Since I received some really great responses in the last post I posted to veteran/PE WSOers (//www.wallstreetoasis.com/forums/pe-interview-question-if-you-can-only-kn…), I thought I should put forth another PE interview question I received awhile back. This one is probably not as open-ended as the last one...
Q: When looking at structuring convertible debt in a private equity deal, what are some things you need to consider, why/when is it used, and how would you work out the pricing and portion to use?
Thanks in advance!
---Message from WSO Below---
Risk can be your friend in this situation. Oddly enough, high risk = high optionality of the convertible option of the bond and thus, higher overall placement value. Nonetheless, this is not in isolation of the debt portion, but it surely is not a 1-to-1 trade-off either. Separate the pieces (debt and option) and evaluate the scenarios/assumptions.
That's actually a great pe interview question.
Wow, it's a great question because you could mention so many things.
Why/when is it used - It's usually used when you want to be in the middle of the cap structure (i.e. equity alone would be too risky, debt too conservative). Also, because these tend to be more confusing instruments, you can sometimes take advantage of more inexperienced mgmt. with your pricing (this is more for lower MM).
What are some things you need to consider? - Everything you need to consider when making a debt AND an equity investment (not going to go through all of them). You need to value the debt and then value the warrants (equity), that will give you the "price". Consider what forces conversion, that's very important - sometimes it's after a set period of time, or if some conditions are met, etc. Lastly, make sure you have dilution protection for the warrant portion in case a down round is done before conversion, as well as protective covenants for the debt too.
I don't know what you mean by "portion to use"...
Thanks Alex!
By portion I mean how many turns of financing should one use for convertibles. So for example if you can put in 4x debt, maybe 2 turns is senior debt, 1x mezz, 1x converts - how would you figure out what's a good amount to use (given that at some point you can convert to equity).
I'm guessing it's the same way you would figure out the value of warrants? By building out a model and tweaking assumptions to ensure mezz investors have their desired 16-18+% return? Except, you would make assumptions on timing of conversion, different price points and work out what your (the PE firm's) equity stake is after conversion in the model after the 5 years...
This is just my guess - I haven't had to deal with converts before, so sorry if this is way off base. I did also mention timing and particular conditions for conversion in my answer. The interviewer didn't tell me whether my answer was sufficient or not, but it sounded like he was alright with it.
Your turns sound roughly right for a "typical" LBO. Conv. notes can be used in growth capital rounds and be the only notes, or the ratios of debt types can vary, etc., so that part of the question is kinda pointless. What you care about is that the interest rate is fair given the amount of leverage, default risk, etc.
You have to build a model, everything you mention would be important in it. You can't really use B-S for valuing the warrant because it's presumably a private company, you basically have to build a model and run sensitivities. Depending on the terms, warrants can make waterfalls a nightmare. Far and away the hardest thing you ever have to do (as far as modeling) is build an accurate waterfall for a company with 6 or 7 capital raisings, with different terms for each deal. Bankers never do that stuff (as far as I know), only the PE firms (in PE, basically you receive the model from the banker, or the co., and then just build out the waterfall and tweak the model with your assumptions/sensitivities - of course, you have to first audit the model to make sure it's right, there's always mistakes).
Thanks Alex, much appreciated!
Anyone else with exp that wants to add to the topic?
I think the comments on this thread miss 2 of the most important reasons why we use a lot of them in a lot of LBO deals (at least as far as the mid-market segment is concerned).
(i) convertible bonds usually come with a PIK interest which is tax deductible and therefore decreases the corporate tax burden.
(ii) they are also used very frequently as a component of the management compensation, alongside warrants and ordinary stock. Indeed the convertible notes are a facial incentive for the managers to own more ordinary stock as a % (because it decreases the amount of ordinary stocks all other things equal in the sources and uses of funds) and the decision to convert or not part of the notes at exit will eventually impact the final % ownership of the managers.
So company management are the ones providing the convertible debt financing usually in these cases? Not other 3rd party investors?
They can provide part of it but it's not that frequent and usually most of it is provided either by the sponsor or by people to whom the sponsor syndicated some tranches of the capital structure.
Let's take an example :
You have a deal with a valuation of 100. 50 is provided by debt and 50 is capital. Out of those 50 of capital you have 25 of ordinary shares and 25 of convertible bonds. Management puts 5 of ordinary shares, sponsor puts 20 so management has 20% of the shares. Sponsor puts the 25 of convertible notes. If said management underperforms, the sponsor can convert all or part of the bonds in order to lower management ownership which was facially granted through the use of the convertible bonds to say 5% and therefore increase the find's returns to compensate for the underperformance.
typically 8-9 years 4 + 10% non conversion
Depending on how aggressive you want to be in the structuring ; how much more powerful you are versus the company mgt, how risky the business is and whether you are using the non-conversion option as a means to encourage the managers to perform better or just because you are very wary of the risks etc..
Kanon,
You've been posting some really interesting questions of late. Keep it up!
These were some questions I got a long time ago. I just remembered them now because of the recent Q&A threads started by leverage10x and someone else who's covering corporate development. The thanks should go to the guys taking the time to write thoughtful answers!
If I can remember any other interesting ones, I'll post more...
Hey Kanon, do you work in PE now or interviewing for PE positions ?
I'm not in PE. On occasion, when firms aren't strictly looking for your traditional 2yr IBer, I get interviews.
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