Alternative Financing Hybrids: When Credit Looks Like Equity and Equity Looks Like Credit
The problem hybrids were built to solve
Let’s start from the beginning: why did hybrids gain so much popularity in recent years? Multiple structural shifts in the world of Private Equity contributed to the trend. Here are a few:
1. Liquidity turned scarce:
Median buyout holding periods crept up from 2.5 years in 2016-2019 to 3.4 years by 2024; meanwhile the share of companies held 5+ years has risen from 19% to 32%.₃
Over the same decade, global buyout AUM has tripled to ~$4.7 trillion, while annual distributions as a share of NAV dropped from around 29% to 12.3%.₄
Sponsors are sitting on large portfolios, thin exit markets, and LPs who want to cash out faster. Selling crown-jewel assets or issuing plain-vanilla equity is often politically or economically unattractive, therefore, many managers started to look for alternative financing (and refinancing) solutions.
2. The cost of traditional leverage reset.
The old playbook, based on maximizing the senior part of the leverage, worked well as long as interest rates were cheap – but that’s no longer the case. For example, a typical large-cap buyout in Europe, financed with 5-5.5x EBITDA of senior notes, can easily cost 400-450 bps. Layering hybrid capital behind it (second-lien, PIK, preferred or structured equity) helps reduce the cash interest, by giving investors access to other repayment structures.₅
3. Fund-level leverage has gone mainstream.
The practice of Net Asset Value financing – debt taken at the fund level, secured by the portfolio’s NAV – has “taken off” in recent years, and its market is forecasted to reach about $700 billion by 2030, with some observers expecting it to be ubiquitous among PE funds within five years.₆ Fund-level debt and preferred equity solutions act as flexible liquidity tools that funds can rely on to keep raising capital even when exits are slow and traditional fundraising gets difficult.
Hybrids are where those three pressure drivers meet: sponsors need non-dilutive, flexible capital, and credit managers want equity-like returns with embedded structural protection. The combined result has been the observed proliferation of these “middle of the stack” instruments, which have become vital in today’s M&A market dynamics.
Meet the middle: what these hybrids actually are
While hybrid instruments are highly customized tools that can exist in a virtually endless number of nuances and combinations, a few categories stand out:
a) Preferred equity at the company level
Preferred equity has evolved from an internal structuring tool to an asset class in its own right. By its position in the capital “food chain”, it’s senior to common equity, but junior to debt. It pays fixed or floating dividends that can considerably exceed the ordinary ones and benefits from a contractual liquidation preference.
Preferred investors usually get board seats and can exercise a certain influence on capital allocation and redemption decisions. Covenants on these contracts are heavily negotiated, and can include several restrictions to the management’s discretion. Upon exit, preferred shareholders exercise special redemption rights and can enforce drag or forced-sale provisions if not redeemed by a set date.₈
On a term sheet, this looks like equity, but in a downside scenario, its behaviour is much closer to deeply subordinated, covenant-rich debt.
b) HoldCo PIK notes
Holdco PIK notes sit at the holding company level, and are therefore structurally subordinated to the Opco’s senior debt, but still have right of precedence on the sponsor’s common equity.
Sponsors use Holdco PIKs to “stretch” the total leverage capacity without increasing the target company’s debt burden: interest is paid in kind, maintenance covenants are light or absent, and terms often mirror the senior facilities but with extra headroom.₉
Economically, this is equivalent to equity-like risk (you are behind the Opco lenders and dependent on a successful exit), but the return profile feels...