Case 010Distressed and special situationsCore
A cement promoter needs Rs 300 crore and will not accept the fund's valuation. The fund proposes a structured instrument: a 16% IRR floor through a redemption premium plus 20% of any upside above Rs 2,000 crore. Work the fund's return across outcomes.
1The situation
Ghanshila Cement, a promoter-owned company with one plant, needs Rs 300 crore to add a grinding unit. The promoter says the equity is worth Rs 2,000 crore and will not sell a larger stake than that implies. The fund thinks it is worth about Rs 1,000 crore today.
Instead of arguing, the fund offers a structured instrument: Rs 300 crore that must be redeemed in year 4 at a price giving the fund a 16% IRR, the floor, plus 20% of any equity value above Rs 2,000 crore at that date. The promoter keeps control and all of the first Rs 2,000 crore. Assume the company can pay the redemption in year 4, from cash or a refinancing. Treat the instrument as described; real ones add security, conversion rights and a cap.
2Your task
Work the fund's cash and IRR at year 4 equity values of Rs 1,500, 2,000 and 3,000 crore, compare it with plain equity at each side's valuation, and say who pays for the floor.
Quick check
At a year 4 equity value of Rs 1,500 crore, below the Rs 2,000 crore threshold, what does the fund receive?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The fund receives Rs 543 crore at Rs 1,500 and Rs 2,000 crore, a 16% IRR either way, and Rs 743 crore at Rs 3,000 crore, 25.5%. Plain equity at the promoter's Rs 2,000 crore would have given 13.0% of the company, worth Rs 196 to Rs 391 crore across the same outcomes; at the fund's Rs 1,000 crore, 23.1%, worth Rs 346 to Rs 692 crore. The promoter pays for the floor by owing Rs 243 crore in the bad case, in exchange for keeping control and 80% of the upside.
Step 1What is the floor worth, and how is it paid?
Think of lending a friend money for a shop with a promise: whatever happens, you get your money back with 16% a year, and if the shop does very well you also get a share of the extra. The first promise is a loan in all but name; the second is a slice of equity. Rs 300 crore at 16% for 4 years is Rs 543 crore, so the redemption premiumThe amount above the original investment that the company must pay to buy the instrument back. It delivers the agreed return without any dividend being paid along the way. is Rs 243 crore. The company pays nothing in between; the obligation builds inside the instrument and falls due in year 4.
| 1.16^4 | four years at the 16% floor IRR |
| V_4 | the company's equity value in year 4, Rs crore |
| 0.20 | the fund's share of value above Rs 2,000 crore |
Step 2What does the fund make in each outcome?
At Rs 1,500 crore and at Rs 2,000 crore the upside share is zero, so the fund receives the floor, Rs 543 crore, 1.81x and 16%. At Rs 3,000 crore it adds 20% of Rs 1,000 crore, Rs 200 crore, for Rs 743 crore, 2.48x and 25.5%. The structure is a flat line until Rs 2,000 crore and then a line with a slope of one fifth; plain equity is a straight line through the origin with a slope equal to the stake. Which is better for the fund depends on where the outcome lands and on what stake the plain equity would have carried.
| Year 4 equity value, Rs crore | Structured: cash | IRR | Plain 23.1% at Rs 1,000 crore pre | IRR | Plain 13.0% at Rs 2,000 crore pre | IRR |
|---|---|---|---|---|---|---|
| 1,500 | 543 | 16.0% | 346 | 3.6% | 196 | -10.1% |
| 2,000 | 543 | 16.0% | 462 | 11.4% | 261 | -3.4% |
| 3,000 | 743 | 25.5% | 692 | 23.3% | 391 | 6.9% |
Step 3Who pays for the floor, and when does the structure fail?
The promoter does, in the bad case. If the company is worth Rs 1,500 crore in year 4, a 13.0% stake would have cost him Rs 196 crore; the instrument costs Rs 543 crore. He has traded a larger loss in the downside for keeping control, the headline valuation and 80% of the upside above Rs 2,000 crore, which is a rational trade only if he believes his own number. What has the fund given up? Less than it looks. A 23.1% stake at its own price overtakes the structure only above Rs 4,654 crore of equity value, more than four times the fund's view of the company today; at Rs 3,000 crore the structure still pays Rs 51 crore more. The cost to the fund is not upside but liquidity and control: it holds a claim that must be paid, not a share it can sell.
The limit is the word floor. The redemption premium is a promise to pay Rs 543 crore from a company that needed Rs 300 crore it did not have, so the floor is only as good as the security behind it and the company's ability to refinance in year 4. Diligence on a structured equity deal is credit diligence: cash flow cover for the redemption, a charge on assets, and a conversion right if the company cannot pay. Without those, the 16% is a hope rather than a floor.
Where candidates lose it
The usual loss is treating the instrument as equity and giving the fund a share of value at Rs 1,500 crore. Below the threshold the fund is a lender: it receives the floor, not a stake, and the equity value is irrelevant to its cash.
The second miss is comparing the structure only with plain equity at the promoter's inflated price, where it always wins. The honest comparison is with the fund's own valuation, which shows what upside the fund gave away to get the floor.
What the interviewer asks next
- Add a cap so the fund's total return cannot exceed 2.5x. How does that change the Rs 3,000 crore case?
- The company cannot pay the redemption in year 4. What rights should the fund have negotiated?
- How would you value this instrument today if you had a view that each outcome was equally likely?
Company names and figures are illustrative.