Preferred equity is gaining in usage across rated fund finance and structured credit products. Sponsors of collateralized fund obligations (CFOs), collateralized loan obligations (CLOs), rated note funds, and other securitization-style vehicles are increasingly using a myriad of bespoke preferred structures to widen and incentivize a growing pool of third-party capital providers willing to sit below the rated debt.

This OnPoint focuses on that structured finance use case and how it is showing up inside and outside the formal capital structure of such transactions. We have been actively involved in many preferred equity arrangements, and share our views based on our work for both asset managers and third-party capital providers.

I.  KNOW IT WHEN YOU SEE IT:  WHAT IS PREFERRED EQUITY?

In a typical securitization, the capital structure runs from senior rated debt down through progressively more subordinated tranches to a single residual equity position. Preferred equity is what happens when that residual position is itself split, or when third-party capital is brought in below the rated debt on negotiated priority terms that participates in residual economic sharing. There is no single form preferred equity takes. In particular, it is best understood as a bundle of contractual rights layered onto an equity or residual interest to make it behave more like a rated tranche economically, without importing the covenant package, collateral, or statutory enforcement rights that would come with an actual debt instrument. And, in our experience, it is not cheap.

Notwithstanding the pricing mechanics, the combination is attractive on both sides of the table. Sponsors and managers get capital that sits below the rated debt without giving up all of the residual economics they intend to retain, and without adding a genuine debt obligation that a rating agency would need to size and stress separately. Investors get a bargained-for priority ahead of the remaining residual holders, and economics to compensate for the incremental risk vis-à-vis holding rated debt.

Recurring features of preferred equity that are often found in this context include the following:

  • A preferred return, structured as a distribution priority within the vehicle's payment waterfall rather than as scheduled interest, often payable in cash, accrued and paid in kind, or a blend of both. Some of these instruments also receive fee rebates outside of the vehicle's payment waterfall.
  • A liquidation or redemption preference entitling the holder to recover its investment, plus any accrued return, ahead of the remaining common or junior equity.
  • Waterfall-level protections, such as restrictions on distributions to the junior residual position until the preferred position's priority amounts have been satisfied for the relevant period.
  • Defined exit mechanics, including call rights after a non-call period and redemption premiums, enhanced transfer mechanics and sometimes a right to require a recapitalization of the structure or a distribution in kind. Most of these instruments carry no fixed maturity whatsoever; instead, the economics are designed to make holding the position progressively more expensive for the issuer over time (typically through a rising preferred rate), which functions as the practical incentive for a redemption, while true forced exits are generally limited to a change of control, significant deterioration of portfolio quality or a handful of other negotiated events.
  • The ability for the preferred holders to inject, without manager or sponsor consent, additional capital to the structure (usually with premium interest rate) in order to cure certain breaches of financial metrics that are set by rated tranche investors or the rating agencies.
  • Consent, consultation and enhanced information rights over a defined set of manager or sponsor actions. Where the preferred position represents a meaningful share of the capital structure, we also see holders push for governance levers beyond consent rights alone, for instance a seat (or observer seat) at the fund level, or the ability to force a sale or restructuring of the vehicle if the preferred position's priority amounts fall materially behind schedule or if the portfolio quality significantly deteriorates.

II.  PREFERRED EQUITY IN CFOs

CFOs are one of the clearest examples of preferred equity's growing role in rated structures. A CFO Issuer typically acquires a diversified portfolio of underlying fund interests and finances that acquisition by issuing tranches of rated notes alongside an equity tranche that absorbs first losses and captures the residual upside once the rated debt has been serviced. Read more about CFOs in our recent DechertOnPoint,
CFO Market Update 2026: The Room Where It Happens.

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 itself 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 notes. 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.

The same structuring rationale explains why preferred equity is often discussed as a natural complement to a CFO's existing liquidity tools, such as a revolving liquidity facility or delayed draw notes used to fund capital calls on underlying fund interests.

Given the high customization of CFOs, we have also advised sponsors that utilize equity vehicles or holdcos to invest in the CFO equity, and there could also be a preferred holder investing through such an equity vehicle or holdco, controlling the relevant entity, which in turn votes on CFO matters in its capacity as CFO equityholder. Depending on how one views the CFO equity vehicles or holdcos, this arrangement could arguably be considered as outside of the CFO structure, but generally speaking these arrangements are one-off, deal-by-deal third party checks tied to such CFO's own modelling. With that said and based on the various inbound calls we have, the market is certainly looking for opportunities to introduce preferred equity outside of the CFO structure.

III.  PREFERRED EQUITY IN CLOs

CLOs present a similar dynamic, but preferred equity is showing up there in two distinct ways: (i) as a formal tier inside the CLO's own equity tranche, and (ii) as an economic overlay sitting entirely outside the CLO indenture, most often at the level of the CLO equity fund or the manager's warehouse arrangements.

Inside the Structure: Tiering the Equity Tranche.

A traditional CLO has a single unrated equity tranche below the rated debt, with the manager or sponsor typically retaining all or a meaningful share of that tranche. As with CFOs, sponsors have in some cases split that equity tranche into preferred and common tiers to unlock demand from hybrid credit/equity investors who want priority within the residual position itself. This mirrors the CFO experience: using a preferred layer to widen the pool of capital willing to sit below rated debt has become a recognized structuring technique in both products.

Outside the Structure: Preferred-Style Capital at the CLO Equity Fund and Warehouse Level.

The more significant recent development, in our experience advising CLO managers, is occurring outside the CLO indenture entirely, at the level of the CLO equity fund and the warehouse facility that precedes a CLO's pricing. In a tight-arbitrage environment, we are seeing third-party capital increasingly come in through joint venture or multi-deal capital commitment arrangements with a CLO manager, committing equity capital across a defined number of future CLOs in exchange for management fee rebates, enhanced distribution rights, or other structural accommodations that would not be available to a stand-alone investor. Economically, these arrangements function much like preferred equity: the third-party capital sits ahead of the manager's own residual economics in the relevant deals and receives a negotiated priority return through fee rebates or distribution enhancements, without the governance or upside of a true anchor or control equity position. A handful of our clients are also exploring cross-platform partnerships and minority stake structures, where a captive vehicle takes the majority equity position and brings in third-party capital for the remainder on preferred-style terms.

IV.  PREFERRED EQUITY IN NAV FACILITIES

In our experience advising on these deals, NAV facilities present a somewhat different structuring problem than CFOs and CLOs, but preferred equity has also become one of the standard answers to it. A NAV lender wants priority ahead of the fund's own equity in the underlying assets it is lending against. Many fund governing documents, however, restrict or prohibit a direct pledge of portfolio interests, prohibit debt incurrence at the fund level altogether, or raise tax or investor-relations concerns among LPs who are sensitive to fund-level leverage. We have advised a number of clients who turned to preferred equity as a structural solution in such circumstances.

The Preferred Issuer / Preferred Holder Structure.

The mechanics we most often see are as follows: a fund forms a special purpose vehicle that issues preferred equity interests (we will call it the preferred issuer), and a separate, typically bankruptcy-remote affiliate acquires those interests and borrows against them under the NAV facility (the preferred holder). Because what the preferred holder actually owns is an economic claim on the underlying portfolio rather than a direct pledge of, or control over, the portfolio investments themselves, this two-step structure avoids many of the transfer and pledge restrictions that would otherwise stand in the way of a conventional NAV facility. The tradeoff is that the lender's collateral package is generally limited to the preferred interests and the preferred holder's own accounts, rather than any direct claim on the underlying assets. Because the lender in this structure sits one step removed from the underlying assets, the preferred equity's own governing terms have to do the work a conventional loan agreement would otherwise do directly and, as remote as this may be, the preferred equity will be structurally subordinated to any claim at the preferred issuer.

A Related but Distinct Use Case: Securitization-Style NAV Facilities for Credit Funds.

A related but distinct pattern we see on the credit fund side: NAV facilities for credit funds frequently take a securitization-style structure rather than a single bilateral loan, since a credit portfolio lends itself to more standardized, fixed eligibility criteria. Structures we have worked on this way can typically support a higher advance rate than a conventional NAV facility and open the financing to a much wider investor base, including rated capital markets investors such as pension funds and insurers, where the structure carries a rating. Preferred equity fits naturally here for the same reason it fits into a CFO or CLO: it lets a sponsor bring in additional capital below the top of the structure without adding a further class of rated debt. That being said, issuers should expect more structuring, reporting, and tax work than a simpler bilateral facility would require.

V.  PREFERRED EQUITY IN RATED NOTE FUNDS AND THE BROADER SECURITIZATION MARKET

Rated note funds and broader fund-of-funds securitizations raise the same structuring question CFOs do: how does a sponsor bring additional capital into the vehicle below the rated debt without either diluting the manager's retained residual position or forcing the vehicle to issue and rate an additional class of debt?

In the rated note fund deals we work on, the equity cushion tends to be thinner than in a CFO's multi-fund structure, since a rated note fund is typically a single pool of directly held assets rather than a diversified portfolio of fund interests. Because that cushion is thinner, many of our sponsor clients have found a preferred layer within it to be an efficient way to attract investors seeking a defined, prioritized return with less exposure to first-loss risk than the fund's true common equity, while avoiding the additional rating agency diligence, sizing, and stress testing that an additional mezzanine note class would require. We see the same logic extending to other securitization-style vehicles collateralized by diversified financial assets, including residuals in other asset-backed transactions, where a preferred layer offers a flexible middle ground between the rated notes and the vehicle's true first-loss position.

Across all of these structures, the appeal of preferred equity over an additional note class comes down to speed and flexibility: a preferred tranche can generally be negotiated and documented among the sponsor, the manager, and the incoming investor without the same level of rating agency involvement, diligence, and structural rigidity that a new class of rated securities would require, even though it is being used to accomplish a similar economic objective.

Reinsurance Sidecars: An Active and Growing Example.

Outside of fund finance entirely, we have watched the (re)insurance market develop one of the clearest and most active examples of preferred equity functioning as a securitization tool. A reinsurance sidecar is a vehicle that a reinsurer capitalizes with third-party money so those investors can take a defined slice of the reinsurer's underwriting book, typically through a quota share, in return for a cut of the ceded premiums and losses. Rather than issuing principal-at-risk notes, sponsors have increasingly chosen to issue preferred or preference shares out of these vehicles, giving investors an equity-like instrument that still carries a defined priority position within the sidecar's capital structure. This is not a one-off: we are seeing repeat sponsors bring successive series of preferred or preference shares to market out of the same sidecar across multiple renewal cycles, and newer entrants have taken listed preferred share issuances to market through segregated account or protected cell structures. The commercial logic mirrors what drives a CFO or CLO sponsor: preferred shares let third-party capital sit inside the vehicle's own equity without the cedant having to build and market a rated note class for what is, commercially, a first-loss or near-first-loss position.

Consumer and Esoteric Asset Backed Securities ("ABS"): Financing the Residual Rather Than Splitting It.

A related but distinct pattern is showing up in consumer and esoteric asset-backed securitizations, where the residual interest retained by a sponsor, whether for risk retention, credit enhancement, or simple economic reasons, is itself increasingly financed or monetized through its own follow-on securitization. In these transactions, the sponsor's residual claims across a pool of prior deals, often including the related spread accounts and overcollateralization, are contributed to a new vehicle that issues its own notes secured by that residual cash flow. While these transactions are typically structured as debt rather than preferred equity, they illustrate the same underlying market dynamics. Preferred equity is one of several structuring tools, alongside residual-interest debt financings of this kind, that market participants are using to unlock value from equity and residual positions that would otherwise sit unmonetized on a sponsor's balance sheet.

Taken together, CFOs, CLOs, NAV facilities, rated note funds, reinsurance sidecars, and residual-interest financings in consumer and esoteric ABS reflect the same structural instinct playing out across very different asset classes: wherever a securitization-style vehicle has a first-loss or residual position that a sponsor wants to share more broadly, preferred equity (or a close structural cousin of it) tends to appear as the tool of choice.

A related and increasingly active market has developed in mandatory redeemable preferred shares ("MRPS") privately placed by registered closed-end funds with insurance companies and other institutional investors. MRPS pay a fixed or floating dividend and are redeemable for cash at a stated liquidation preference on a defined maturity date, giving institutional buyers a bond-like instrument while the fund avoids issuing a "senior security representing indebtedness" under Section 18 of the Investment Company Act of 1940 (as “senior securities representing stock,” MRPS are subject to lower asset coverage requirements than traditional debt instruments such as bonds). A number of our sponsor clients have completed rated MRPS private placements with institutional investors in recent years, and MRPS now represent a meaningful and growing share of traditional closed-end fund preferred share assets industry-wide. The same commercial logic recurs: institutional capital accessing fund-level economics through an instrument priced and structured like debt.

VI.  LEGAL CONSIDERATIONS

Preferred equity in these structures is a creature of contract so both the risk profile and the tax analysis look different from work on the rated notes themselves. Based on our involvement on both sides of these, three issues recur on nearly every engagement: first, a preferred holder'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 actual debtholders, so clarity is important. Relatedly, a preferred holder should not assume that being ahead of the common or residual position in the waterfall guarantees a timely payment: without the bankruptcy and creditor protections that come with an actual debt claim, a manager can, in some circumstances and consistent with its duties running to the residual holders, defer an amount owed to the preferred position where paying it out immediately would impair the vehicle's longer-term economics, which is precisely why negotiated step-up mechanics and hard triggers for enforcement matter so much in these instruments. Second, because preferred equity sits behind all of the vehicle's rated debt, it is exposed to being primed by new indebtedness or diluted by additional preferred issued on equal or better terms. Thus, anti-layering considerations are a threshold negotiating point, not an afterthought. Third, a preferred position's value depends on how it interacts with the vehicle's own overcollateralization and coverage tests, since a breach will typically redirect cash flow away from the preferred equity tranche generally, and we make sure the documentation specifies whether the preferred priority survives that diversion. It is important to note that if 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 very treatment the structure was built to achieve, so exit triggers need to be calibrated against the debt's maturity schedule rather than set independently of it. We advise our clients to review any outside of the structure arrangements, such as joint ventures and the various forms of investment and fee sharing arrangements, with the same level of care and diligence they would use in reviewing an indenture or other debt document even though these arrangements may take the form of side letters rather than securities.

In the UK and European markets there is often a focus on whether or not a transaction should be structured as a securitization. For some investors, this will improve capital treatment significantly whilst others will not want to hold securitized tranches. In Europe and the UK, preferred equity can be viewed as constituting a tranche in a securitization depending on its terms and the overall structure. As a result it is important to address this issue early on when contemplating an issuance of preferred equity in circumstances where there are UK or European sell-side or buy-side parties. Preferred equity and rated debt may be characterized differently for tax purposes, with differences that can affect items such as income timing and character, deductibility, and withholding. Because the relative advantages depend on the particular structure, entity classification, and investor profile, it is important to evaluate those distinctions specifically for the preferred layer rather than assume the analysis is the same as for the rated notes.

VII.  CONCLUSION

Preferred equity has moved decisively from a niche accommodation to a mainstream, and expanding, feature of the structured finance toolkit. Across CFOs, CLOs, NAV facilities, rated note funds, reinsurance sidecars, and the broader securitization market, its growing footprint reflects real structural staying power, and the surrounding markets bear that out. It lets a sponsor or investor approximate the priority of a senior claim with attractive economics, while avoiding the transfer restrictions, debt covenants, or additional rating agency process that a genuine new debt instrument would require.

Hard figures on preferred equity itself are scarce given how bespoke and private these arrangements are, but the markets it inhabits are growing quickly: one industry estimate attributes roughly 22% (and growing) of the NAV financing solutions market to preferred equity structures specifically; CLO equity, inside which preferred tiers increasingly sit, stands at roughly $160 billion of a $1.3 trillion global CLO market; and annual CFO issuance, where preferred tiering of the equity tranche is getting popular, is estimated to have reached $20–$25 billion in 2025 with some projections of $30 billion for 2026.

We see every reason for that growth to continue, and to accelerate. As sponsors borrow structuring ideas across CFOs, CLOs, and NAV facilities, and as rating agencies and regulators grow more comfortable with how residual and equity tranches are tiered, preferred equity is well positioned to become a standard, rather than a bespoke, feature of the market's capital structures. We expect the pace of innovation to continue, and look forward to helping our clients capture the opportunities it creates.