferred Stock.

As the next step, you return to the bridge calculations at the top and deduct either the Convertible Preferred as Debt or Equity, depending on the investors’ conversion decision:

You use a negative sign for the Accrued Value and multiply by (1 – Conversion Switch) for the Debt; for the Equity, multiply the Value as Common Shares by the Conversion Switch and put a negative sign in front.

You can then calculate the cash-on-cash multiple and IRR for each group, which demonstrates the advantages of Convertible Preferred Stock in different deal outcomes:

Why Convertible Preferred Stock Does Not “Guarantee” Returns in an LBO

Suppose this deal is a complete disaster and the multiple falls from 12x in the initial deal to the 2 – 4x range in the exit.

In this case, there won’t be enough exit proceeds after the repayment of the traditional Debt to cover the full Convertible Preferred Stock balance.

You can set this up with MIN formulas based on the remaining proceeds and the owed Debt balances:

The Convertible Preferred Stock IRRs fall to the 2 – 5% range in this case because the investors are not fully repaid in the exit.

The same issue comes up with liquidation preferences in VC deals: Yes, they protect the investors in the case of an exit at a reduced valuation, but they don’t help if it’s a true disaster.

How to Avoid Circular References from the Convertible Preferred Stock Calculations

Circular references make models unstable and more difficult to modify, so many groups and firms do not allow them.

If your model has circular references, you should always build in the option to disable them by using a simple approximation for the numbers.

One “trick” here is to escalate the initial Investor Equity AT the rate of return on the Convertible Preferred Stock and compare that to the Exit Equity Proceeds assuming the Convertible Preferred is counted as traditional Debt.

This tells you whether the Common Equity has increased by more than 12% per year.

If it has, the investors should convert into Common Shares; if not, they should stay in the Convertible Preferred Stock:

You can add this feature by building in a “switch” for circular references at the top and then referencing it in the Convert to Common switch at the bottom, as shown above.

If circular references are enabled, compare the Accrued Value to the Value as Common Shares.

If they’re disabled, compare the Common Equity at the Convertible Preferred Rate of Return to the Exit Equity Value with the Convertible Preferred treated as Debt and base the decision on that.

This method is slightly less accurate, but it also produces models that are more stable and easier to modify.