Case 080LBOHard

A sponsor buys a healthcare services business with cash-pay opco debt and holdco PIK notes compounding at 12%. Compare its return with the PIK tranche against funding the same slice with equity.

The situation

A sponsor buys Tulvara Healthcare Services, a chain of diagnostic and day-care centres, at 9.0x EBITDA of Rs 120 crore, Rs 1,080 crore. Funding: Rs 480 crore of operating company debt at 9% paid in cash, Rs 200 crore of holding company PIK notes at 12% that compound for five years with no cash interest, and Rs 400 crore of sponsor equity.

The plan has EBITDA reaching Rs 170 crore in year 5 and cash flow paying the operating company debt down to Rs 250 crore. The exit is at 9.0x. The alternative structure drops the PIK notes and has the sponsor put in Rs 600 crore of equity; the operating company debt and its paydown are the same.

Your task

What are the MOIC and IRR under each structure, why does the PIK raise or lower the return, and when does it stop helping?

Quick check

What are the Rs 200 crore of PIK notes owed at exit after five years at 12%?

Worked solution

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

30-second answerThe answer to give first

With the PIK notes the sponsor makes 2.32x and about 18.3%; with Rs 600 crore of equity, 2.13x and about 16.4%. The notes grow to about Rs 352 crore, a 12% cost, while the equity they replace would have earned about 16%. PIK helps only while equity earns more than 12%; below an exit EBITDA of about Rs 145 crore it hurts.

Step 1What does the PIK tranche actually cost?

Start with the balance, because it is the number people get wrong. A PIK note pays nothing in cash; its interest is added to the amount owed, and then earns interest itself. It is like a credit card where you never make a payment: the bill at the end is not the purchase plus five years of interest, it is the purchase compounded. Here Rs 200 crore becomes Rs 352.5 crore, and that whole amount is paid out of exit value before the sponsor sees a rupee. The attraction is cash: opco interest of Rs 43.2 crore is all the business must pay, cover of 2.8x, even though total debt is 5.67x EBITDA.

The Rs 200 crore of PIK notes compound at 12% with no cash paid, reaching Rs 352.5 crore by year 5, so Rs 152.5 crore of interest is settled out of the exit proceeds.

Step 2What does each structure return?

Exit value is 9.0x Rs 170 crore, Rs 1,530 crore. Take off the debt that ranks ahead of the sponsor. With PIK, equity at exit is 1,530 less 250 less 352.5, Rs 927.5 crore on Rs 400 crore: 2.32x and an IRR of 18.3%. Without it, equity is 1,530 less 250, Rs 1,280 crore, but on Rs 600 crore: 2.13x and 16.4%. The sponsor ends with less money in absolute terms but on much less capital, so the rate of return is higher.

Rs crore	With PIK notes	All equity
Exit enterprise value (9.0x 170)	1,530	1,530
Opco debt at exit	(250)	(250)
PIK notes at exit	(352.5)
Equity at exit	927.5	1,280.0
Equity invested	400	600
MOIC	2.32x	2.13x
IRR	18.3%	16.4%

The PIK structure leaves the sponsor Rs 928 crore on Rs 400 crore, an IRR of 18.3%, against Rs 1,280 crore on Rs 600 crore, 16.4%, for the all equity structure.

The relationship

\frac{1{,}530 - 250 - E}{400} = \frac{1{,}530 - 250}{600} \quad\Rightarrow\quad \text{PIK helps only while } \text{IRR}_{\text{equity}} > 12\%

E	the PIK balance at exit, 352.5
400 and 600	sponsor equity with and without the PIK slice
12%	the PIK coupon, which is the cost of the Rs 200 crore it replaces

What it says in wordsSwapping Rs 200 crore of equity for PIK is like borrowing at 12% to fund that slice; it lifts the return only if the money would otherwise have earned more than 12%.

Step 3When does the PIK stop helping the sponsor?

Treat the PIK as the sponsor borrowing Rs 200 crore at 12% instead of writing that cheque. Leverage at a fixed cost helps when the asset earns more than the cost and hurts when it earns less, and the crossing point is exactly an equity IRR of 12%. With operating company debt held at Rs 250 crore, that happens at exit EBITDA of about Rs 145 crore. If EBITDA stays flat at Rs 120 crore, the PIK structure returns 1.19x, about 3.6% a year, while the all equity structure returns 1.38x, about 6.7%. The PIK keeps compounding whatever the business does.

The PIK structure's IRR is steeper in exit EBITDA: it beats the all equity structure above about Rs 145 crore of EBITDA, where both earn exactly 12%, and falls further behind below it.

Close with the judgement and its limit. On the base case the PIK adds about 2.0 points of IRR, bought with a structure that is more fragile if growth disappoints. A PIK toggleA note that lets the borrower choose each period whether to pay interest in cash or add it to the balance, usually at a higher rate when it is added. or a call option on the notes would let the sponsor pay them down early if cash allows. The limit: this treats exit debt at the operating company as fixed, when a weaker business would also repay less, which makes the downside worse than the chart shows.

Where candidates lose it

The classic slip is accruing PIK interest on the original Rs 200 crore each year, which gives Rs 320 crore at exit instead of about Rs 352 crore. Thirty two crore of missed compounding flatters the PIK structure's return by almost a point of IRR.

The second is calling PIK free because it pays no cash. It is the most expensive debt in the structure and it is paid in full from exit value; what it saves is cash today, not cost.

What the interviewer asks next

The holdco notes carry a 3% call premium. Would the sponsor refinance them in year 3 if EBITDA is on plan?
Why does a PIK at the holding company rank behind the operating company debt even though both are debt?
How would a dividend recap in year 3 interact with the PIK notes?
What exit multiple would make the PIK structure and the all equity structure return the same?

Company names and figures are illustrative.