Large capital growth on a loan?

[Ultraviolet]

Quick question to the PH finance / Private Equity gurus...

I'm looking at a potential investment in a start-up. The investment would be structured as equity and loans. That is, the investor would be acquiring a small amount of equity and the rest would be a loan to the company - the split is around 90% of the investment is loan, the rest is equity.

The base case suggests a potential return of 3x - 7x money. The loan notes are not convertible; the loan would be repaid on exit and provide a decent income in the meantime.

In theory this is a great idea as the investment element structured as a loan would be lower risk than the equity (that is, the loan is ranked after the bank debt and mezzanine debt from a creditor perspective).

I've done a fair amount of PE so know the risks etc. I've seen deals with a small amount structured as loans. However, I can't seem to get my head around the potential returns of 3x - 7x money when such a large portion of the investment is structured as a (non convertible) loan....

Any idea how this is achieved?

cheers,

UV

[wattsm666]

Could be an element of interest is rolled up or there is a kicker on redemption, both would increase the return on exit.

[Alpinestars]

Not entirely sure of the question, but as you know PE deals are highly leveraged. A typical example might be external funding 65%, shareholder loans 25%, shareholder equity 10%.

Because of the high level of external leverage, which is repaid at cost (plus interest), the investors get high relative returns. It's easy to see how a doubling in the value of the portfolio company can translate to returns for the investors of 5x.

Is that what you mean?

[HootersGsy]

It depends what % equity you own really.

I assume you're leveraging the company up to take advantage of the tax shield in the company? Anyway, as the loan gets repaid you get your capital back plus the interest, at the end of it lets say you've been fully repaid so you have no loan left and your, lets say 50% equity, which cost you comparatively little but is worth a lot as you now have a (hopefully strongly performing) company with no debt.

e.g.

Initial loan = £900k
Equity cost £100k (50%)

Total equity value at this stage = £200k

Company performs well, pays back your loan on which for arguments sake lets say you've earned £100k interest

Equity value of the company (really simply assuming no increase in EBITDA or multiple) is now £1.1m

Your equity is now worth £550k

Total return on the investment is £100k interest + £450k uplift on equity = £550k

If it is a good cash generative business lets say that happened within the space of a year, 55% in 12 months. Not too shabby. If the business actually grows during the period then of course the equity related growth is much bigger.

Not too dissimilar to how some of the large PE houses used to go about using financial engineering to enhance their IRR on deals. Just don't over leverage the company though, insolvent companies don't tend to be worth much

[Alpinestars]

Using the example above, how was the loan repaid? You'd have had to either
A) borrow to repay
B) made enough profit/cash to repay (which suggests huge cash flow/profits) which would have been taken into account in the first place, or
C) used existing cash to repay the loan.

Assuming B) then whoever bought the equity in the first place got a bargain.

PE returns are not made like this unless someone gets lucky buying a valuable company that no one else has info on. They make money by leveraging their position. It's a bit like spread betting. Not much required up front, but if it goes well, the multiple return is very good.

The corollary is that if the business performs badly, their loans and equity rank behind all the other loans the company has.

Edited by Alpinestars on Sunday 17th August 14:59

[HootersGsy]

Alpinestars said:

Using the example above, how was the loan repaid? You'd have had to either
A) borrow to repay
B) made enough profit/cash to repay (which suggests huge cash flow/profits) which would have been taken into account in the first place, or
C) used existing cash to repay the loan.

Assuming B) then whoever bought the equity in the first place got a bargain.

PE returns are not made like this unless someone gets lucky buying a valuable company that no one else has info on. They make money by leveraging their position. It's a bit like spread betting. Not much required up front, but if it goes well, the multiple return is very good.

The corollary is that if the business performs badly, their loans and equity rank behind all the other loans the company has.

Edited by Alpinestars on Sunday 17th August 14:59

The loan is stated as being made TO the company so the company repays it from profits of the business. And yes, PE returns are made that way, leverage up against the companies operating profit, take your money out leaving a small residual, let the company repay the loans over 3-5 years over which time the equity value grows as the debt clears and bob's your mothers brother, nice healthy IRR. Hopefully

[Alpinestars]

HootersGsy said:

The loan is stated as being made TO the company so the company repays it from profits of the business. And yes, PE returns are made that way, leverage up against the companies operating profit, take your money out leaving a small residual, let the company repay the loans over 3-5 years over which time the equity value grows as the debt clears and bob's your mothers brother, nice healthy IRR. Hopefully

Not sure I agree with all of that. The high return is made because of the leveraged position. The total return cannot be changed without the business itself performing well, PE or not.

I'll illustrate with a similar example of buying and selling a property.

Let's say the cost of the property is 1000, and funded as follows;
Deposit 100
Loan from parents 200
Loan from third party building society 700

Let's say it's sold after 5 years for 2000

Repayment of loan to parents including interest payments 300
Repayment to third party including interest payments say 900

My return would be 800/100 ie 8 times. I only make 8 times because the denominator is low. The overall return is always going to be 2000 less 1000 initial cost, less interest. Had I not leveraged up, and instead bought the property for cash, my return would be higher in absolute terms (1000), but only 2x (2000/1000).

Also as a general rule, portfolio companies do not repay loans until exit. The third party loans provide tax relief on interest costs so it's not generally sensible to repay them, and shareholder loans can only be repaid once the third party loans are repaid. Companies do however "remortgage" sometimes and any excess cash is usually paid to investors via dividends or repayment of shareholder loans.

I'm still not sure if that answers OPs question?

[wattsm666]

wattsm666 said:

Could be an element of interest is rolled up or there is a kicker on redemption, both would increase the return on exit.

I mis-read the OP, I assumed the investor was putting in loan stock, which they do sometimes. However the subsequent posts are spot on.

[Alpinestars]

wattsm666 said:

I mis-read the OP, I assumed the investor was putting in loan stock, which they do sometimes. However the subsequent posts are spot on.

Which again is typical so you could be right. Before the tightening of thin cap rules in Europe, the portfolio company would be funded up to 99% with loans (third party and investor).

[BobToc]

Ultraviolet said:

The base case suggests a potential return of 3x - 7x money. The loan notes are not convertible; the loan would be repaid on exit and provide a decent income in the meantime.

It's difficult to comment too much without knowing the specifics, but it likely won't provide any income in the meantime (shareholders loans being payment in kind normally). I also wouldn't take too much comfort from downside protection if it's a startup.

As to the 3-7x question, is this on the total equity (SHL and ords), or just te ords?

[BobToc]

Alpinestars said:

Which again is typical so you could be right. Before the tightening of thin cap rules in Europe, the portfolio company would be funded up to 99% with loans (third party and investor).

That's still often the case, although primarily for the purposes of incentivising management. As you note tax losses are typically mostly disallowed under almost all European jurisdictions.

[HootersGsy]

Alpinestars said:

Not sure I agree with all of that. The high return is made because of the leveraged position. The total return cannot be changed without the business itself performing well, PE or not.

I'll illustrate with a similar example of buying and selling a property.

Let's say the cost of the property is 1000, and funded as follows;
Deposit 100
Loan from parents 200
Loan from third party building society 700

Let's say it's sold after 5 years for 2000

Repayment of loan to parents including interest payments 300
Repayment to third party including interest payments say 900

My return would be 800/100 ie 8 times. I only make 8 times because the denominator is low. The overall return is always going to be 2000 less 1000 initial cost, less interest. Had I not leveraged up, and instead bought the property for cash, my return would be higher in absolute terms (1000), but only 2x (2000/1000).

Also as a general rule, portfolio companies do not repay loans until exit. The third party loans provide tax relief on interest costs so it's not generally sensible to repay them, and shareholder loans can only be repaid once the third party loans are repaid. Companies do however "remortgage" sometimes and any excess cash is usually paid to investors via dividends or repayment of shareholder loans.

I'm still not sure if that answers OPs question?

Indeed, you can't make money unless the underlying business does well but if it's a good, cash generative business then it makes perfect sense to pay the loans, maybe have some profit to distribute or reinvest and see a nice large increase in equity value. It makes no sense to keep the debt just for the tax shield I you don't need it for anything else.

It's all about timing for IRR so getting cash out early by leveraging the company up with external debt reduces your residual cost and makes it much easier to get what looks like a very healthy IRR later on, even if the cash multiple is average.

[Ultraviolet]

Thanks for the responses...

I'm looking at this as an investor.

I guess there must be a kicker or some sort of dependency between the repayment of the loans and the exit value of the company... The equity element is very small (around 10% of the total investment),.. For example:

The base case is 3 x money. I put in £50k, where £45k is a loan and £5k is equity.
The company exits and the base case is achieved.
The equity returns £15k
The loan repayment must return £135k

The management "stretch" case is 5 x money if they meet more difficult objectives. I make the same investment:£50k where £45k is a loan and £5k is equity.
The company exists and the stretch case is achieved (5x money).
The equity returns £25k
The loan repayment must return £225k

In other words, the loan repayment must be pegged to the exit value of the business because the management do not know, at the time of investment, whether they will subsequently achieve base case or the stretch case. The loan is being treated in the same way as the equity - both must return either 3x money or 5x money (for the purposes of this example) in order for the base case and the stretch case to be feasible. The advantage being that the loan carries lower risk, as it is more likely to be repaid as a creditor (although ranking behind bank and mezzanine debt in this instance).

I've not seen a loan engineered in this way before (but then I'm no expert at financial engineering as you can tell)... in essence, the total amount repayable to the investor for the loans made is (amount loaned + interest + x), where x is the final amount required to deliver a total return of 3 x money (base case) or 5 x money (stretch case). Any idea of the mechanics of achieving this? And how would the investee company accrue for the settlement of these loans, when the final repayment amount x is not known until the point of exit?

Hope that makes sense... any thoughts welcome

UV

[BobToc]

Ultraviolet said:

The base case is 3 x money. I put in £50k, where £45k is a loan and £5k is equity.
The company exits and the base case is achieved.
The equity returns £15k
The loan repayment must return £135k

This is almost certainly not how it will work. Loan accrues at some percentage, likely in the 10-20% range. Equity value on the ords is just the incremental value on top. Returns on the ords in a "good" outcome will be much higher than on the loans, although given it's a strip be sure to look at it in the aggregate.

[Alpinestars]

That is a strange way of funding a company. A company does not generally return more than principal plus interest on a loan, so in your case the interest element is going to be very very high. Which is likely to kill your P&L and balance sheet. Could you not have a loan at say the usual investor interest rates of c15% and then have 2 classes of shares. One that ranks ahead of the others and provides the returns required and the other class which replicates the returns in your scenario. This has the advantage of not having to accrue the interest, but provides the legal subordination of the equity which you require and does not affect the returns needed.

Having re read your post, what's the concern? If the investors invest in loans and equity pair passu, then there is no need for a second class of shares. The investors will get the same return, it will just be classed as capital gain rather than interest. This makes it simpler and probably more tax efficient for the investors. A creditor ranking issue only arises if there is something sandwiched between the investor loans and equity (highly unlikely).

Edited by Alpinestars on Sunday 17th August 21:25