Case 085Private credit and direct lendingCore

A software company with Rs 400 crore of recurring revenue and thin EBITDA offers a senior loan, mezzanine with warrants, or equity. Where in the capital structure would you invest?

HPS Investment PartnersNew York · 2021

The situation

Zenmira Software sells subscription software to mid-sized manufacturers. Recurring revenue is Rs 400 crore a year and customers renew at high rates, but EBITDA is only Rs 40 crore because the company spends heavily on sales to keep growing. A sponsor is buying it for Rs 1,200 crore, three times recurring revenue.

The financing on offer: a senior loan of Rs 500 crore at 11% cash interest; mezzanine of Rs 200 crore at 14%, accruing rather than paid in cash, with warrants for 10% of the equity; and Rs 500 crore of equity. Businesses like this have changed hands at anything from 1.5x to 3x recurring revenue, depending on growth and the market.

Your task

What does each layer recover if the business is sold at 3x or at 1.5x recurring revenue, and which layer would you invest in?

Quick check

If Zenmira sells for only 1.5x recurring revenue, what does the mezzanine recover?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

I would take the senior loan: it is repaid in full at either value and still earns 11% in cash. At 3x revenue, Rs 1,200 crore, every layer is repaid and equity keeps Rs 500 crore. At 1.5x, Rs 600 crore, the senior loan is still covered 1.2 times, mezzanine recovers half and equity nothing. Mezzanine beats the senior loan only if the good case is more than about 70% likely.

Step 1How do you decide where to sit in a capital structure?

Find the layer that is still covered in the downside and still paid enough in the base case. Each layer is paid only after the one below it, so the question is where the value line falls in a bad sale. For a software company the value is mostly in the recurring revenue, and the multiple on it can halve when growth slows or markets turn. Think of a building whose rent is shared out floor by floor from the ground up: in a bad year the rent runs out before it reaches the top floors, and equity lives on the top floor.

Which layer is still covered when the sale value halves, Rs croreSenior loan 50011% cash, first claimMezzanine 200, 14% + warrantsEquity 500Sold at 3.0x revenue: 1,200all debt repaid, equity keeps 500Sold at 1.5x revenue: 600senior 100%, mezzanine 50%, equity 0Senior: covered 1.2xeven at 600
At a sale value of Rs 1,200 crore, 3x recurring revenue, the Rs 500 crore senior loan and the Rs 200 crore mezzanine are repaid and equity keeps Rs 500 crore, but at Rs 600 crore, 1.5x, only the senior loan is fully covered, the mezzanine recovers Rs 100 crore and equity is wiped out.
Step 2What does each layer earn over a year?

Suppose the business is sold after one year at either value. The senior loan earns 11% in cash either way. The mezzanine's claim grows to Rs 228 crore with accrued interest. At 3x it recovers that plus warrants worth Rs 47.2 crore, a 37.6% return; at 1.5x it recovers Rs 100 crore, a loss of half. On even odds the mezzanine returns -6.2%. It matches the senior loan's 11% only if the good case is about 70% likely.

One-year return by layer: only the senior loan is paid in both casesSenior, sold at 3.0x+11.0%Senior, sold at 1.5x+11.0%Mezzanine, sold at 3.0x+37.6%Mezzanine, sold at 1.5x-50.0%Mezzanine, even odds-6.2%0%
Over one year the senior loan earns 11% whether Zenmira sells at 3x or 1.5x recurring revenue, while the mezzanine earns 37.6% at 3x and loses half at 1.5x, for -6.2% on even odds.
Step 3What worries you even about the senior loan?

Cash. Senior interest is Rs 55 crore a year against EBITDA of Rs 40 crore, so the company cannot pay it from earnings today. This is a loan against recurring revenue, not against cash flow, and it works only if the company can cut sales spending and turn revenue into cash when it needs to. At a mature margin of 30%, Rs 400 crore of revenue would earn Rs 120 crore. A lender would ask for a covenant on recurring revenue and on minimum cash, and would want the mezzanine's interest to accrue, as it does here, so that cash goes to the senior loan first. The limitation: the two sale multiples are assumptions, and a customer base that renews less reliably would push the downside below 1.5x.

Where candidates lose it

Candidates pick the mezzanine because 14% plus warrants sounds like the best of both worlds. It is paid well only in the base case; one bad sale halves it, and the warrants are worth nothing in exactly that case.

The other miss is ignoring that EBITDA does not cover senior interest. Saying so, and naming the covenant that deals with it, is what separates a lender's answer from a spreadsheet answer.

What the interviewer asks next

  • At what sale multiple does the senior loan start to lose money?
  • How would you structure covenants for a loan that EBITDA cannot yet service?
  • Would you rather hold the mezzanine at 14% cash-pay or 16% accruing?
  • Why do lenders to software companies lend on recurring revenue rather than EBITDA?

Asked at HPS Investment Partners, Credit, New York, 2021 (Wall Street Oasis): say we were looking at a software company. where would you invest in the capital structure and why?

Company names and figures are illustrative.