Related Practices

Preference Shares

May 2009

As the global credit crisis and economic downturn have shown, the value of ordinary shares has been severely hit. This has led investors to seek out alternative securities which may fare better amidst this financial turmoil. One such instrument, the preference share, has in these circumstances become more appealing to investors, one of the most notable examples in recent times being Warren Buffet’s $5 billion investment in Goldman Sachs in exchange for preference shares (rather than just ordinary shares) with a 10% fixed dividend attaching.

Both ordinary shares and preference shares represent a piece of ownership of a company and offer the holder an opportunity to benefit from the future success of the company. However, as their name suggests, preference shares give their owners certain preferences over ordinary shareholders.

The two significant differences between ordinary shares and preference shares are:

  • Preference shareholders are often entitled to a fixed dividend, even when ordinary shareholders are not.
  • Preference shareholders cannot (in normal circumstances) vote at general meetings.

The preference dividend is fixed at the time of issue by reference to a fixed dividend rate (or coupon) which is applied to the nominal value of the preference share to determine the actual dividend payable.

If a company is unable to pay its preference share dividend then it will not be permitted to pay any ordinary share dividend because the preference shareholders have the right to receive their dividend in priority to the ordinary shareholders in all situations. Furthermore, preference shareholders rank before ordinary shareholders if a company goes into liquidation, although they still rank behind the holders of any form of company debt, including debentures, loan notes and the monies owed to the bank (secured and unsecured)

Essentially, therefore, preference shares are a hybrid of both equity (or risk capital) and debt. The preference shares pay out a fixed rate of dividend (akin to interest payments on debt), which don’t vary with the company’s profit, unlike ordinary shares. Consequently, the preference dividends do not increase if the company grows and its results improve, but they do offer certainty of return and therefore added protection during a company’s downturn.

Preference shares are usually expressed to be cumulative, which means that if a dividend is not paid out in any given year, then it will accumulate and be carried forward into the following year and paid (assuming the company has sufficient distributable profits to do so).

It is also possible to afford preference shareholders the right to participate to the maximum extent possible in any upturn in the company’s fortunes by making the preference shares redeemable (possibly at a premium) and/or convertible. Redeemable preference shares will be bought back by the company at some pre-determined future date. If the preference shares are convertible then the preference shareholders have the right at some point in the future to convert their preference shares into ordinary shares, thereby allowing them to benefit from any growth in the company.

Other features which may be built into a preference share instrument and which will ultimately enhance their value include:

  • Special voting rights to approve certain extraordinary events, such as the issue of new shares or the approval of the acquisition of a company, or voting rights which arise when the preference dividend is in arrears.
  • Protective provisions which prevent the issue of new preferred shares with a senior claim.

The appeal of preference shares in the current economic climate is that they are far less volatile than ordinary shares, which is attributable in part to the fact that they are less widely traded. In addition, preference shares have been shown to pay out more than ordinary shares (even though yields on ordinary shares have risen as prices have tumbled) and they come with the added security that they rank ahead of ordinary shares, both in relation to dividends and on a return of capital on a winding up. Furthermore, with interest rates in the UK now falling to all-time historical lows, the relative attractiveness (and therefore worth) of preference shares with their fixed dividend feature has (and is likely to continue) to rise, which would normally place upward pressure on the price of preference shares.

At present, however, most of the companies that have been issuing preference shares are finance businesses who are seeking to increase their capital base and a number of commentators have observed that, unless you are able to negotiate the sort of gilt-edged deal that Warren Buffet did with Goldman Sachs, the risks of investing in that sector still outweigh the potential benefits from holding preference shares.