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 (<$1M based on current share price - pretty much negligible and it shouldn't be included in the IRR calc anyways). They state 14% IRR for this particular investment. How is this possible?

Would appreciate your thoughts / insight.

Cheers

Comments (10)

 
Sep 10, 2015 - 4:06pm

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%.

 
Sep 10, 2015 - 5:37pm

Another thing to consider would be that some mezzanine debt funds are SBIC funds and can lever up to provide incremental returns.

Play the long game - give back, help out, mentor - just don't ever forget where you came from. #Bootstrapped
 
Sep 11, 2015 - 8:30am

EightAceTres:

Another thing to consider would be that some mezzanine debt funds are SBIC funds and can lever up to provide incremental returns.


Makes sense. The sum of funds investments adds up to the amount to which they say it has been drawn, so my original thoughts were that they do not lever up. However, it might be possible that they count SBIC financing as part of investors commitments to the fund, but do not take it into account when calculating IRR, which creates artificial leverage.
 
Sep 11, 2015 - 3:01am

BatMasterson:

thorekka: plus make-whole penalties which may have happened, plus warrants which would add another 1-2% which will get you your 14%.

Can you elaborate ?


http://www.investopedia.com/terms/m/make-wholecall.asp
"After you work on Wall Street it’s a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side.” - David Tepper
 
Sep 11, 2015 - 8:33am

thorekka:

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


Thank you, it makes sense and I had similar thoughts. It seems like they are using small boosts here and there to improve IRR, although I can't get to their number yet.

Regarding OID, they might do it for some investments, but for that particular one they say they issued 15M of bonds at issue price of $1. Is my understanding correct that there is no OID in that case? Or is it possible that they actually provided less than the announced $15M amount to the borrower?

Also, when you mention make-whole penalties, can these be higher than the payment required to achieve the IRR originally targeted by the creditor? I thought that they could only help the fund maintain its IRR at the required level, but not increase it beyond what was calculated under the assumption that the debt would not be repaid early.

 
Sep 15, 2015 - 4:05pm

sicaf101:

which represents c.0.8% of stock capital (IRR calc anyways). They state 14% IRR for this particular investment. How is this possible?

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.

 
Sep 16, 2015 - 10:37am

ThaVanBurenBoyz:

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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