USA – TEXAS Trends and Developments Contributed by: David Stringer, Kyle Kreshover, Austin Johnson and Shaq R. Taylor, Clifford Chance
seat or veto rights over certain fundamental deci - sions. Direct lending substitutes operational control for contractual protections through security interests and affirmative and negative covenants in regard to certain financial metrics or key business activities of the company. As part of these governance structures, sophisticated investors also plan for downside scenarios. For exam - ple, investors often ensure that developer-controlled projects include step-in mechanisms to flip govern - ance control from a developer to a major investor or combination of the other investors upon missed milestones, events of default, failures to exit or other agreed adverse events. Financial terms These instruments’ financial terms can be flexible to the desires of the parties and the commercial profile of the investment, and must balance investor protec - tions in the distribution waterfall, liability allocation and capital contributions with the company’s or pro - ject’s capital requirements and risk profile. While “all common” structures remain standard in JVs, convertible and preferred equity structures are increasingly used to mitigate early-stage downside risk, especially for investments in development-stage projects. Sponsors can find comfort in the risk-miti - gation mechanics of preferred equity that mimic fea - tures of debt finance, such as fixed coupon returns, “first-out” preferred returns in the distribution water - fall, and anti-dilution mechanics to secure its option for equity-like upside upon an optional conversion into common equity. Preferred equity can be structured to remain in place until an exit; however, in the con - text of large greenfield project development, it has become common to have convertible preferred units that convert (either automatically or at the option of the sponsor) to common units upon substantial com - pletion of construction, because once the project reaches substantial completion, the risks that initially justified the preferred equity structure will have been materially reduced. In true co-investments, the most common scenario is for the co-investor to push to receive the same treat - ment of equity as the sponsor and to ensure that their
interests are pari passu in all economic scenarios, as the most important factor for most co-investors is ensuring their interests are aligned with the sponsor. In direct lending, returns come from interest, which may be a fixed amount or a floating rate tied to an index such as SOFR or some other measure. Direct lending has a more limited upside than the other instruments discussed here, but the lender receives greater security for its loan via priority returns (ahead of any hybrid, preferred or traditional equity) and col - lateral security in the project or company. In multi-layer capital stacks, cross-default and accel - eration provisions require careful drafting to craft solutions that allow parties to correct issues and to avoid a “race to the exit”, and to carefully resolve the implications of these items. It is also becoming com - mon for any “governance flip” or “step-in” rights to be triggered if the project or company defaults under a credit facility or other material contract. In arranging the economics and governance terms of the various instruments and securities, parties must also ensure that the respective elements are struc - tured in a manner that achieves the debt and equity treatment desired by the parties from an accounting perspective, which may be influenced by governance and economic protections, especially certainty of return of capital and levels of control of the business. Exit considerations Exit mechanisms for any of these complex capital structures should reflect both the project’s likely path to liquidity and the relationships (and differences) among the investors in the capital stack. The relevant considerations will vary depending on the type of instrument being used. In JVs, where certain investors are bringing capital to a management-driven project, financial investors may ask for a put right or tag right if the manager exits, in order to provide an exit ramp if the initial operational team the investor trusted to develop the project is no longer the development part - ner. Similarly, in a co-investment, the co-investor often requires tag-along rights or co-sale rights tied to a sale by the sponsor in order to align its incentives and exit opportunities with the sponsor, whose larger, con - trolling stake in the company is typically more liquid
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