Preferred equity: Possible conversion should not negatively affect share price
Before we describe the impacts on VCP’s equity valuation that have arisen from its
preferred equity, we provide some background to the preferred equity.
In October 2020, VCP announced the issue of up to £175m convertible preferred equity
to Koch Equity Development (KED). KED is the acquisition and investment subsidiary
of Koch Industries, one of the largest privately held companies in the US, with ownership
of a diverse group of companies including US carpet businesses. In November 2020,
KED agreed to increase the preferred equity investment to £225m. Alongside the preferred
equity, KED was awarded warrants to subscribe for 12.4m shares at a price of £3.50.
At the same time, KED acquired 10% of VCP’s equity in the secondary market from a
long-term investor that wanted an exit.
The rationale for raising the preferred equity was to help VCP make acquisitions;
£75m was issued at the outset, in October 2020, and the balance was issued in FY22.
VCP’s management claims the relationship has provided other benefits apart from helping
to provide funding for acquisitions, including know-how in sourcing materials and
with respect to acquisitions in North America.
The initial terms of the preferred equity included a dividend of 9.35% if settled
in cash, or 9.85% if paid in kind (PIK) by way of issuing additional preference shares.
Starting in year five, the dividend moves from a fixed rate to a spread over the three-month
Libor rate. The spread starts at 9.35% and 9.85% (for cash and PIK, respectively)
and increases by 1% in each subsequent year up to year nine, after which it remains
flat. The dividend and spread rates were reduced by 100bp on the increased commitment
in November 2021. After the sixth anniversary (ie 30 October 2026 for the first tranche
of preferred equity), KED can elect to convert the outstanding preferred equity and
PIK’s dividends into ordinary shares at the 30 business day volume weighted average
price of the ordinary shares. We should highlight that the conversion is not mandatory
and therefore KED might not opt to convert the preferred equity into ordinary shares
from the start of November 2026. There are two scenarios in which mandatory cash redemption
of the preferred equity can occur outside the control of VCP’s management: first,
if VCP becomes insolvent, or second, a change in control with various conditions.
The preferred equity is a perpetual instrument but VCP can choose to redeem in cash
at any time, subject to a redemption premium that varies with time.
The warrants are exercisable following the third anniversary (October 2023) with certain conditions at an exercise price of £3.50, significantly higher than
the current share price.
As might be expected, accounting for the instruments is relatively complicated. Put
simply, the underlying host instruments sit on the balance sheet and are revalued
at every reporting date. The cost of the host instrument is amortised and the increase
in the value of the instrument is taken through the income statement as financial
charges. In addition to the underlying host instruments, there are associated derivatives
and instruments that reflect the options open to both parties, for example cash redemption
by VCP and KED’s option to convert. The potential dilution from the preferred equity
and contractually linked warrants is included in VCP’s calculation of diluted adjusted
earnings per share.
At the end of FY25, the balance sheet liability for the preferred equity was valued
at approximately £283m and the contractually linked warrants at c £3m, versus £274m and £12m,
respectively, at the end of FY24.
The effects of the preferred equity liability on VCP’s share price
As the preferred equity liability has increased over time and VCP’s share price has
fallen in recent years due to the deterioration in trading and increase in debt, the
‘feared’ potential dilution to equity holders from the possible conversion of the
preferred equity by KED has also weighed on the share price as more shares would have
to be issued to satisfy the potential conversion. Effectively, this has created a
vicious circle, with share price declines magnifying the potential dilution from the
preferred equity and so on. Therefore, more encouraging signs of an increase in profitability
from internal initiatives and any revenue recovery, along with fewer concerns about
financial liquidity, should be helpful in improving VCP’s equity valuation, which
in turn would reduce any potential dilution from the conversion of the preferred equity.
The conversion of the preferred equity should not negatively affect Victoria’s share
price. In November 2026, if KED chose to convert the preferred equity, it would be
exchanged into ordinary shares at the prevailing share price, so the debt reduces
by the same amount as the equity increases. Although the existing shareholders would
own a lower percentage of the company, their shares would not be worth any less.
