Flexibility to Invest Across the Cap Structure

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In what cases, would an investor generally want to invest in the debt of the business (as opposed to equity) assuming he has the flexibility to do invest anywhere in the capital structure?

Talking from the perspective of middle market (private owned businesses)

Comments (4)

 
  • Prospect in IB - DCM
Sep 15, 2020 - 8:56pm

Different businesses make better debt and equity investments based on reward and risk characteristics. If I'm able to lend a company 4% yielding debt and be 1st lien (1st in line in the capital structure in the event of bankruptcy) that might be better risk reward trade off for being the equity that has a 5% return. This is just an example.

Good credit stories are ones where you don't risk losing money. They generate stable cash and revenue, maybe even slightly declining or growing, but aren't at risk of going to zero overnight.

Good equity stories are ones where there are new inventions and products that can be value enhancing. Maybe it's a declining business with undervalued equity, or a high flying tech stock with secular tailwinds.

You'd normally invest in the debt when you want to play it safer in the same company, the reward to risk is better, the equity might be hard to value (or predict), maybe you want current income from bonds or loans (interest income), it could be a distressed name and you want them to go bankrupt so you can takeover the company for cheaper. Lots of different reasons depending on the strategy.

Debt guys are usually pessimistic -- worried what could go wrong, so they want to play it safe and clip a coupon in a better part of the structure. Equity guys are optimistic -- investing because things can go right and the business is worth through new products and ideas.

 
Sep 15, 2020 - 9:11pm

Yep agree with all of the above. Another scenario could be lending in a situation where the previous owner doesn't want to give up more than a certain % equity or you can't quite bridge valuation expectations. The sponsor might be willing to forego some return for current income + priority position in an asset they like. Doesn't always work because the returns are obviously vastly different but certain PE firms / LPs are okay with that.

 
Sep 15, 2020 - 9:54pm

In turnaround/distressed, it's crucial because it's sometimes more sensible to play the loan-to-own game instead of buying equity. Really depends on the company/transaction/geo. 

Outside of that, I know it's increasingly popular for large traditional private equity firms to launch a lending arm. This is a really funny article:
https://www.ft.com/content/6d7e4fb9-672b-4088-a2ef-30807a2358dc

FT has quite a few good ones if you have a sub!

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