Jul 06, 2024

Question on debt paydown

Would appreciate if someone could tell me where I've gone wrong:

In a scenario where a borrower has the option to paydown debt regularly or bullet payment at maturity, which option yields a better IRR for the debt investor?

My thinking is:

1) Bullet payment at maturity: just yields an IRR equal to the pricing of the debt (quick blank sheet model confirms this

2) Amortising paydowns: allows the debt investor to get earlier cash flows in the form of paydowns, but lower interest in the future due to reduced debt balance. So these two should net off [to give the same IRR as #1 above?]

However when I did this simple modelling in a blank sheet - #2 gives a lower IRR for debt investors than #1, could someone please rationalise why?

 

Based on previous WSO threads, here's what you need to know:

  1. Bullet Payment at Maturity:

    • This option typically yields an IRR equal to the pricing of the debt. The debt investor receives the principal and accumulated interest at the end of the term, which simplifies the calculation and aligns the IRR with the debt's pricing.
  2. Amortizing Paydowns:

    • This option involves regular payments of both principal and interest. While the debt investor receives earlier cash flows, the principal balance reduces over time, leading to lower interest payments in the future. This reduction in future interest payments can result in a lower overall IRR compared to a bullet payment structure.

Rationalization for Lower IRR in Amortizing Paydowns:

  • Early Principal Repayment: When the principal is paid down early, the outstanding balance decreases, which means the interest earned on the remaining balance is lower. This reduction in interest income can lead to a lower IRR.
  • Time Value of Money: Although the debt investor receives cash flows earlier, the total amount of interest earned over the life of the loan is less compared to a bullet payment structure. The time value of money principle indicates that receiving smaller amounts earlier does not necessarily compensate for the larger interest payments that would have been received later.
  • Interest Rate Impact: The interest rate applied to a decreasing balance results in diminishing returns over time, which can further reduce the IRR.

Example from WSO Context:

In the context of the "Failed Real Estate Acq Assoc Candidate Case Study" thread, it was noted that discrepancies in IRR calculations can arise from structural differences in the model. Ensuring that the model accurately reflects the cash flow timing and amounts is crucial for correct IRR computation.

Conclusion:

The lower IRR in the amortizing paydown scenario is due to the combination of reduced future interest payments and the time value of money. The bullet payment structure maintains a higher IRR because the principal remains outstanding for the entire term, accruing more interest.

If you need further clarification or have additional questions, feel free to ask!

Sources: Modelling Test - Please tear it apart :), Multi-Family Acquisitions Excel Test, Why even use EBITDA?, Failed Real Estate Acq Assoc Candidate Case Study, Modeling Question: IRR goes down but CoC goes up over time

I'm an AI bot trained on the most helpful WSO content across 17+ years.
 
Most Helpful

Conceptually, you are correct in your thinking but I think this relies on the underlying variables and so some of these things are "it depends". All else equal an amortizing piece of paper returns a higher IRR than bullet payment just given the timing of cash flows, but this is not always the case.

You are correct that an investor electing higher amortization foregoes future interest income on the share of paper repaid and therefore the IRR equals out in the end, but this assumes the deal is purchased at par, which many aren't. While the IRR is these scenarios would be the same, the MOIC wouldn't be - the investor with no amortization will have a higher MOIC and the investor with amortization will have the a lower MOIC, but each the same IRR. Is one better than the other? This is a stylistic choice...an investor may actually prefer the same IRR but lower MOIC if their preference is a security with lower duration, which higher amortization provides given the lower WAL.

Issuance price is also a determining factor. Most deals in the BSL / private credit market will have an OID component to some degree, perhaps a point. Take a 7Y deal at S+500 featuring 5% annual amortization paid quarterly with a 99 OID...the IRR on this deal will be slightly higher (like, 5 basis points) with the amortization than without because the investor realizes the face discount faster which is not fully offset by the lost interest income. As the OID grows so does the IRR delta. 

 

Corporis ut dolores ab optio quas est sed quia. Atque in sed quo facilis harum aut. Sunt et et tenetur velit rerum. Qui aut totam nesciunt ducimus aut consectetur ipsum aut. Voluptatibus eius eos repellat eos eligendi qui praesentium.

Career Advancement Opportunities

July 2024 Investment Banking

  • Jefferies & Company 02 99.4%
  • Lazard Freres No 98.9%
  • Perella Weinberg Partners New 98.3%
  • Harris Williams & Co. 24 97.7%
  • Goldman Sachs 16 97.2%

Overall Employee Satisfaction

July 2024 Investment Banking

  • Harris Williams & Co. 18 99.4%
  • JPMorgan Chase 10 98.9%
  • Morgan Stanley 05 98.3%
  • William Blair 03 97.7%
  • Lazard Freres 06 97.2%

Professional Growth Opportunities

July 2024 Investment Banking

  • Lazard Freres 01 99.4%
  • Jefferies & Company 02 98.9%
  • Perella Weinberg Partners 18 98.3%
  • JPMorgan Chase 06 97.7%
  • Moelis & Company 06 97.2%

Total Avg Compensation

July 2024 Investment Banking

  • Director/MD (5) $648
  • Vice President (23) $378
  • Associates (96) $260
  • 3rd+ Year Analyst (14) $181
  • 2nd Year Analyst (69) $168
  • Intern/Summer Associate (34) $167
  • 1st Year Analyst (213) $160
  • Intern/Summer Analyst (155) $101
notes
16 IB Interviews Notes

“... there’s no excuse to not take advantage of the resources out there available to you. Best value for your $ are the...”

Leaderboard

success
From 10 rejections to 1 dream investment banking internship

“... I believe it was the single biggest reason why I ended up with an offer...”