In a world of QE3 and Fed-mandated ultra-low interest rates, where 10-year U.S. Treasuries yield 1.6%, five-year certificate of deposits pay 0.98%, and the coupon of investment grade bonds averages 4.71%, yield-focused retail investors have limited options in the fixed income world. These yield investors have “rediscovered” fixed income’s second cousin: preferred equity. (All numbers are as of Sept. 30, 2012.)

Over the past year, preferred equity has undergone a renaissance in demand not seen in the past 40 to 50 years. The supply of preferred securities has soared well beyond the $200-billion level that the preferred market reached in 2010, as high net worth and retail investors clamor for new issues with yields that frequently exceed 7%, as opposed to the paltry yield of a CD or investment grade corporate bond.

While preferred securities have traditionally occupied a slice in the capital stack in industries such as utilities and real estate investment trusts (REITs), oil and gas companies have only just begun to tap into this seemingly insatiable investor demand for yield, and to employ this nondilutive option to de-lever and finance ongoing operations.

Background

Preferred stock is an equity security with many debt-like characteristics. Similar to debt, preferred shares generally pay each holder a fixed payment, or dividend, regardless of the corporation’s underlying profit or loss. Like common stock, preferred shares are considered equity on the balance sheet and represent a right of ownership in the corporation.

Preferred shares rank senior to common stock in the right of priority of dividend payments as well as for any payments made upon liquidation of the issuer, otherwise known as “liquidation preference.” (However, in each case, preferred ranks below debt in the capital structure of a corporation.) Unlike common stock, preferred has extremely limited voting rights that only come into play if the preferred’s dividends have not been paid for an extended period, or if the corporation wishes to take an action that might impair the rights of the preferred’s holders.

The most common type of preferred issued today is nonconvertible, perpetual preferred stock. These shares neither carry a maturity date nor are they convertible into the underlying common shares of a corporation.

Preferred equity has its roots in the transportation industry. The first preferred stock was issued by The Baltimore and Ohio Railroad in 1836. By 1850, preferred shares became the standard method for railroad companies seeking to raise emergency capital to fund specific railroad projects. These became widely accepted as a regular means of financing when, in 1871, the Pennsylvania Railroad used preferred shares to finance multiple acquisitions to become the world’s largest corporation.

By the turn of the century, preferred shares had become a permanent capital solution and were used extensively. Unsecured debt, or debentures, did not become mainstream until after World War I, and therefore the typical financing instrument of the day was first mortgage bonds that fully encumbered the assets of a corporation.

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The development of preferred equity provided companies with a flexible instrument that did not encumber a company with liens, and thereby provided another vehicle for obtaining growth capital. Preferred stock hit its peak popularity in the 1920s, financing the public utilities boom representing 20% of new dollars raised. Today, preferred shares represent less than 5% of total capital raised.

Benefit to issuers

Nonconvertible perpetual preferred shares provide chief financial officers with another arrow in their capital raising quiver. It gives a CFO options: If the company needs to raise capital, but its stock is undervalued, a viable alternative is to issue preferred. Similarly, if a company wishes to avoid adding additional leverage to the balance sheet, nonconvertible perpetual preferred stock provides an elegant solution.

Preferred shares count as equity for GAAP purposes, while they do not dilute common shareholders. Simultaneously, these preferred shares serve to de-lever the capital structure. Preferred shares are covenant free, receive partial equity treatment from the rating agencies, and are typically nonvoting.

Issuing preferred shares allows a company to avoid the typical discounts experienced when raising capital via a traditional follow-on common stock offering. The average discount to market price for a traditional follow-on equity offering was 8.55%. This discount was for companies with an average market capitalization of $3.6 billion.

For smaller companies that issue securities through registered direct/confidentially marketed public offering structures, the typical pricing discount for a follow-on equity offering was 12.93%. Beyond the readily apparent impact on stock price and destruction of shareholder value, these smaller deals also frequently subject issuers to warrant coverage as a sweetener to help get the deal done, a device that further dilutes common shareholders. When analyzing all the negative impacts that a common stock follow-on has on existing shareholders, a preferred stock offering provides a compelling alternative.

If a company that is hesitant to issue common equity wants to issue high-yield debt, the market currently dictates it raise at least $250 million in an offering to create the necessary liquidity to attract institutional investor interest. Many companies don’t require that large a slug of capital, or don’t desire to lever up by such a large amount. Once again, the issuance of preferred shares provides a valuable alternative, whereby a company can size a preferred offering to meet its needs without having to conform to the minimum size requirements of the institution-driven high-yield market.

The average size of a preferred share issuance in 2012 was $187 million as compared to $485 million for a high-yield offering. More importantly, for small and mid-cap issuers, there have been many instances where issuers have raised $50 million or less (and in several cases, $20 million or less) in the preferred market: an amount that is a nonstarter in the high-yield market.

An additional consideration is the lack of a requirement to obtain a rating for a preferred issuance. Companies avoid the overall hassle and expense of obtaining a rating for preferred shares as compared to what is typically required in the fixed income markets. Almost 80% of all preferred shares issued were unrated.

Benefit to investors

Preferred shares are very high net worth and retail investor friendly. The average yield for preferred shares was 7.37%. This security satisfies a need in the market place by providing investors with access to higher yielding products.

Preferred equities give individuals a way to play the high-yield market, which is effectively closed to most retail investors due to cost and lack of transparency. The face value, or liquidation preference, of a typical preferred security is $25 per share, which is more affordable to a broader range of investors when compared to the typical $1,000 or $10,000 par bond.

Preferred shares are also much easier to trade since they are exchange-listed versus bonds, which typically trade in opaque over-the-counter markets where investors must rely on a dealer quote to execute a trade. Any individual can obtain the trading price of a preferred share as easily as they could the price of a share of common stock, whether punching in a ticker on Bloomberg or Google Finance.

Preferred stock dividends are paid more frequently than bonds, typically monthly or quarterly as opposed to semi-annually for bonds. Moreover, preferred stock dividends are tax advantaged as compared to corporate fixed income interest. Qualifying dividend payments from preferred stock are subject to a 15% federal rate while interest from bonds is taxed at an individual’s marginal tax rate. (At press time, it was uncertain whether this tax rate would change.)

In some circumstances, if an issuer is generating net tax losses, a tax shield is created whereby the dividends are not taxed. Rather, the tax is deferred until the holder sells the preferred shares with the dividend being considered a “return of capital” that results in a reduction in the holder’s tax basis.

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Almost 80% of all preferred shares issued were unrated.

The price of preferred shares is also much less volatile than that of common stock, providing less capital risk during periods of gyrating stock prices. This is because preferred stock usually trades more in line with long-term interest rates as opposed to the overall stock market.

Current preferred market

The desire for yield products in the current interest rate environment can be seen by the marked increase in dollars raised in the debt and preferred markets. So far $32.6 billion of preferred shares have been issued in 2012, an 86% year-over-year increase. This compares

with year-over-year increases of 33% for high yield and 14% for investment grade.

Recent changes by the Federal Reserve regarding bank capital rules represent another macro-event contributing to the current demand for new preferred share issues. These revised bank capital rules encourage banks to redeem their existing trust preferred securities (TruPS) as they will no longer count as Tier 1 capital.

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Since most banks are in a much stronger capital position today, these entities will not be issuing new preferred shares to replace the TruPS on a dollar-for-dollar basis. As outstanding TruPS are redeemed over the next 12 to 24 months, portfolio managers previously holding these yield products in their portfolios will be looking to replace them with another yield product, which will increase demand for new issues of preferred above the increase in demand from high net worth and retail investors.

Preferred shares and energy

In addition to the nondilutive, de-levering aspects of preferred shares described above, portfolio diversification represents another reason why oil and gas companies should consider tapping into the preferred market. CFOs can take advantage of the over-concentration of preferred securities issued in certain industries.

Currently, most preferred shares are issued by utilities, financial institutions, and real estate investment trusts or REITs. Demand exists from investors looking to diversify their holdings beyond these three industries. Oil and gas preferred offerings fit that bill. Each new preferred issue in the oil and gas sector has been well received. As demand by investors for diversification increases, oil and gas companies can expect to obtain improved pricing on their offerings.

The perpetual nature of preferred shares present another benefit for energy companies. The long-lived nature of the security matches the time horizon for capital expenditures rather than employing short-dated debt to pay for drilling expenses. Preferred shares give a company permanent capital with locked-in costs. As the credit worthiness of an individual issuer improves, that issuer can usually repurchase the outstanding shares or, alternatively, issue a new series of preferred at a lower all-in cost of capital, creating the same laddering effect in terms of yield and tenor, as companies typically accomplish with debt.

The list of oil and gas companies issuing preferred is growing. Companies such as Enbridge Inc., Magnum Hunter, AltaGas Ltd., Gastar Exploration, Evolution Petroleum, Husky Energy Inc., Miller Energy Resources, and TransCanada Corp. have all issue preferred shares. In fact, Enbridge has more than $3.3 billion of preferred shares outstanding, raising $2.8 billion in 2012 alone.

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Some $32.6 billion of preferred shares had been issued in 2012 as of September 30, an 86% year-over-year increase. This compares with year-over-year increases of 33% for high yield and 14% for investment grade.

The impact of the high net worth and retail investor in their never-ending quest for yield cannot be understated in this current low-interest-rate environment. Based on Corporate Finance 101, preferred shares should trade wide of a company’s senior notes, as they are structurally subordinated both in right of payment and right of liquidation.

Yet, this has not been the case. In fact, in several recent cases a company’s preferred shares have sold over 75 basis points inside of where its senior notes were then trading. The only explanation for this phenomenon is that two very distinct markets exist for each of the respective securities, with the preferred being priced by retail purchasers chasing yield and the senior notes being priced by more traditional institutional buyers.

Conclusion

The lesson to be learned is that retail investors have helped to drive the yields of preferred securities to record low levels given their appetite for income producing securities. Oil and gas companies can take advantage by participating in the preferred equity market to minimize shareholder dilution and “re-boot” their capital structure using a new, lower baseline cost of capital. At the same time, these companies will be tapping into a new investor base to which many have not yet been exposed.