Case 091Leveraged finance and LBO financingHard
Paper LBO with a revolver, a cash sweep and a PIK note: build the debt schedule for a packaging company bought at 8x and work out the sponsor's return.
1The situation
A sponsor buys Durvani Packaging at 8.0x EBITDA of Rs 200 crore, Rs 1,600 crore. Funding: a Rs 800 crore term loan at 9% with Rs 40 crore of mandatory repayment a year and a 100% cash sweep of whatever cash is left; a Rs 300 crore PIK note at 12%, whose interest is added to principal and paid at exit; a Rs 100 crore revolver, undrawn at close, costing 8.5% when drawn and 0.5% a year on the undrawn amount; and Rs 500 crore of equity.
EBITDA grows 8% a year. Depreciation is Rs 40 crore and equals maintenance capex, and in year one Durvani spends another Rs 60 crore moving a plant. Working capital is flat, tax is 25%, all interest including PIK is deductible for this exercise, and interest is charged on opening balances. Cash above the mandatory repayment first repays the revolver, then the term loan. Exit is at 8.0x after five years.
2Your task
Build the debt schedule, find the money multiple and IRR, and explain what the PIK note does to the sponsor's return.
Quick check
By the end of year five, which is larger: the term loan or the PIK note?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
About 3.2x the money and an IRR of about 26%. Exit EBITDA of Rs 294 crore at 8.0x is Rs 2,351 crore. The sweep cuts the term loan to Rs 219 crore, but the PIK note compounds to Rs 529 crore, so debt at exit is Rs 748 crore and equity Rs 1,603 crore. The revolver bridges a Rs 13.4 crore gap in year one. The PIK note quietly takes Rs 229 crore of the value.
Step 1What order does the cash go in each year?
Write the waterfall before any numbers. Start from net income, add back depreciation and the PIK interest, because it was expensed but not paid in cash, and subtract capex. That free cash flow pays the mandatory Rs 40 crore first; anything left repays the revolver, then the term loan; any shortfall is drawn on the revolver. The PIK note sits outside the waterfall entirely, growing on its own. A household that uses every spare rupee to prepay its home loan while a relative's loan to it quietly accrues interest is running the same structure.
Step 2Why is the revolver drawn in year one?
Year one has the Rs 60 crore plant move on top of normal capex. Net income is about Rs 51 crore; add back Rs 40 crore of depreciation and Rs 36 crore of PIK interest, subtract Rs 100 crore of capex, and free cash flow is Rs 26.6 crore. That is Rs 13.4 crore short of the mandatory Rs 40 crore repayment, so the revolver covers the gap, and year two's cash repays it before the sweep touches the term loan. That is exactly what a revolver is for: a short, cheap bridge, not permanent funding.
| Year | EBITDA | Cash interest | PIK interest | Free cash flow | Revolver | Term loan, end | PIK note, end |
|---|---|---|---|---|---|---|---|
| 1 | 216.0 | 72.5 | 36.0 | 26.6 | +13.4 | 760.0 | 336.0 |
| 2 | 233.3 | 70.0 | 40.3 | 102.6 | -13.4 | 670.8 | 376.3 |
| 3 | 251.9 | 60.9 | 45.2 | 124.6 | 546.2 | 421.5 | |
| 4 | 272.1 | 49.7 | 50.6 | 149.5 | 396.7 | 472.1 | |
| 5 | 293.9 | 36.2 | 56.6 | 177.4 | 219.3 | 528.7 |
Step 3What is the return, and where does the PIK note bite?
Exit value is 8.0x Rs 293.9 crore, Rs 2,351 crore. Take off Rs 219 crore of term loan and Rs 529 crore of PIK note and equity is Rs 1,603 crore: 3.21x and about 26.2% a year. Split the gain and the PIK cost shows up: growth adds Rs 751 crore, paydown adds Rs 581 crore, and PIK interest takes back Rs 229 crore. The note was 18.8% of the purchase price and is 22.5% of the exit value, a growing slice of the company that nobody paid for in cash.
| 2,351 | exit value, 8.0x year five EBITDA |
| 219 | term loan left after five years of sweep |
| 529 | PIK note, Rs 300 crore compounded at 12% for five years |
| 500 | sponsor equity at entry |
Close with the credit view, since this is a lender's test. The PIK note is cheap cash for the company and expensive value for the sponsor, and for the senior lender it is useful: it takes no cash while the term loan is being swept. Round on paper and say so: growth of about 750, paydown of about 580, PIK drag of about 230, and a 3.2x in five years is in the mid twenties.
Where candidates lose it
The usual loss is sweeping cash into the PIK note or forgetting to add back its interest in the cash flow. PIK interest is an expense that costs no cash; miss the add-back and every sweep is understated by Rs 36 crore to Rs 57 crore a year.
The second is skipping the revolver: letting year one's cash go negative instead of drawing it, then forgetting to repay it first in year two. The order, revolver before term loan, is part of what is being tested.
What the interviewer asks next
- What would the IRR be if the PIK note paid 12% in cash instead?
- Exit falls to 7.0x. How much of the loss lands on the sponsor and how much on the PIK holder?
- Why would a sponsor accept a 12% PIK note rather than put in Rs 300 crore more equity?
- The plant move costs Rs 150 crore instead. Is the revolver big enough?
Asked at Carlyle Group, Credit, New York, 2023 (Wall Street Oasis): LBO modeling test conducted remotely, 90min, with a revolver, cash sweep, and PIK note
Company names and figures are illustrative.