Debt fund returns / IRR
Hello all,
I have a presentation from a growth debt fund which invests in senior debt in small early stage companies ($15-30MM tickets). They talk about 15+% gross IRR (YTM) (before carry and management fees). Now, when looking at the investments they have done so far, it always seems to be debt with coupons in the range of LIBOR/EURIBOR + 7%-11% and maturity of 4-5 years. They mention structuring fees of 2-4% and potential additional upside to IRR from warrants, etc.
My question is HOW can they achieve 15+% IRRs while providing debt at c.10% coupon? Would their returns not be limited to the coupon plus one time structuring fees spread across the maturity?
They do not seem to be using leverage on their funds, as when summing up their debt investments one can get to the amount to which the fund is drawn to date.
To give a concrete example:
They have provided a $15MM worth of financing at EURIBOR+7.75%, with maturity of 4 years, issued in 15M bonds at $1 each. A small portion of bonds has warrants attached to them, which represents c.0.8% of stock capital (IRR calc anyways). They state 14% IRR for this particular investment. How is this possible?
Would appreciate your thoughts / insight.
Cheers
One major thing is when the company pays back the debt. A lot of times the company will want to refinance the debt with cheaper debt, but there may be a make-whole. In addition, there may also be an OID of a percent or two which is significant if the company only holds the debt for a couple years. Third, because of quarterly interest payments, a 10% coupon paid quarterly actually gives above 10% IRR (try it yourself in excel). Lastly, the penny warrants in your example are like IRR a bit as well. so 10% coupon would be around ~10.5%, + OID which may add .5% to 1%, plus make-whole penalties which may have happened, plus warrants which would add another 1-2% which will get you your 14%.
Another thing to consider would be that some mezzanine debt funds are SBIC funds and can lever up to provide incremental returns.
Can you elaborate ?
Why wouldn't you include warrants in the IRR? MM mezz funds in the U.S. are targeting mid-high teens and rely on warrants to juice returns to hit and/or exceed their target returns. If the value of that position grows (investment in a growth company), it can easily add at least 1-2%, if not closer to a 5% return.
Take an example we had recently:
11% coupon + 2 % PIK + 2-3% warrants + 2% orig fee, interest-only.
That 2% PIK will provide some nice kick as well as it compounds. All-in, probably looking at 16% excluding orig. fee.
Geez, in what market are you getting 13% all-in AND warrants? Proprietary, non-sponsored deal?
Yep, highly leveraged non-sponsor recap, basically plugged in to provide growth. Business is also tried strongly to economic cycle. First time I have seen warrants since late 2011/ early 2012.
On sponsored side, pricing is obviously much more competitive. But, even on non-sponsored mezz, still seeing 10+2/11+1 depending on deal.
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