Case 083Deal structuring and pricingCore

The seller agrees to take Rs 150 crore of a Rs 900 crore price as a subordinated note paying 6% PIK. What does that do to the sponsor's cheque and IRR if exit equity is Rs 1,000 crore in year 5?

The situation

A sponsor is buying Kashtakar Furniture, a maker of modular office furniture, for Rs 900 crore. Senior lenders will provide Rs 450 crore, so the sponsor's base plan is Rs 450 crore of equity. The founder, who is staying on as chairman, offers to take Rs 150 crore of the price as a vendor loan notePart of the purchase price that the seller lends back to the buyer, repaid later, usually ranking behind the banks.: subordinated to the banks, paying 6% a year that accrues rather than being paid in cash (PIKPayment in kind: interest added to the loan balance instead of being paid in cash, so the amount owed compounds.), repaid at exit before the equity.

Assume the business is sold at the end of year 5 and that equity value after the senior debt is Rs 1,000 crore either way.

Your task

Work the sponsor's equity cheque, the note's value at exit, and the money multiple and IRR with and without the note. Then say what the founder's offer tells you.

Quick check

The note costs 6% a year. The sponsor's base-case IRR is about 17%. Does taking the note raise or lower the sponsor's IRR?

Worked solution

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

30-second answerThe answer to give first

The note cuts the sponsor's cheque from Rs 450 crore to Rs 300 crore and lifts the IRR from about 17% to about 22%. At 6% PIK, Rs 150 crore grows to Rs 201 crore by year 5. The sponsor then takes Rs 799 crore of the Rs 1,000 crore instead of all of it: 2.66x on 300 against 2.22x on 450. The offer also says the founder expects the business to be worth paying him back.

Step 1What is a vendor note, in plain terms?

It is the seller lending you part of your own purchase price. If you buy a shop for Rs 90 lakh and the owner says pay me 75 now and 15 in five years with interest, you need less from your own pocket and the owner is betting the shop will still be there to pay him. The note is cheap deferred consideration: it sits behind the banks, costs 6%, and because the interest is PIK it takes no cash from the business during the hold. For the sponsor it is a slice of the capital structure that costs far less than equity and does not come with a lender's covenants.

Same price, same exit: the vendor note changes who puts in what and who takes out whatWithout the vendor noteSources at entry450Senior debt450Sponsor equityPrice 900Exit equity 1,000Sponsor 1000on 450 in2.22xWith a Rs 150 crore vendor noteSources at entry450Senior debt150Note, 6% PIK300Sponsor equityPrice 900Exit equity 1,000Note 201Sponsor 799on 300 in2.66x
Without the note the sponsor funds Rs 450 crore and takes all Rs 1,000 crore at exit, 2.22x; with the note the sponsor funds Rs 300 crore, the note accretes to Rs 201 crore, and the sponsor takes Rs 799 crore, 2.66x on less money.
Step 2How do the numbers move?

Start with the note itself. Rs 150 crore at 6% compounding for five years is Rs 150 crore times 1.06 to the fifth, about Rs 201 crore, repaid out of the Rs 1,000 crore before the equity sees a rupee. The sponsor's proceeds fall from Rs 1,000 crore to Rs 799 crore, a drop of 20%, but the sponsor's cheque fell by a third, from 450 to 300. Money multiple rises from 2.22x to 2.66x, and IRR from about 17.3% to about 21.7%.

Rs croreNo noteWith note
Price900900
Senior debt450450
Vendor note150
Sponsor equity450300
Exit equity after senior debt, year 51,0001,000
Note repaid with accrued PIK(201)
Sponsor proceeds1,000799
Money multiple2.22x2.66x
IRR17.3%21.7%
The note replaces Rs 150 crore of equity that would have earned about 17% with money that costs 6%, so the sponsor's multiple rises from 2.22x to 2.66x and the IRR by about 4 points.
The relationship
Note at exit=150×1.065=200.7MOIC=1,000−200.7300=2.66×\text{Note at exit} = 150 \times 1.06^{5} = 200.7 \qquad \text{MOIC} = \frac{1{,}000 - 200.7}{300} = 2.66\times
150the vendor note at entry
1.06one plus the 6% PIK rate, compounding yearly
300sponsor equity with the note in place
What it says in wordsThe note grows at its PIK rate and is paid off exit equity first; the sponsor's multiple is what is left over the smaller cheque.
Step 3What does the offer tell you, and where is the catch?

That the founder expects to be repaid, which is a signal about the business from the person who knows it best. A seller who takes 6% paper ranking behind the banks is saying the equity will be worth more than Rs 201 crore in five years; a seller who refuses any deferred consideration is saying the opposite, or needs the cash. The catch is leverage. The note is debt in substance: in a bad exit it is still owed before the equity. The two structures give the same multiple at an exit equity of about Rs 602 crore; below that the note hurts. At an exit of Rs 400 crore the sponsor without the note keeps 0.89x of its money and with the note only 0.66x, so the note raises the upside and deepens the downside at once, as all leverage does. Check too whether the senior lenders accept it, since they will want it deeply subordinated with no cash interest and no acceleration rights.

Where candidates lose it

The usual loss is treating the note as free money and forgetting the PIK accrual, so the sponsor is credited with Rs 850 crore at exit instead of about Rs 799 crore. Six per cent compounding for five years is a third more than the face value.

The second is missing that the note is leverage. It lifts the IRR in the base case and cuts the multiple in a weak exit, and a candidate who says only the first half has not thought about the second.

What the interviewer asks next

  • The founder asks for 9% PIK instead of 6%. At what rate does the note stop helping the sponsor?
  • The senior lenders insist the note be converted to preferred equity. What changes?
  • How would you use the note to bridge a valuation gap when the founder wants Rs 950 crore and you will pay Rs 900 crore?

Company names and figures are illustrative.