I. Introduction
This is the second in our series of follow-up pieces to CFO Market Update 2026, each taking a closer look at a topic we flagged only briefly in that broader overview. Last month, we focused on LP-led CFOs and the particular considerations that arise when a sponsor does not control the underlying fund GPs (LP-Led CFOs: Their Rise and Key Considerations). This installment turns to a different thread from the same overview: the growing use of preferred equity within the CFO equity tranche.
A collateralized fund obligation, or CFO, finances a portfolio of fund interests by issuing tranches of rated debt alongside an equity tranche that absorbs first losses and captures the residual upside once the rated debt has been serviced. As we noted in our July 2026 OnPoint, raising that equity tranche has historically been one of the more significant execution constraints in a CFO transaction, and that constraint has only grown more acute as CFO issuance volumes have risen sharply in recent years. Sponsors have increasingly found it harder to execute a CFO efficiently by funding the entire equity tranche themselves, or by placing it primarily with existing relationship investors on a pure common basis. Preferred equity, sitting between the rated debt and the unrated common equity, has emerged as the market’s answer to that problem. This OnPoint looks at why CFO sponsors are turning to preferred equity, the commercial terms that recur across the deals we see, and the legal considerations that come with layering a preferred position into a rated securitization-style vehicle. We share our own views, informed by our work for CFO sponsors and third-party capital providers on both sides of these transactions.
II. Why CFO Sponsors Are Turning to Preferred Equity
The size of the equity tranche in a CFO is not really a matter of sponsor preference. It is set largely by what the rating agencies require to achieve the ratings sought by the debt investors, since the equity tranche functions as the overcollateralization cushion the ratings analysis depends on. As CFO transaction sizes have grown, so too has the dollar amount of equity capital a sponsor needs to raise or retain for any given deal, making that already significant execution constraint even harder to manage.
Traditionally, the equity tranche was funded by the sponsor itself, often supplemented by placements with key relationship limited partners. As the number and size of CFO transactions has increased, that approach has put considerable pressure on how sponsors fund their own commitment. A growing share of the market has responded by splitting the equity tranche into a preferred layer and a common layer, sitting alongside the rated debt rather than as an additional class of rated debt, on the theory that a preferred return makes the position more attractive to prospective investors and correspondingly reduces the size of the harder-to-place common tranche.
We have advised several sponsors who did not want to retain an entire equity tranche themselves, or who wanted a broader set of investors than would otherwise be comfortable taking a pure residual position. In those deals, the equity tranche was tiered into a preferred layer and a common layer. The preferred layer sits ahead of the common position within the equity tranche’s own distributions, giving a hybrid credit/equity investor a negotiated priority return and a liquidation preference relative to the residual equity, without requiring the CFO to issue an additional class of rated debt that could stretch the modeling too far. In practice, this lets a sponsor widen its investor base for the equity tranche to include capital that would not otherwise accept a pure first-loss position, while preserving the manager’s incentive alignment in the residual common layer.
Preferred equity typically attracts a different investor base than the common layer. The preferred position is generally taken by third-party investors, such as credit funds and sovereign wealth funds, seeking a levered play on the private funds market with a priority return, while the common layer is typically held by the sponsor itself, key relationship limited partners, and rolling limited partners who sell an existing fund interest into the CFO’s portfolio in exchange for liquidity plus upside participation in the CFO’s common equity. Because preferred equity lacks typical secured creditor remedies, the providers who take that position tend to be a smaller and more specialized group than the broader secured lending market, even as the pool of such providers continues to grow with the asset class.
III. Key Commercial Considerations
The commercial balance between preferred and common equity depends on the portfolio, the financing structure and the objectives of the investors. Rather than a single standard package, the documentation needs to address a series of connected questions: how capital is contributed by each class of equity investor, how proceeds are shared between the preferred and common equity and how the parties manage ongoing business or economic changes over the life of the transaction.
Sizing.
The allocation between preferred and common equity needs to work for both the financing and the investors. For the sponsor, a larger preferred component may reduce the amount of common capital it needs to raise or retain, but it also changes how the residual proceeds are shared. Investors will therefore focus not only on the relative size of each layer, but also on whether the sponsor retains a meaningful economic interest in the transaction. The appropriate balance is transaction-specific.
Economics and the payment waterfall.
The central economic question is how proceeds available to the equity are divided between a priority return and residual common equity participation. The waterfall should make clear: (i) how the preferred entitlement is calculated, (ii) when distributions can be made, (iii) in which priority in favor of the preferred equity (whether linked to an anniversary of the debt, a financial hurdle metric or otherwise) and how the common equity participates in the remaining proceeds. Those provisions need to be considered together: a headline preferred return alone does not explain the allocation of risk and reward between the investors.
Funding obligations.
A CFO structure must be able to meet its funding obligations throughout its life. The equity documentation should address how those obligations are allocated, how much capital each investor is committed to provide and what happens if an investor does not fund when required. Any arrangements for additional funding (including via the preferred equity) should be assessed alongside the existing capital structure, including their effect on the relative position of preferred and common investors.
Recallable distributions.
Where distributions from underlying investments may be recalled, the equity arrangements need to address the resulting liquidity exposure. Investors should understand whether amounts distributed to them can be called back and how any continuing obligations are supported. The objective is to avoid a mismatch between cash released to investors and funding that the structure may subsequently need. Preferred limited partners will pay particular attention to the extent to which they may be required to return distributions and the limits on that exposure.
Managing changes over time.
Depending on the structure, the occurrence of a trigger event could give preferred equity investors an accelerated exit, step-up return, greater cash diversion (within the equity tranche), loosen transfer restrictions and/or more control over the CFO, although a trigger event itself usually does not give the common equity holders any such equivalent right. These covenants, and the alignment they are meant to preserve, tend to carry more weight and get negotiated harder where the sponsor is not itself associated with the underlying fund GPs, since a third party preferred equity investor in that position has no operational control over, or visibility into, the underlying funds, and the sponsor can offer only its retained common equity, rather than operational control, as evidence of continued alignment.
Control and consent rights.
These typically cover matters such as material amendments to the transaction documents, changes to the equity holding vehicle’s investment scope or capital structure, incurrence of additional indebtedness, transfers or encumbrances of the CFO interests, and settlement of material third-party claims, generally subject to customary carve-outs and cure periods.
Preferred investors will want protection against decisions that could undermine their negotiated economic position, while the sponsor needs sufficient flexibility to manage the transaction. The scope of information, consultation and consent rights is therefore an important part of commercial negotiations. The documentation should identify where those rights operate within the structure and how they interact with the powers and obligations of the CFO manager and other stakeholders.
Distributions in kind.
Distributions in kind are an additional key consideration when structuring the equity arrangements. Rather than requiring assets to be realized for cash, the structure can be designed to permit assets to be distributed to investors, subject to both the CFO’s financing terms and applicable transfer restrictions. This flexibility can help avoid a forced sale or accommodate different investor preferences, but requires careful agreement on valuation, the allocation of assets between preferred and common investors, and how the preferred entitlement is satisfied. The investors’ ability and appetite to hold the distributed assets, in addition to any associated consents, tax consequences and continuing funding obligations each need to be addressed. It is therefore important to ensure that flexibility is built into both the structure and reflected in the documentation from the outset.
Transfers.
Transfer provisions are not simply administrative restrictions: they help preserve the investor base, the sponsor’s economic alignment and the commercial agreement between preferred and common investors. Restrictions on transfers of the sponsor’s common interest can give preferred investors comfort that the sponsor remains exposed to the residual performance of the portfolio, while controls on incoming investors can protect the remaining parties. Conversely, restrictions that are too tight can limit liquidity, narrow the pool of potential buyers and make the equity harder to place. The balance may differ between preferred and common interests and may change following a trigger event. Negotiations should therefore distinguish permitted transfers from those requiring consent, consider whether minimum retention requirements are appropriate, and reconcile any agreed flexibility with restrictions elsewhere in the CFO structure. The objective is to preserve alignment without unnecessarily trapping investors in their positions.
Side letter protections.
Depending on the setup, preferred equity investors sometimes seek most-favored nations protection over more favorable economic, reporting or control terms granted to any other debt investor, and in some deals will also seek broader disclosure of side letters granted to other investors, debt or equity. These protections are typically for the exclusive benefit of preferred equity investors and are a further respect in which the preferred and common equity positions are treated asymmetrically.
Exit mechanics.
Liquidity expectations should be addressed at the outset, particularly where distributions depend on realizations from a portfolio of private fund interests. The parties should distinguish between liquidity through portfolio cash flows, a transfer of the investor’s interest and any other negotiated exit arrangements. Those expectations need to be reconciled with the CFO’s financing terms and the interests of the remaining investors. No particular exit route should be assumed to be available simply because the investment has been outstanding for a given period.
IV. Legal Considerations
Preferred equity in a CFO is a creature of contract, so both the risk profile and the tax analysis look different from work on the rated debt itself. Three issues recur on nearly every engagement.
First, a preferred equity investor’s remedies on a shortfall are limited to whatever was negotiated up front, typically rate step-ups and enhanced consent rights, rather than the acceleration, foreclosure, or statutory remedies available to an actual debtholder, so clarity in the documentation matters. Relatedly, sitting ahead of the common equity position in the waterfall does not guarantee a timely payment. Without the bankruptcy and creditor protections that come with a genuine debt claim, a CFO manager could defer an amount owed to the preferred equity position where paying it out immediately would impair the CFO’s longer-term economics. That is why step-up mechanics and enforcement triggers are often heavily negotiated by preferred equity investors, depending on how the CFO is structured.
Second, because preferred equity sits behind all of the CFO’s rated debt, it is exposed to being primed by new indebtedness or diluted by additional preferred equity issued on equal or better terms, so anti-layering protections are a threshold negotiating point rather than an afterthought.
Third, preferred equity’s value depends on how it interacts with the CFO’s own overcollateralization and coverage tests, since a breach will typically redirect cash flow away from the equity tranche generally, and the documentation should specify clearly whether the preferred equity’s priority survives that diversion. Where an early redemption or put right could force repayment of the preferred position ahead of the rated debt’s own final maturity, rating agencies, accountants, or the vehicle’s own covenants may treat the instrument as debt rather than equity, undoing the treatment the structure was built to achieve. Exit triggers accordingly need to be calibrated against the debt’s maturity schedule rather than set independently of it.
In the UK and European markets, it is also worth considering early whether the CFO structure, and the preferred equity within it, could itself be treated as constituting a tranche in a securitization. As we discussed in our July 2026 OnPoint, whether a CFO constitutes a securitization within the meaning of EU Regulation 2017/2402 turns principally on whether the transaction involves a tranching of credit risk, and a preferred layer inserted into the equity tranche is itself a form of tranching that should be assessed for that purpose rather than assumed away. Where the securitization regime applies, it can carry retention, disclosure, and diligence obligations depending on the instrument’s terms and the overall structure. Preferred equity and rated debt may also be characterized differently for tax purposes, with differences that can affect income timing and character, deductibility, and withholding, so those distinctions should be evaluated specifically for the preferred layer rather than assumed to track the analysis for the rated notes. The CFO market also remains bespoke enough, in this respect as in others, that broad documentation standardization of these terms is unlikely in the near term, notwithstanding the benefits it would bring.
V. Conclusion
Preferred equity occupies a negotiated position between the CFO’s rated debt and its common equity. Its commercial value depends not simply on a stated priority return, but on the interaction between the payment waterfall, funding obligations, governance arrangements and liquidity expectations. Those features need to be assessed as a whole and in the context of the CFO’s own financing terms. The result is a transaction-specific allocation of risk and reward, rather than a uniform package of investor protections.
Preferred equity has moved from an occasional accommodation to a sought-after tool for sizing and placing the equity tranche in a CFO. It lets a sponsor widen its investor base and reduce the amount of common equity it needs to place or retain, while giving investors a bargained-for priority within the residual position without the covenant package or enforcement rights of the rated debt. As CFO issuance continues to grow, we expect preferred tiering of the equity tranche to become more common, and to continue generating the negotiating points described above on nearly every transaction we see.
