Comments on: Equity returns for debt risk… please

By: The Private Equiteer

The Private Equiteer — Mon, 11 Jan 2010 06:48:06 +0000

Your last line is the point I was making, but upon re-reading, I see I didn't explicitly mention the assumption of other co-investors (whether they're founders, managers, other PE firms, residual passive investors, etc.)

Of course you're right; it doesn't really work if you're the only equity holder. But if you've bought 30% of the business on pref terms, while the founders are holding 70% as common stock, and there's little debt, then I think this quasi-debt effect exists.

My omission of that assumption probably has to do with the nature of the deals we've been doing lately, which have involved large founder holdings.

Thanks for the note Alex... and for keeping me honest.

By: The Private Equiteer

The Private Equiteer — Thu, 03 Sep 2009 12:27:43 +0000

Your last line is the point I was making, but upon re-reading, I see I didn’t explicitly mention the assumption of other co-investors (whether they’re founders, managers, other PE firms, residual passive investors, etc.)

Of course you’re right; it doesn’t really work if you’re the only equity holder. But if you’ve bought 30% of the business on pref terms, while the founders are holding 70% as common stock, and there’s little debt, then I think this quasi-debt effect exists.

My omission of that assumption probably has to do with the nature of the deals we’ve been doing lately, which have involved large founder holdings.

Thanks for the note Alex… and for keeping me honest.

By: Alex

Alex — Thu, 03 Sep 2009 11:41:53 +0000

I think this sort of misses the point a little bit – if PE wants equity returns and debt risk then there is someone else in the capital structure doing the opposite to make room for them.

Therefore the easiest way to achieve this is to get banks to take equity risk with debt returns eg by lending up to 5 x EBITDA as senior debt, and another couple of turns as slightly more expensive Mezz.

In an equity only deal you can call your instrument whatever you want but if there’s nothing at risk before it in the capital structure then it’s taking equity risk, and if there are instruments buffering it from losses first up then they are losing out by allowing you a “higher-than-debt” return while taking more risk themselves.

My basic point is that financing risk vs financing return across the capital structure is stable so to get one and not the other it’s a zero sum game where you have to screw some of your other co-investors.