Convertible Pref Question Asked by Mega Fund
Had an interview with Bain Capital lately. I Was asked to explain how convertible pref works in context of an LBO. Is this how this works?
Let's say I invest $1000 in convertible preference that accrues at 4% / annum (PIK), has a liquidation preference of 1.5x, and is convertible into shares at a $10 strike price. The current shareholder structure is 600 shares to sponsor (common equity) and 300 to management. Now, fast forward to year 5, the business has an EBITDA of $2000 and an exit multiple of 10x, and its convertible pref is now "in the money." For simplicity, the business only has a convertible preference and common equity in its capital structure.
At end of yr 5, convertible pref's balance stands at $1217 (4% accrual and compounded each year), but since the liquidation preference is 1500 that means the pref is actually entitled to $1500. Enterprise value is 20,000 and after deducting for pref equity (1500), the equity value (pre new shares) is $18,500. The convertible pref equates to 100 new shares ($1000 face value / $10 strike), and since they're now in the money, are exercised. % ownership attributed to convertible pref is 10% (100 / (600+ 300 + 100)). Cash created by exercising conv prefs' options amount to $1000 (100 shares * 10 strike price), so new equity value is now 19500 (18500+1000) and 10% of that is 1950.
Total MoM to Pref = (1500 in liq preference + 1950 returns attributable to them - 1000 that they had to spend to exercise the options) / 1000 of total investment = 2.45x
IS this how the math is supposed to work? Please could you guide me? Thanks.
not sure i understand the interview question - you gave a theoretical answer to a "real-life" question? if somebody would asked me this question, i would run them through (i) rational of a convertible pref (ii) how this impact financial statements/debt schedule.
or, were the numbers given and you were asked to explain it in a general way?
I was asked to explain with a basic example how would a convertible pref investment work. She did first ask me about the basics. I said it helps you protect your downside and entitles you to at least a certain return. The interest on that is not tax deductible though and any cash return you get (on your conv pref) is reflected on the cash flow statment under financing and later subtracted from retained earnings appearing under common equity. Then she was like Ok, walk me through an example and then I made something up to the effect that I Described in my initial post
Sounds like you got an interesting interview question.
The economics that you described seems to refer to a participating preferred instrument as opposed to a typical convertible preferred.
In a typical convertible that I have dealt with, you have the right to the proceeds that are the greater of 1) PIK or the liquidation preference; OR 2) the value of your equity share. You typically don't get to double dip as you have a min return in the form of your liquidation preference, while the equity entitles you to participate in the upside. So, either convert and forego the liquidation preference amount; or you don't convert and forego your equity share.
Thank you!
Sorry I am having a bit of trouble following - so in this case the proceeds would just 1500 if they choose to liquidate OR however much 10% of the closing equity proceeds are in stock?
Yes, sure. Let's go through to what happens at exit:
Then, at exit you get: 1500, if you exit some time before Year 10, or 1000 *((1+ 4%) ^ n), if you exit some time Year 11 onwards, where n is the number of years you hold your instrument (that's because your PIK interest of 4% pa will be higher than your liquidation preference for a long hold period)
Your way of explaining is really good and concise. It seems as if you’ve spent a considerable amount of time in the industry. I had some confusion on enterprise value and would love to hear from you on that - if you don’t mind. Here’s the link to this thread https://www.wallstreetoasis.com/forums/how-why-does-enterprise-value-ch… I would have tagged you on my thread but WSO doesn’t allow anymore. Many thanks in advance
No problem. I just shared my thoughts on that thread. Thank you for asking.
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