Case 061Financing, capital structure and treasuryHard

Sukhmani Software has EBITDA of Rs 100 crore and trades at 8x, with senior secured, second lien and mezzanine debt below the equity. Where in the capital structure would you invest, given downside values of 5x and 4x?

HPS Investment PartnersNew York · 2021HPS Investment PartnersNew York · 2021

The situation

Sukhmani Software sells billing software to hospitals. EBITDA is Rs 100 crore and the business is worth about 8.0x, Rs 800 crore. It carries Rs 300 crore of senior secured debt at 9%, Rs 150 crore of second lien debt at 13%, and Rs 100 crore of mezzanine notes at 15% that come with warrants over 5% of the equity. The equity is the rest, Rs 250 crore.

You can buy into any one tranche. Your base case is that EBITDA grows 8% a year and the business still sells at 8.0x in three years. Your downside cases are a sale at 5.0x or at 4.0x. You put 60% on the base case, 25% on 5.0x and 15% on 4.0x. Assume coupons are paid for three years in every case and principal is recovered at the sale.

Your task

Which tranche would you invest in, and why? Show what each one recovers in each case.

Quick check

At a 4.0x sale, which is the most junior tranche that still gets anything back?

Worked solution

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

30-second answerThe answer to give first

The second lien. At 13% it earns 4 points a year more than the senior and is whole at 5.0x; at 4.0x it recovers 67%. Over three years its probability-weighted payoff is about 134 per 100 against 127 for the senior and 131 for the mezzanine, whose 15% and warrants do not pay for being wiped out below 5.0x. The senior wins only if you put more than about 36% on the 4.0x case.

Step 1What does each tranche actually own?

A place in a queue. Value is paid from the bottom of the stack up, so each tranche is safe exactly as long as the business is worth more than everything ranked ahead of it plus itself. Leverage through the senior is 3.0x EBITDA, through the second lien 4.5x, through the mezzanine 5.5x; the equity is the cushionThe value below a tranche in the capital structure that must be lost before that tranche takes a loss. of Rs 250 crore, 2.5 turns, that sits above all of them. A family selling a flat for Rs 1 crore with a Rs 60 lakh bank loan and a Rs 20 lakh loan from an uncle works the same way: the bank is safe unless the flat fetches under 60, the uncle is safe unless it fetches under 80, and the family keeps whatever is left.

Step 2What does each tranche recover in each case?

Run the three values down the queue. At 8.0x, Rs 800 crore, everyone is whole and equity is worth Rs 250 crore. At 5.0x, Rs 500 crore, the senior and second lien are whole, the mezzanine gets Rs 50 crore of its Rs 100 crore, and equity is wiped out. At 4.0x, Rs 400 crore, the second lien recovers Rs 100 crore of Rs 150 crore, 67%, and the mezzanine gets nothing. The senior is impaired only below 3.0x, which for a billing business with recurring revenue would take a collapse, not a bad year.

Value fills the stack from the bottom; losses climb from the topSenior secured 300wholeSecond lien 150wholeMezzanine 100wholeEquity 250whole8x EBITDA: EV 800Senior secured 300wholeSecond lien 150wholeMezzanine 10050%Equity 2500, wiped out5x EBITDA: EV 500Senior secured 300wholeSecond lien 15067%Mezzanine 1000, wiped outEquity 2500, wiped out4x EBITDA: EV 400Rs crore. Ticks mark the enterprise value; each tranche is paid in full before the one above it sees a rupee
Against the same Rs 550 crore of debt, Sukhmani's value of Rs 800 crore at 8.0x leaves every tranche whole, Rs 500 crore at 5.0x halves the mezzanine and wipes out the equity, and Rs 400 crore at 4.0x cuts the second lien to 67% and leaves the mezzanine with nothing.
TrancheFace, Rs croreLeverage throughCouponRecovery at 8.0xAt 5.0xAt 4.0x
Senior secured3003.0x9%100%100%100%
Second lien1504.5x13%100%100%67%
Mezzanine1005.5x15%100%50%0%
Equity2508.0x100%0%0%
Each tranche's recovery falls to zero only once the business is worth less than the debt ranked ahead of it, so the senior survives every case here and the mezzanine survives only the base case.
Step 3Does the extra coupon pay for the extra risk?

Put the three years of coupon and the recovery together, per 100 invested. The senior returns 127 in every case. The second lien returns 139 at 8.0x and 5.0x and 106 at 4.0x, so it gives up 33 points in the worst case to earn 12 points more in the other two. The mezzanine returns 168 in the base case once the warrants on 5% of about Rs 458 crore of exit equity, about Rs 23 crore, are added, but only 95 at 5.0x and 45 at 4.0x. Weighted at 60, 25 and 15, the expectations are 127, 134 and 131. The second lien has the best expected outcome and a far narrower range than the mezzanine.

What 100 becomes in three years: the second lien pays best for the risk it takesSenior secured9% coupon127127127expected127Second lien13% coupon139139106expected134Mezzanine15% coupon + warrants1689545expected131100 = money back8x, p 60%5x, p 25%4x, p 15%
Per 100 invested for three years, the senior returns 127 whatever happens, the second lien 139 or 106, and the mezzanine between 168 and 45; weighted by the stated probabilities the second lien's 134 beats the senior's 127 and the mezzanine's 131.
The relationship
E[2L]=0.85×139+0.15×105.7≈134p∗=139−127139−105.7≈36%E[\text{2L}] = 0.85 \times 139 + 0.15 \times 105.7 \approx 134 \qquad p^* = \frac{139 - 127}{139 - 105.7} \approx 36\%
139second lien payoff per 100 when it is whole: three coupons of 13 plus principal
105.7second lien payoff at 4.0x: three coupons plus a 67% recovery
p*the probability of the 4.0x case at which the second lien and the senior have the same expected payoff
What it says in wordsThe second lien beats the senior unless the chance of a 4.0x sale is above about 36%.
Step 4What would change the answer?

Your view of the downside, and the terms you cannot see in the summary. If you believe the 4.0x case is more than about 36% likely, the senior's certainty is worth more than the second lien's extra 4 points. If you believe the base case is far more likely than 60%, the mezzanine's warrants start to pay: they are the only piece of this stack that participates in growth. And before any of this, read the documents: whether the second lien shares the senior's security and sits behind it only in payment, whether the mezzanine can be paid cash interest or will PIKPayment in kind: interest added to the principal instead of paid in cash, so the claim grows and nothing arrives until maturity. when cash is tight, and what covenants give each tranche a seat at the table if the business slips. The interviewer at a credit fund wants the tranche, the reason, and the condition under which you would switch.

Where candidates lose it

The common miss is picking the mezzanine for its 15% and warrants without running the downside. A tranche that is wiped out at 4.0x and halved at 5.0x needs a lot of base-case probability to justify 2 points of extra coupon over the second lien.

The second is picking the senior as the safe answer and stopping. A credit interviewer wants to see you price the risk, and the senior gives up a certain 12 points over three years to avoid a loss you have assigned a 15% chance.

What the interviewer asks next

  • EBITDA grows 15% a year instead of 8%. Does the mezzanine now win?
  • The second lien is unsecured rather than second-ranking on the same security. What changes?
  • How would you think about this if the mezzanine coupon were PIK rather than cash?
  • At what price below par would you buy the mezzanine today?

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?
Asked at HPS Investment Partners, Credit, New York, 2021 (Wall Street Oasis): They seemed to be very focused on the questions "where would you invest in the capital structure?"

Company names and figures are illustrative.