LFCF to include PIK interest or no?
Hey all!
Some context - currently a junior working at a buyside shop, and very common for our team to build cashflow down to LFCF and bridge LFCF to change in cash with one-offs, M&A and debt movements. The idea being LFCF should be a "run-rate" number that measures the cashflow to equity holders (excluding these lumpy one-offs).
That said have seen some inconsistency with how some members go about calculating LFCF. Some only calculate it as UFCF - cash interest. Hence the question I have is if one should include PIK interest in that calculation (understand this is a non-cash interest) but illustratively and conceptually if you are trying to understand what is the real cashflow flowing to equity holders presumably PIK interest should also be included in the LFCF calculation else one would be underestimating the cashflow generation for equity holders?
Understand this is probably a matter of preference, but let me know what y'all think! :)
I usually like to show both LFCF and LFCF post PIK interest as seperate items.
If your LFCF post PIK is continuously negative it means that the capital structure would be unsustainable from a cashflow perspective but can work if your EV / Equity is growing faster than the PIK interest (i.e. all of the HoldCo PIK Notes done for high growth software LBOs). Now it gets scary if you are a GDP grower with little margin improvement/synergies or whatever else.
Thanks! This is a great intuitive way of thinking about it. :)
So I guess in the case where LFCF post PIK is continuously negative, it’s much more of a multiple expansion play (where you are playing for the market to re-rate you higher maybe because of growth expectations) such that even though ur HoldCo PIK is growing at a rate where your cashflow is not sufficient to service it, your EV is growing quicker such that equity value still rises.
Is that the right line of thinking?
Not necessarily. Say you have a 12% PIK in a software business growing at 10-15% and 100bps of margin expansion p.a. you don’t need to believe any multiple expansion.
In the second case probably, or you assume that there is further M&A to be done funded by cheap senior that will improve CF profile or that a lot of the capex is growth capex and therefore the modeled CF profile is not reflective of a mature CF profile. Many variables and ways to look at but I simplified it a lot in my first example and it mostly comes down to the above.
Following
I would personally not include PIK interest in LFCF since it's not a cash expense, but i would correct the equity value of the company by deducting the oustanding balance of PIK interest on the investment exit date. With this method, you can slightly increase your IRR if PIK interest are expected to be paid at a later date : more LFCF in the short-term => larger dividends with better time value than if they were distributed at period n+1.
What do you guys think? Is that correct?
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