The formulas, tricks and trade secrets of Private Equity

# Vendor Financing Example

### Sample Chapter

In a previous post, I talked about vendor financing. In this post, I am going to give a numerical vendor finance example from the point of view from a private equity firm. Let’s start with a few assumptions.

• My private equity firm is interested in buying TPE Healthcare
• TPE Healthcare has FY09 EBIT of \$10m
• Based on previous analysis, I decide that the highest multiple I will pay is 7x
• The owner of TPE Health care wants \$85m for the business

So, the highest price I can pay (and justify to my investors) is 7x \$10m, which is \$70m. However, the owner (or vendor) wants \$85m. In preliminary talks, I explain the concept of vendor financing, and vendor finance example, and that it may help to get the deal done. The vendor wants to retire and I think TPE Healthcare is a great business, so we really want to come to an agreement.

I start with the idea of paying \$50m initially and \$35m in three years. The total is \$85m, which the vendor wants, but the deferred \$35m is worth less when considering a dollar today is worth more than a dollar tomorrow (let’s assume we don’t have a deflating value through currency trading). Say I use a 20% discount rate as the opportunity cost of my funds. (So, I’m inferring that I think I can invest my money for 20% elsewhere if I had to.) Discounting the \$35m back to today’s money results in a present value of 35/(1.2)^3 = \$20.25m. So the real value of the proposed deal is \$50m + \$20.25m = \$70.25m, which is close enough to the \$70m limit that I hoped to pay.

If we agree on this structure, I’ll pay \$50m upfront with a combination of equity and debt. Then in three years’ time, hopefully the business is performing much better, and I can decide to pay the \$35m in either cash or completely with debt (since earnings should be much higher). The risk, of course, is that the business goes backward and I can’t afford the \$35m. In this case, I’d have to call on equity from the fund, which would be a very bad outcome. So, there is certainly risk with vendor financing (as you can see from the vendor finance example), but it’s important to remember that the present value of the deal is still \$70m, which I was fine with paying (as long as I believe in my discount rate too).

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