Reorganizing the Capital Structure For an Economic Recovery
By Ken Stapleton
Whether you call it a slowdown or recession, the state of the economy has had a direct affect on all business segments, particularly the middle market. Traditionally reliant upon senior bank debt to fund operations, with little or no access to the public capital markets, middle market companies are experiencing a decrease in available financing due to credit tightening at financial institutions. Companies are seeing existing debt availability diminish due to increased drawdowns or bank line reductions, putting them in the precarious position of having to restrict operations in a down market. Companies may be forced to turn away business at a time when every dollar counts. The difficulties of the present market may be compounded by an economic recovery, which generally precedes an upswing in bank lending. A lack of "dry powder" to take advantage of an economic recovery can hamstring a company and present a severe competitive disadvantage. These scenarios underscore the need for a sound capital structure, complete with the necessary level of underlying junior capital, to ensure sufficient access to financing.
The Current Banking Environment
The current banking environment is characterized by significant credit tightening, particularly among those institutions previously focused on traditional cash flow lending. Lenders are more cautious now than at any other time in the last eight years and are taking a closer look at external factors, such as relationships with suppliers and customers, fearing a domino effect in the economy. In the asset-based arena, accounts receivable and inventories are being discounted at greater rates than in the past, due to fears that their values will not be fully realized in the future. As a result, there has been a reduction in the overall availability of bank lines and the virtual disappearance of undercollateralized deals or "airball" lending. The general decrease in company sales, and resulting decrease in receivable and inventory balances, has caused borrowing capacity to ratchet downward.
It can be argued that, as a result of the aggressive credit standards employed during the recent economic expansion and the resultant increase in non-performing loans at many banks today, some lenders are now prohibited from underwriting "non-vanilla" transactions. Banks may be forced to turn away deals to focus on troubled accounts or may be unwilling to entertain new business in an uncertain market. To combat this effect, many companies must turn to the junior capital markets in order to obtain the financing necessary for current survival and future growth.
New capital sources may be the best answer as most banks are also putting ceilings on the amount of total debt client companies may obtain. Today, senior debt is generally advanced at a maximum of 2.0x to 2.5x earnings before interest, taxes, depreciation and amortization ("EBITDA"), with total debt capped at 3.0x to 3.5x EBITDA. Increased equity can complete the capital structure and is often encouraged by senior lenders. Equity, however, is the most expensive and most dilutive form of capital. As a result, "quasi-equity" or mezzanine debt will often better serve the borrower, while satisfying the lender.
Junior Capital
Junior capital encompasses any type of financing which is junior in liquidation preference to senior debt and senior to common stock or equity. The level of junior capital on a company's balance sheet directly affects the level of senior debt it can obtain, as banks are more comfortable with a layer of longer-term capital beneath them in the capital structure. This level of capital supports the bank debt and enables the company to obtain long-term financing. The two most common types of junior capital are subordinated (also referred to as mezzanine) debt and preferred equity. Mezzanine debt usually has a current coupon, typically 12%, and provides the lender with warrants to purchase a small ownership position in the company at a predetermined price. Target internal rates of return, which are derived from the coupon combined with a projected valuation of the equity value of the company in five years, range from 18-25%. Preferred equity may have a current dividend payment, but the bulk of an equity investor's return is based upon conversion of preferred stock into common stock at an agreed upon ownership percentage in the company. Target internal rates of return range from 25-35%. Both types of capital usually require board seats, and investors are active in assisting management in developing the strategic plan. Such investors rarely have an interest in actually owning a portfolio company but seek warrant positions as a means of achieving target returns.
Currently, mezzanine and private equity funds are searching for sound companies, especially those with consistent cash flows in growing markets. With large dollar amounts to invest, mezzanine and private equity funds can be an excellent source of capital for companies across a broad spectrum of industries.
Criteria for Investment by Mezzanine and Private Equity Investors
When reviewing potential investments, junior capital providers will focus on specific factors to determine the overall attractiveness of the opportunity. The various attributes of a company and its business environment play an important role in the final investment decision as each opportunity is measured against stringent criteria. The following factors represent some of the most important areas of review by junior capital providers.
- Management Team - This is perhaps the most important aspect of a potential transaction. Junior capital partners are looking for a team of highly qualified professionals with a history of success and experience within their industry. There must be adequate depth of qualified personnel to ensure the stability of leadership for the company and to demonstrate a breadth of knowledge and resources.
- Growth Potential / Market Size - A company must demonstrate the ability to achieve a consistent level of growth and the potential to become a market leader within its market niche. Competitive advantage within an industry segment is highly desirable. The ultimate size of the target market will determine if there is room to reach a targeted level of growth and whether the growth potential is adequate to attract investor interest. Investors are looking for high growth industries to achieve their desired returns.
- Business Plan - A thoughtful, analytical and achievable plan for the future growth and success of the company, taking into account its business environment, is a required item when approaching junior capital providers. Topics such as the company's products or services, the market, the competition, historical financial results and projections and the overall marketing plan should be discussed in depth to provide potential investors with a clear understanding of the company and the related investment opportunity.
- Identified Exit Strategy - As the overall return on investment for junior capital providers is dependent upon obtaining value for their equity position, a clearly defined exit strategy is highly important. A liquidity event can take numerous forms, including recapitalization, refinancing, company sale or, occasionally, initial public offering. The typical investment horizon for junior capital investors is five years from the time of closing.
Benefits of Adding Junior Capital
It is often tempting for a company that has been performing well to avoid accessing the mezzanine and equity markets in favor of lower cost senior debt. Senior debt has a lower interest rate and does not entail any "ownership giveup" or board representation. However, without a solid foundation of junior capital, senior lenders generally cannot increase their lending to a company, making growth extremely difficult. It is important for business owners to appreciate the basic principle that a smaller ownership interest in a growing business is more valuable than a larger ownership interest in a stagnant or contracting business. Often, banks will look more favorably upon those companies that are backed by institutional investors and may be willing to extend credit at better pricing levels. Another benefit to a company is access to additional sources of capital, thereby reducing reliance upon a single institution. In addition, mezzanine lenders and equity investors will often reserve a portion of their available capital for follow-on investments for those companies which are performing well or need an additional capital infusion. This provides a level of comfort to both senior lenders and company management.
The overall benefits of adding junior capital go beyond the increase in available funding. Mezzanine and equity providers are professional investors with the ability to assist a company in developing and implementing growth strategies, cost reduction plans, mergers and acquisitions and, if desired, the eventual sale of the company as a liquidity event for its owners. Fund investors draw upon their years of experience in the purchase, operation and sale of companies to guide management on the intricacies of ensuring a successful completion of business initiatives. Often, funds will have other portfolio companies operating in similar business sectors and will encourage interaction to increase the overall performance of each company.
Existing banking relationships can be strengthened with an influx of junior capital, and new relationships can be formed with those banks that have ongoing relationships with mezzanine and equity investors. Mezzanine and private equity investors can often obtain more favorable financing terms on behalf of their portfolio companies from senior lending institutions with which they conduct business on a consistent basis. A company's flexibility is increased by its ability to explore the senior lending market and chose an institution which best suits its current and future needs.
Summary
As the economy rebounds and bank credit remains tight, a well-balanced capital structure is crucial to the current and future financial success of a company. By adding a layer of junior capital, a company can obtain funding necessary for survival and/or growth, while at the same time partnering with professional, highly competent investors whose interests are aligned with those of the current ownership. Additional junior capital can also enhance existing funding relationships and diversify capital sources. Business owners must recognize that a properly capitalized company will be better able to weather the storm and will have the capacity to take advantage of an economic recovery.
Ken is an Associate with Ironwood Capital Ltd., a 15-year old investment banking firm in Avon, Connecticut. Ironwood specializes in raising mezzanine debt and private equity raising debt and providing financial advisory services for middle market companies. Ironwood Capital is affiliated with Ironbridge Mezzanine Fund LP, a Small Business Investment Company. Ken can be contacted at stapleton@ironwoodcap.com. Go to www.ironwoodcap.com to learn more about both firms.
Copyright © 2002 by Ironwood Capital Ltd. All Rights Reserved.
|
