The cost of a good price

When is the sale price not the price you actually paid? Many who have been involved in the private equity market for some time are used to seeing the headline figures in the press release ?stretched?. That is to say, the transaction values quite often include other elements of the funding provided. Conversely, if a buyer purchases less than 100 per cent of a target, or does not pay for all of the target at once, what has the vendor actually realised? Deferred consideration (in effect where the purchase is paid for in instalments), and earn-outs (where the price the buyer pays depends upon the acquired company effectively proving its worth), are not new. However, situations where the vendor actually provides a significant proportion of the deal's funding are.

So-called vendor loans, another term for deferred consideration, have proved a very effective method of bridging the gap between the price that private equity houses are willing to pay and those that companies seeking to make disposals wish to realise. Indeed, such is the importance to some public companies of being seen to achieve what is currently deemed an acceptable price, that negotiating such facilities is becoming central to the completion of the transaction.

Take, for example, the mooted disposal of Vivendi Universal's business and health publications. It has been widely reported that Cinven, together with Apax Partners and Carlyle, have been locked in price negotiations which, purportedly, are now expected to result in a headline figure of around €1.7bn rather than the initially touted €2bn. Current market rumours suggest that a vendor loan will form a significant proportion of the price paid. In other words Vivendi, which has recently reported a rather embarrassingly large write-off of goodwill after overpaying for a number of previous acquisitions, is seeking to generate disposal proceeds at what will pass as an acceptable ?price? even if the cash they receive at completion is rather less than the reported figure.

Such arrangements can in fact account for a substantial portion of the total financing structure, as was the case with the €137.5m loan extended by Italian bank Bipop-Carire for the €450m disposal of Azimut, its asset management division, to Apax Partners ? a vendor loan representing more than 30 per cent of the so-called purchase price.

So what do vendor loans look like and what does everyone get out of the deal? The acquisition of Cognis from Henkel is a good example. Late last year Permira and Goldman Sachs Capital Partners completed the acquisition of the speciality chemicals division of Henkel for a headline figure of €2.005bn. However, of this total, €350m, or 17.5 per cent of the total consideration, was actually provided by Henkel itself in the form of a vendor loan. This loan has a ?maximum? maturity of 10-years and carries noncash interest (which is accrued and added to the principal amount) at a fixed rate of seven per cent per annum for the first three years and 16 per cent thereafter, according to Henkel's latest annual report. What is not included in the report is the fact that such a loan is likely to be subordinated to all the other debt in the transaction, probably ranking equally with most of the shareholder funding (i.e. the equity capital provided by Permira and Goldman Sachs Capital Partners) and, most importantly from the buyers' perspective, comes with no voting or other equity rights. It is also likely that prepayment provisions will be triggered should the latter exit ? hence the maximum maturity term.

The fact is that the effective purchase price for this transaction ? as calculated by the cash proceeds generated at completion plus the net present value of the redemption value of the vendor loan ? could well be lower than the headline figure. For example, assume that an exit occurs on the third anniversary of completion (as Permira and Goldman Sachs presumably intend). Henkel would have the right to receive €428.8m when the loan is repaid. However, if Henkel's cost of capital is above seven per cent (the rate of interest accruing during this period) – and chances are, it probably is – then the net present value of this amount will in fact be lower than €350m. As a result the effective purchase price is less than that stated. Indeed, this picture only starts to reverse beyond four to five years, a period of time that looks remarkably like the average life cycle of a private equity investment.