Luxembourg’s flexible corporate law and long-standing experience with these instruments make it a go‑to jurisdiction. Preferred shares, Preferred Equity Certificates (PECs) and convertible instruments are commonly layered into capital structures. They may sound like equity - but add fixed returns, redemption mechanics and limited governance rights, and the legal and tax analysis can look very different from “plain vanilla” equity. In Luxembourg, instruments that look like equity often need to be carefully structured from a tax perspective to ensure the intended treatment matches investor expectations. This is not a technical footnote: it can materially impact withholding tax exposure, deductibility and ultimately investor returns.  

Why sponsors prefer hybrids

There is a clear commercial logic behind the trend. Sponsors are using preferred instruments to:

  • optimise leverage without tripping traditional debt covenants;
  • manage ratings / optics in the capital stack;
  • offer bespoke economics to specific providers (including in add‑ons and refinancings); and
  • deliver equity‑like economics without full voting or governance rights.

Redemption rights and the art of the possible (and why liquidity is the real point)

While preferred instruments typically benefit from contractual priority over common equity, they remain structurally subordinated to all debt and generally lack creditor enforcement remedies and protection in downside / bankruptcy scenarios.

This is where deals can be won or lost. A preferred instrument can have attractive economics on paper, but if the holder cannot realistically get taken out, returns can become theoretical.

By setting out how redemption operates (at par / with premium / in kind / if set-offs are permitted or not), when it can occur (on fixed dates / specific liquidity events / subject to performance), and at whose option (investor / company / automatically on occurrence of events such as exit or refinancing), the instrument can be shaped to match the governance and liquidity needs of the transaction. Each choice has trade‑offs that can affect debt/equity characterisation, tax outcomes and investor expectations.

Investors should also exercise additional caution around the legal mechanics of redemption. Negotiated step‑in rights (including powers of attorney, pre‑authorisations and similar arrangements) are typically contractual in nature and may fall short, without proper structuring, in delivering the automatic or self‑executing handover that capital providers may expect. By contrast, a true financial collateral package (such as a pledge) is rarely - if ever - granted in these structures.

Typical Luxembourg instruments (in practice)

In Luxembourg structures, these mechanics are commonly implemented through a mix of:

  • preferred shares (articles‑driven preferential economics, sometimes paired with redemption features);
  • beneficiary shares (parts bénéficiaires) (often used for tailored economics and milestone‑style outcomes);
  • preferred equity certificates / convertible preferred equity certificates (frequently long‑dated, subordinated, sometimes limited‑recourse in practice, often with mandatory redemption features and carefully defined return mechanics); and
  • PIK / deferred‑accrual structures (where returns accrue until liquidity exists, often paired with toggles, step‑ups or equity‑linked sweeteners).

The instrument label matters less than whether the redemption path is credible in the actual structure.

Tax treatment: room for surprise

From a tax perspective, debt qualification is generally favored because of interest deductibility and the absence of withholding tax. Preferred equity is often chosen for non-tax reasons (e.g., flexibility, no voting rights, avoiding additional debt load), even though they can also be structured in a tax efficient manner, making use of Luxembourg’s flexible withholding tax exemption regimes. Whilst hybrid instruments and structural features can mitigate some disadvantages, depending on jurisdiction and investor objectives, it is considered prudent structuring to include appropriate protection mechanisms in the terms and conditions of a hybrid instrument (i.e. such as gross-up and tax indemnity clauses).

Preferred instruments at fund level

An analogous structuring approach may be implemented at fund level, subject to applicable tax and regulatory constraints. Preferred instruments may be used to diversify a sponsor’s investor base by raising additional capital for the financing of existing portfolio investments or follow‑on investments and/or to provide liquidity to existing investors. The terms of such instruments typically include preferential distribution rights vis‑à‑vis ordinary investors, leverage covenants designed to limit indebtedness ranking senior to the preferred instruments, and tailored redemption mechanics. While preferred instruments may, in principle, be issued within an existing fund, sponsors often elect to structure preferred equity through a dedicated co‑investment vehicle to minimise amendments to existing fund documentation. In all cases, ensuring compliance with the sponsor’s existing legal and contractual obligations, as well as maintaining transparency and an appropriate alignment of interests with the existing investor base, are key considerations for the fund sponsor.

What this means for dealmakers?

Preferred instruments are not new - but their role is changing quickly. They have evolved from a downside‑protection tool into a strategic lever in capital structuring. That makes this one of the most interesting legal spaces right now, but also one that punishes sloppy assumptions and badly drafting redemption mechanics.

The practical takeaway is simple: priority is not liquidity. If liquidity is the premise of the investment, careful attention should be paid to the remedies actually available to achieve it!

For more guidance on this topic, reach out to one of our colleagues, mentioned below.