June 26, 2024

What’s An Equity Kicker?

The Underappreciated Value-Add, Explained in Clear Terms

One hears the term “equity kicker” often in the debt financing industry. But what exactly is an equity kicker, and why is it advantageous to investors?

To understand, let’s first look at debt. Debt (whether a loan, bond or other instrument of lending) includes a promise to pay back a fixed amount (principal) plus an agreed upon stream of cash payments (interest). A simple example is a par value loan: A borrower receives upfront use of capital and promises to pay it back on time, plus interest. The investor receives the interest income, and of course, their principal investment is returned. It’s simple, but limited. The only upside for the investor is the interest paid on the amount lent. The benefit stops once repayment is made.

But debt is only one half of the equation in a company’s value. A capital structure of a company consists of both debt and equity, and a value can be assigned to both based on the real-world value of the company’s assets. In our simple example, assets minus liabilities equal equity.  Debt is a liability and detracts from the equity value of the company.  As the company grows and/or earnings increase, value accrues to the equity holders – So, we can say the equity upside represents a call option on the value of the assets. We can think about the level of debt as indicative of the strike price for the call option. If the company does well, there can potentially be a large upside.

The debt side is different.  The upside for a debt holder is the interest paid on the debt amount lent.  The expectation is for the repayment of the full principal plus interest. Thinking of it in option terms, the debt holders are essentially short a put option with the interest paid to the debt holders as the premium received from the short put position.

T = Time of Debt Payoff

V = Firm Value

F = Debt Face Value

The owners of equity have true skin in the game and are risking the full loss of their investment, but also stand to gain more than the debt holders. As such, the use of debt needs to be carefully considered and the expected benefit for the use of the debt capital must be higher than the cost of the debt.

Let’s compare 2 companies in a similar industry:

  • Company A has big plans and is risk taking.
  • Company B is slow, steady and risk averse.

Both companies are expected to grow, but Company A is likely to grow more, albeit with greater volatility than Company B. Under this scenario, Company A calls would be worth more than Company B calls and Company B bonds would be worth more than Company A bonds.

One way for the debt holders of Company A to benefit from the expected volatility they are faced with is to have participation in the equity upside. This is known as an equity kicker, of which there are three main types:

  • Warrants: The right to own a percentage of the company, where a right to own is explicitly a call option on the value of the firm.
  • Convertible Debt: Instead of being paid back the fixed amount (principal) at maturity, bond holders have the right to convert the principal amount into equity ownership, which is representative of an embedded call option on the value of the company.
  • Put Features: A “put” provides the ability to put back the option of ownership for an agreed upon price. In our example, the lender combines warrants with a put option which enables the lender to receive value from the warrants even if the warrants are not exercised. This is an explicit downside protection that leaves the debt holder short a put spread, rather than just an outright put (debt as a put option plus the put option on the warrants). You could think of it as a reverse original issue discount. Instead of a discount at origination, it’s a discount at the end. In the world of private credit, this extra protection might also be called a success fee or an exit fee. A rose by any other name is still a risk mitigator in providing another lever of attachment to the company.

An option model can be used to assign a value to these options, however, there is also value in these options’ abilities to further align investors to the business of the lenders. Instead of being a last-minute deal sweetener or a way to reduce the cost of the debt, equity kickers can help enhance the level of partnership. Debt financing is often a substitute for an equity raise. A business owner is willing to pay a high rate of interest in order avoid selling much of their company at a perceived discount to future value. But that future value shouldn’t be a low probability event. It should be the result of solid planning and steady execution that involves funding the value-creating vision of the owners by a trusted partner.

The bottom line: Investors and borrowers can participate in value creation via one or more of the mechanisms noted above. Equity kickers provide a vehicle to participate in the upside, offer a measure of risk mitigation and help bring more alignment between the borrower and investor. The potential result is an increase in the level of return from the issued debt in excess of the interest paid, which could result in an overall blended equity-like return.


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