Trying to calculated projected returns on a tranche of term loans and have some questions:
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Would I actually need to build a model for the whole business going forward (ie 3 statements, debt tables, etc) considering term loans don't participate in the upside?
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Should I be using quarterly, semi-annual, or annual periods for the interest repayments?
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How do I weave in the prepayment premiums into the returns analysis?
Thanks!
Depends on the granularity of your analysis. If it's a back of a hand calculation to calc approximate returns without any debt paydown, you don't need a model - just a few rows to calc returns. If you're including debt paid down by ECF in your analysis (TLs usually always have a ECF stipulation in the CA), projecting future cash flows are necessary, especially when looking at returns on a case-by-case basis (upside: more TL paid down quicker, downside: covenant breaches, leverage grids, etc.). No real need to build out the balance sheet for this (do have an understanding of how 3 statements flow), CF model should be fine. I've usually seen returns calculated based on the former (back of the hand with mand. amort., OID, and rate)
Depends on timing of interest payments - usually quarterly
IRRs for TLs are usually calculated based off a 5-yr projection period or until maturity (in both cases, probably no prepayment premiums by that time). I'd have functionality for prepayments so you can run a sensitivity around IRRs based on time horizon (i.e. 3-yr to 5-yr holds)
Thank you. A couple follow-ups
- What OID should I use for a 2nd lien TL if not disclosed?
- If there's a hard call with a prepayment premium for just the first two years, is it correct then that if retired anytime in year 3 onward, the IRR on the loan would essentially be its coupon rate assuming it was issued at par? By the same logic, the lender would actually prefer prepayment in years 1 or 2 because it would generate a higher IRR than if the loan remained outstanding for say 5 years, correct?
- On the payment schedule, while you mentioned quarterly in practice, but is that also the convention in modeling? If annual, do you assume end-of-year payments or mid-year?
Also, if there is an ECF stipulation, isn't that contradictory to prepayment premiums? So the lender wants you to pay say 50% of excess cash flow toward outstanding debt, but at the same time if that falls within the hard call period, they want you to pay a premium? If my understanding is correct of these stipulations, then it seems the lender is penalizing the company for generating excess cash flow.
- On OID, 2-3% is a standard assumption
- First part, yes, coupon rate being the IRR, if issued at par and prepaid after call premium is 0. The second part, not necessarily. Key to remember that returns are measured by both IRR and MOIC. Although, the IRR may be higher if prepaid within the first ~2 years, loans are provided with the purpose of generating returns through interest payments. The longer the loan remains outstanding, the more cash you generate from the facility - impacts your IRR, yes, but also serves its inherent purpose of generating an L+500-700 return (referring to vanilla sr secured, 2L loans - risk appetite changes if opportunistic lending, BS recap, structured equity, etc.). Keep in mind that lenders also like to be invested good cash flow generating companies with solid downside protection; so even if the lender was prepaid within the first 2 years for a repricing transaction (assuming markets have moved that way), wouldn't be out there to assume that the existing lender would want to refinance itself for a lower rate to ensure it remains attached to a good company (once again, vanilla lending with no minimum IRR / rate thresholds)
- Seen both quarterly and annual models. More accurate to assume mid-year interest payments - in the grander scheme of things, don't think it matters a ton, different firms have different templates
- Call premiums include language that specify the repayment of the loan is made in full and for a repricing or other transaction. See example below: "If on or prior to the first anniversary of the Closing Date the Borrower makes an optional prepayment in full of the Initial Term Loans pursuant to a Repricing Transaction, the Borrower shall pay to the Administrative Agent, for the ratable account of each Lender, a prepayment premium of 1.0% of the aggregate principal amount of Initial Term Loans being prepaid."
1) You should build a full model to the extent required to determine whether the business will be a leveraging or de-leveraging story as well as what your exit leverage multiple will be / FCF generation over the life of the loan as both will determine the company's future ability to refinance you out or fully amortize your loan. I always like to model out returns to equity to see what they're playing for.
2) Quarterly or semi-annual would be most typical, but if you are just modeling an existing loan you should be able to find what the payment terms are.
3) You would generally not weave in prepayment premiums into the returns analysis to determine your base case pricing as prepayment premiums are usually only applied to optional prepayments and are thus hard to model with much accuracy, but you should certainly build in functionality to sensitize returns under various prepayment scenarios. This is where having a detailed cash flow model would come in handy as you could try and predict in which periods the company would have excess cash available for a prepayment and what the associated premium would be.
Thanks. Could the IRR ever be lower than the coupon rate assuming the loan was issued at par or a discount? If yes, then if there is no excess cash flow to pay it down before it becomes callable, then is it fair to think that year 3 or 5 or 7 IRR will always be the same?
Loan would have to be issued at a premium for that to occur.
I’d honestly try to think out how you would model this out without looking at WSO. It’s pretty straightforward beyond the ECF sweep which tbh rarely hits, so it’s a good exercise to understand levers of credit returns.
I may have our new joiners do a similar exercise.
As the other poster said, you should just model this out and try different combinations of things to see the effect on IRR.
At the end of the day, a debt security is just a contractual stream of cash flows with par value being the PV discounted at the coupon rate.
Ok, very helpful, thanks! So on voluntary prepayments, can the company draw down on the revolver to prepay junior debt? If yes, would the prepayment premium apply in that case?
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