A Strategist's Guide to Preferred Shares

An exploration of how subsidiaries use preferred shares to build assets, and what it means for companies and investors.

The Big Picture: What Are Preferred Shares?

This section breaks down the fundamentals. Preferred shares are a hybrid security, blending features of stocks and bonds. They offer a unique way for companies to raise money. We'll compare them to common stock and explore the different types you might encounter.

Preferred vs. Common Stock

Preferred and common stock differ significantly in terms of dividend payments, voting rights, liquidation priority, capital appreciation potential, and volatility. Understanding these distinctions is crucial for both investors and companies.

Common Types of Preferred Shares

Not all preferred shares are the same. Their features can change the deal for both the company and the investor. Here are some common types:

An Investor's Perspective

For an investor, preferred shares present a unique set of trade-offs. This section explores the balance between risk and reward, detailing the pros of stable income against the cons like limited growth potential.

Advantages for Investors

• Steady Income: Fixed dividends provide a predictable cash flow.

• Priority in Payouts: Higher claim on assets and earnings than common stockholders.

• Lower Volatility: More stable price compared to common stock.

• Potential for Growth: Convertible and participating types offer upside.

• Tax Advantages: Corporations can often deduct dividends received.

Disadvantages and Risks for Investors

• Limited Capital Appreciation: Little potential for capital appreciation.

• No Voting Rights: No say in corporate decisions.

• Subordinated to Bondholders: Paid after bondholders in liquidation.

• Dividends Not Guaranteed / Deferrable: Company can defer or stop payments.

• Interest Rate Sensitivity: Value can fall if interest rates rise.

• Call Risk: Company can buy back shares, limiting upside.

• Lower Liquidity: Can be harder to sell than common stock.

• Poor Performance in Crises: Can be more volatile than common stocks during downturns.

• Default Risk: Higher exposure to default risk compared to high-yield bonds.

The Parent Company's Playbook

Why would a large corporation have its subsidiary issue preferred shares? It's a strategic move to raise funds without giving up control or taking on too much debt. This section explores the benefits and risks involved.

Strategic Corporate Benefits

Financial and Accounting Implications

When a parent company controls a subsidiary, the subsidiary's financial statements are consolidated with the parent's. Preferred shares issued by a subsidiary to external investors are generally treated as "non-controlling interest" (NCI) on the consolidated balance sheet. Dividends on a subsidiary's preferred stock are included in non-controlling interest as a charge against income, affecting how consolidated net income is attributed to the parent.

Risks and Guarantees for the Parent Company

Parent companies may provide implicit or explicit guarantees on their subsidiary's preferred stock. While this can facilitate issuance or improve terms, it exposes the parent to the subsidiary's financial health. If a subsidiary defaults, the parent may be obligated to make payments, impacting its own cash flow and stability. Upstream guarantees (subsidiary guaranteeing parent debt) can be particularly problematic and challenged in bankruptcy.