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Deciding to invest in junior equity can be thrilling yet confusing. It’s a high-risk, high-reward game; only some people are up for it. But with the right knowledge, you can reap significant benefits that could align with your investment goals.
In this article, we’ll walk you through what junior equity is, its advantages and risks, examples of investments, and a framework for making a decision.
Read on to understand the nuances of junior equity, which can unlock attractive investment opportunities.
Defining junior equity and how it works?
Junior equity signifies shares in a company that are less prioritised than other shares. In the event of bankruptcy or asset liquidation, those who hold junior equity will receive payment last.
Specifically, junior equity:
- Receives dividend payments only after other stakeholders, like preference shareholders
- Has subordinate status in receiving assets/proceeds from asset sales if the company shuts down
- Comes with voting rights to participate in company management
Essentially, junior equity holders take on more risk compared to other types of investors in exchange for the possibility of higher returns. This means that junior equity investors can make a lot of money if the company does well.
However, if the company doesn’t do well, junior equity investors can also lose a lot of money. Understanding this trade-off between risk and reward is important before deciding whether to invest in junior equity.
Balancing risks and rewards of junior equity
Investing in junior equity has its pros and cons. On one hand, it can allow investors to earn higher returns than investing in preference shares or debt. However, it is important to consider the potential risks, as junior equity can also come with greater downside risks.
Potential rewards of junior equity
1. Higher returns potential
When you invest in something that carries more risk, like buying stocks in a growing business, you have the potential to earn more money in the long run. This is because as the business grows, the value of their stocks also increases. Investing in stocks can give you better returns compared to other investment options.
2. Voting rights
Junior equity investors have a say in company matters and can influence business strategy by voting. This means that they have some control over how the company is run, which can help reduce investment risks. Unlike preference shareholders, junior equity investors have more power to guide the company’s direction.
Potential risks of junior equity
1. Lower liquidation priority
When a company goes bankrupt, many parties have a stake in the company’s assets. However, if you own junior equity in the company, you are at the bottom of the list regarding receiving money.
However, this means that you may only get something back if the company goes bankrupt because other parties will get paid first. It is important to keep this in mind if you’re investing in a company because it can be a risky proposition.
2. Dividend fluctuations
When a company makes profits, they can share some of that money with their shareholders. Those shareholders who own debt instruments like bonds or preference shares receive a fixed amount of money as dividends.
However, when it comes to equity dividends, which are paid to shareholders who own stocks, the amount of money paid out can vary depending on how well the company is doing and how much it needs to invest in its business.
This means that shareholders who own stocks might need to learn how much money they will receive in dividends, making it difficult to plan for the future.
In action: case studies of junior equity investments
Analysing how junior equity performed for investors in real-world cases better highlights the pros and cons discussed earlier. Here are two examples of ventures that issued junior equity:
Case study 1 – food delivery startup
A new company that delivers food started with help from some people who invested money in it, even though there was a high risk of the company failing to do well. Those investors got a lot of money back when the company grew quickly in just a few years.
They also had a say in how the company grew. But if the company had failed, those investors would have lost their money before anyone else got paid.
Case study 2 – auto components business
An auto parts maker in trouble offered some of its ownership to a private investment company, hoping the new investment would help the business recover.
Unfortunately, the car market slowed down in the following years, and the auto parts maker couldn’t bounce back. In the end, the company had to declare bankruptcy.
Since the private investment company owned a type of ownership called “junior equity,” it couldn’t recover most of its investment when it went bankrupt and had to pay off all its debts.
Here are some examples that illustrate how investing in junior equity can be a risky but potential way to invest in fast-growing companies.
Evaluating if junior equity investments suit you
Here is a framework to evaluate if such investments match your risk appetite and financial situation:
1. Risk tolerance
Assess your willingness to stomach investment losses and volatility. Skip junior equity if you are close to retirement or have a low-risk tolerance.
2. Portfolio balance
Junior equity provides diversification for investors who already hold stocks, bonds and other assets. Figure out if you need this or additional stability instead.
3. Time horizon
The long lock-in periods for junior equity align better if you have 15-20-year investment horizons to allow sufficient time for value appreciation.
4. Information access
Junior equity investors should closely track company performance. So, assess your ability to access reliable information and gauge the impact of business decisions.
5. Evaluate alignment
Map your investment goals, such as capital growth needs, income stability preferences, and risk tolerance, to the junior equity proposition.
This structured approach clarifies whether junior equity works for you by looking inward at your finances and outward at the instrument. Institutions like private equity funds or angel investors have higher risk appetites, access to research and resources to engage with management if needed actively – so junior equity suits them more.
Conclusion
Junior equity undoubtedly comes with higher risks, given lower payment priority and dividend fluctuations. However, for investors with adequate risk tolerance, access to information and long-term horizons, it also provides superior return potential compared to other instruments. So, the key lies in aligning these rewards and risks to your investment objectives. By understanding what junior equity entails and evaluating fitment with a structured framework, you can make informed decisions to solve the puzzle of investing in this complex instrument.
FAQs
The main benefits of junior equity investments are strong capital appreciation potential as the business grows, higher proportional ownership for every rupee invested compared to senior equity, and voting rights allowing investors to guide future business strategy. However, investors need to balance returns with higher risks.
Junior equity investors face risks like low priority for dividend payouts, which fluctuate with profits, lower priority for receiving liquidation proceeds, which may get exhausted before reaching junior equity holders, and high risk of 100% capital loss if business deteriorates.
Investors can assess expected value by probability weighting upside and downside return scenarios, evaluate business quality to estimate the likelihood of base case playing out, assess loss absorption capacity in downside scenarios, and structure terms to mitigate risks like buyback facilities.
Experts suggest limiting exposure to high-risk junior equities at 10-15% of your overall portfolio, as allocating more could jeopardise one’s overall financial stability in case of adverse outcomes. Stick to exposure limits aligned with loss absorption capacity.
Unlike preferred or senior equity, which carry fixed dividend rights and higher priority for payments, junior equity promises much higher but more volatile returns, giving lower priority for dividends and higher risks of underperformance and capital loss, thus appealing to investors with higher risk appetite.