What Is Incremental Preferred Stock?
Incremental preferred stock refers to the issuance of additional shares of an existing series of preferred stock by a company. This practice falls under the broader umbrella of corporate finance and is a method of equity financing. When a company issues incremental preferred stock, these newly issued shares typically carry the exact same terms, rights, and privileges as the original shares within that specific series. This means they generally have the same dividends rate, liquidation preference, and other features. The primary reason for issuing incremental preferred stock is often to raise additional capital without creating a new class of stock or altering the existing capital structure by introducing different terms.
History and Origin
The concept of issuing additional shares of a security as needed is not new in financial markets. Preferred stock itself has existed for centuries as a hybrid security, blending characteristics of both debt financing and equity. Incremental preferred stock issuances have become particularly relevant in modern capital markets, especially for financial institutions, due to evolving regulatory capital requirements. For instance, following the 2008 financial crisis, the U.S. Department of the Treasury's Capital Purchase Program involved the issuance of perpetual preferred stock by banks to bolster their capital. Guidelines from regulatory bodies, such as the Board of Governors of the Federal Reserve System, addressed how these instruments could be included in Tier 1 capital, facilitating the issuance of such preferred stock to support financial stability.5
Key Takeaways
- Incremental preferred stock involves issuing more shares of an existing preferred stock series.
- The newly issued shares typically share identical terms with the original shares in that series.
- It serves as a flexible way for companies to raise additional equity capital.
- Issuances often occur without requiring a new shareholder vote for approval, provided the original series authorized such expansion.
- Financial institutions frequently utilize incremental preferred stock to meet regulatory capital requirements.
Interpreting the Incremental Preferred Stock
The issuance of incremental preferred stock can be interpreted in several ways depending on the issuing company's financial health and strategic objectives. For a company, it represents a decision to raise capital through equity rather than debt financing, potentially to strengthen its balance sheet or fund growth initiatives. Because incremental preferred stock typically maintains the same characteristics as the existing series, it avoids diluting the rights or introducing new complexities for existing shareholders of that specific preferred series. It also avoids impacting the corporate governance structure by not introducing new voting rights, which is common with common stock. Investors might view such an issuance as a sign that the company is prudently managing its capital needs, especially if the funds are used for productive purposes or to enhance financial stability.
Hypothetical Example
Imagine "MegaCorp Inc." previously issued 10 million shares of its Series A 5.0% Cumulative Preferred Stock. This preferred stock has a par value of $100 per share, meaning it pays an annual dividend of $5 per share.
Due to a need for additional capital to expand operations, MegaCorp decides to issue incremental preferred stock by selling another 5 million shares of its Series A 5.0% Cumulative Preferred Stock. These new shares are identical in every aspect to the original 10 million shares already outstanding.
- Original Shares Outstanding: 10,000,000 shares of Series A Preferred Stock
- New Incremental Issuance: 5,000,000 shares of Series A Preferred Stock
- Total Shares Outstanding (after issuance): 15,000,000 shares of Series A Preferred Stock
Each of these 15 million shares now commands the same $5 annual dividend per share and holds the same rights and preferences. MegaCorp has successfully raised additional capital by expanding an existing class of stock rather than introducing an entirely new one.
Practical Applications
Incremental preferred stock finds practical application primarily in the realm of corporate finance and capital markets. Companies often use this mechanism to efficiently raise additional funds without incurring the legal and administrative complexities of creating an entirely new class of securities. This is particularly common among financial institutions, where preferred stock can count towards regulatory capital requirements.
For instance, a large banking corporation might have multiple series of preferred stock. When it needs to raise more capital, it can issue additional shares of an already established series. A prospectus supplement for Bank of America Corporation's 7.25% Non-Cumulative Perpetual Convertible Preferred Stock, Series L, indicates that the corporation "may elect from time to time to issue additional shares of Preferred Stock, without notice to, or consent from, the existing holders of Preferred Stock, and all those additional shares would be deemed to form a single series with the Preferred Stock described by this prospectus supplement and the attached prospectus."4 This illustrates the nature and practicality of incremental issuances within an existing preferred stock framework. Such issuances allow companies to maintain a consistent capital structure while tapping into investor demand for fixed income-like securities.
Limitations and Criticisms
While beneficial for capital raising, issuing incremental preferred stock is not without limitations. A primary concern for investors, like with any investment, is risk.3 Although newly issued shares typically have identical terms, a significant increase in the total number of outstanding preferred shares could theoretically affect the liquidity or market dynamics of that specific series, especially if the market for that series is small.
From the company's perspective, while it provides financial flexibility, the cumulative dividends associated with most preferred stock represent a fixed financial obligation that must be paid before common shareholders receive any distributions. This increases the company's overall financial burden. Furthermore, if the terms of the existing series are less favorable than current market conditions (e.g., a higher dividend rate than what new preferred stock issues would command), issuing incremental preferred stock effectively locks the company into those less favorable terms for the additional shares. Banks, for example, must manage their regulatory capital, and while preferred stock can be a component, its features must align with supervisory guidelines concerning risk-weighted assets.
Incremental Preferred Stock vs. Perpetual Preferred Stock
It is important to distinguish between "incremental preferred stock" and "perpetual preferred stock." Perpetual preferred stock refers to a type of preferred stock that does not have a maturity date, meaning the issuer is not obligated to redeem the shares at a specific time. Investors in perpetual preferred stock typically receive dividends indefinitely, unless the shares are called by the issuer or the company is liquidated.2
Incremental preferred stock, on the other hand, describes the act of issuing additional shares of an existing series of preferred stock. This existing series is often, but not exclusively, a perpetual preferred stock series. Therefore, incremental preferred stock is not a distinct type of preferred stock, but rather a description of how additional shares of an already established preferred stock series (which could be perpetual or have a fixed maturity) are brought to market. The confusion often arises because many preferred stock series, particularly those used for regulatory capital by financial institutions, are indeed perpetual in nature.
FAQs
Why do companies issue incremental preferred stock?
Companies issue incremental preferred stock primarily to raise additional capital. It allows them to increase their equity financing without creating a new class of shares or significantly altering their existing capital structure. This can be more efficient than launching an entirely new security offering.
Are the newly issued shares identical to the old ones?
Yes, shares of incremental preferred stock are typically identical in every material aspect to the existing shares within the same series. This includes the dividend rate, call provisions, and liquidation preference. The intent is for the new shares to be fungible with the original ones.
Does it require shareholder approval?
Generally, if the company's charter already authorizes a certain number of shares for a particular preferred stock series, and the incremental issuance falls within that authorized limit, specific shareholder approval for each new increment is not usually required. This allows for greater flexibility in capital management.
How does incremental preferred stock affect the stock market?
The issuance of incremental preferred stock can increase the supply of that particular preferred stock series in the market, which might affect its trading price, similar to how increased supply of any security can influence its value. However, because it's an existing series, the market is already familiar with its terms.
What are the risks for investors in incremental preferred stock?
The risks are generally the same as those associated with the original preferred stock series. These include interest rate risk (as preferred stock prices often move inversely to interest rates), credit risk of the issuer, and liquidity risk if the market for that specific series is thin. Preferred stockholders have priority over common stock holders in case of liquidation, but rank below bondholders.1