By Jon Wiley
For many business owners, a large portion of their net worth is tied up in a single asset: their company. This can be an unsettling situation, especially for those that may not have the time or inclination to ride out the next downturn before seeking a full sale. Increasingly, there are options available to business owners to diversify net worth or add growth without having to sell or give up control.
As frothy M&A markets drive ever higher exit multiples, investors continue to expand into additional segments of a company’s capital structure providing more financing alternatives and flexibility. Private equity funds continue to raise capital and the buyout market is sitting on a record $1.6 trillion of uninvested capital according to Pitchbook. We are experiencing one of the strongest seller’s markets in history. As a result, investors are looking for alternative methods for deploying capital. Traditional PE groups are raising minority equity and yield driven funds. A record $97.2 billion in debt funds were raised in 2017 compared to a low of $17.2 in 2009. Including the $69.6 billion raised in 2018 the estimated amount of alternative debt funding waiting to be invested now totals $208.9 billion according to Pitchbook.
There has always been a market for alternative lending (non-bank financing) but the focus had generally been on turnaround situations. More often we are seeing this source of capital being used to finance healthy, growing companies. General debt and direct lending funds have outpaced distress debt funds in amounts raised, accounting for more than half of total new debt funds. Lenders have expanded from traditional asset based and mezzanine lenders to include more unitranche, 2nd lien, and hybrid equity options. Mezzanine and 2nd lien lenders provide junior capital that is subordinated to traditional bank debt. The lenders work together through a negotiated intercreditor agreement. In some cases, a one-stop solution might make more sense. Unitranche facilities offer a similar ability to borrow more capital than a bank will typically provide with an interest rate that ranges somewhere between bank and subordinated debt, often designed to match the overall blended rate of the two separate facilities. Hybrid solutions include preferred equity securities with financial profiles very similar to alternative debt options.
USES OF PROCEEDS
Private equity firms are generally willing to have owners retain some ownership after a purchase but typically want majority ownership. While these majority recaps are becoming very common, they don’t help business owners that would like to diversify their holdings but aren’t ready to concede control. This is where the dividend recap comes into play. The company would borrow money from an alternative lender in an amount larger than a bank would provide and use the capital to make a distribution to the business owners. In this scenario, the business owner has achieved some level of diversification without ceding control of the business. This can also be a solution when there are multiple owners that have different objectives. The active owner can borrow or use minority equity to buy out passive owners.
Alternative lenders are also interested in growth situations, whether through acquisitions or organic growth. In the case of acquisition, the lender will look to the combined earnings and capital structure of the companies post-acquisition to determine how much capital they can provide. We also see situations where a company has unique organic growth opportunities but, without the proper capital in place, won’t be able to take advantage. Alternative lenders have the ability to be more forward-looking than banks. While banks typically base loans on trailing twelve-month financial information, alternative lenders may be able to finance based on new contracts or qualified growth opportunities.
TERMS AND STRUCTURE
In general, alternative lenders are willing to take on more risk than a bank, often lending an additional 1x EBITDA. As a result, they will need to generate higher returns. This comes in the form of higher fees, interest rates, and in some cases equity kickers such as warrants or preferred equity. The trade-off for a borrower is additional flexibility. While the interest rate will be higher, the loan is often amortized over a much longer period and is sometimes interest only. This creates more cash flow to fund operations and growth. In some situations, lenders will offer payment in kind (PIK) options for interest. PIKs reduce the need for cash interest payments, further increasing cash flow.
Alternative lending options are not a fit for all companies. Early stage companies with no track record of earnings or collateral will not meet necessary criteria. As with private equity, the market for alternative lending options gets more efficient for middle market companies. The number of lenders providing capital in amounts less than $10 million is reduced significantly. That said, for companies that do qualify, alternative lending can be a great option for situations where additional capital is needed but owners prefer to minimize dilution and outside control.
About John Wiley
Jon Wiley is a Managing Director at The Forbes M+A Group, where he leads the firm’s capital formation practice. He has advised companies in a variety of industries including medical devices, food and beverage, energy, aerospace & defense, and technology. He has also advised numerous specialty lenders in sourcing debt and equity investments including facilities ranging to hundreds of millions of dollars.