Insulating Investors from Cash Flow Seasonality

 

Do investors prefer distributions tied to fluctuating cash flows or fixed dividends, all else equal? 

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Case Study: 

A partnership successfully acquired a small, established business via a 506(b) offering, raising capital from investors by projecting a return of 20%.  By the third quarter after closing, the business was doing well.  Management had distributed cash that already exceeded the investor's annual expected return for year one. Management was happy and investors were content; but then came fourth quarter. Much like two pre-acquisition fourth quarters, the company posted negative cash flow.  The seasonality effect in this last quarter had been even greater than management forecasted. Their formula of distributing all remaining cash flow per quarter calculated a dreaded capital call from investors to balance out the negative quarter.

The last thing that management wanted to do was to ask investors to pay back some of their distributions, so, instead of issuing a capital call, they accrued negative amounts in each investor’s capital account and paid out no distribution.  They formally communicated to the investors that the quarter was affected by seasonality, and that the first year, which had appeared to be stellar, would turn out to just meet expectations overall.  The feedback was mixed, and disappointment was not absent.  The rest of the project was successful, though the seasonality continued to fluctuate distributions.  Some investors chose not to reinvest with that team due to the turbulent nature of distributions.

Do investors need to be insulated?

When it comes to their distributions, many professional investors prefer consistency over caprice.  Yet seasonality or other major changes in business can produce results that are anything but constant. Fortunately, there are other methods to distribute cash flow to investors that still reflect profits, while insulating them from the typically turbulent cycles of business.   


Preferred stock 

Preferred stock for investors can be a balanced solution in such cases. Preferred stock distributes the company’s cash to investors based on a dividend, and not only is the dividend rate fixed but also the dividend amount. The dividend is calculated in the initial offering documents by multiplying the dividend rate by the predetermined par value.  It does not change or fluctuate in tandem with net cash flow but instead remains steady each quarter.  Consequently, preferred stock and its reliable distribution is one of the desired share types among many private investors.

With this increased stability comes increased risk - not to the investors, but to management. With a predetermined dividend, management will have to take extra caution to ensure that they can continue running business in a healthy manner with preset dividend payments. The dividend payments can become as burdensome to a company as debt service payments even though preferred stock dividends are junior to debt payments in liquidation events.  At the same time, if management wants to keep their investors happy, they may want to treat dividend payments just as non-negotiable as they treat their debt service payments. 

 

Additional Details of Preferred Stock

Issuing preferred stock does not issue ownership, so managers wishing to keep or protect ownership rights in the company may benefit from issuing preferred stock. It does not have normal voting rights. Though junior to lien holders, preferred stock is senior to common stock, which comes into play in liquidation events.  

A company must specify in their articles of incorporation that they can issue preferred stock. A common trend of doing so is via a “blank check” preferred stock clause, which allows the company to issue any type of preferred stock in the future. Based on the company’s preferences, that may include callable, cumulative, non-cumulative, retractable, etc.

 

Callable Preferred Stock

Callable preferred stock gives the issuer the right to “call” or buy back the preferred shares at a pre-defined date and at a predefined price.  This is particularly useful for a highly profitable business that has earned enough money to buy out investors within a few years or even earlier without having to get shareholders to agree to the buyout. That way the business can keep the otherwise distributed cash flow.  

If management desires to call the shares earlier than anticipated they can do so at the predetermined call price, which is usually higher than the issue par value, thereby securing a return to the investors regardless of the call date. 

For large private or public companies, another benefit of callable preferred stock is being able to call the shares when market interest rates drop.  If management is confident in market demand for their preferred shares, they may call their current shares and then reissue new preferred shares nearer the lower interest rate, lowering their dividend obligations and increasing their free cash flow.

 

Cumulative versus non-cumulative preferred stock

Another feature management can add to their preferred stock issue is cumulative or non-cumulative.  The most common is non-cumulative, which means if there is no cash to pay any dividend in a quarter and, according to the offering documents, the company is not obligated to pay preferred dividends in such a case, and the company chooses not to pay out, then there is no obligation management to “catch up” on that missed dividend in the future.  On the other hand, cumulative preferred shares require that even if there ever is a quarter when the company cannot and does not pay a dividend, management must accrue that missed dividend amount as a liability and pay it to investors when cash flow returns. 

 

Wrap Up

Among the myriad ways investors receive cash flows from private investments, fixed dividends from preferred stock may not only gratify selective investors but also convert them into long-term equity sources.  Distinctly different distributive arrangements may ironically mirror each other when cash flow is consistent and reliable quarter after quarter, yet investments in businesses with seasonal or cyclical cash flow may enjoy the constancy of fixed dividends, such as those that come from preferred stock dividends.  Even more, management may benefit from the flexible freedom of callable preferred shares in times of high profitability or low interest rates.  Though no single arrangement of shares will suit all types, tailoring cash distributions to investor’s preferences may be a good start.