Vol. 9, No. 8, November 2011
Operating nationally and internationally, FOCUS currently is working with buy- and sell-side corporate clients, private equity groups, holding companies, and late stage venture capital firms in 23 areas:
We have executed dozens of transactions in a range of market segments, but the same fundamentals apply across all of them. Our on-going transaction process provides us with up-to-the-minute market knowledge in these sectors that may be of corporate development interest to you.
A Financing Alternatives Primer
By John Slater, FOCUS Partner and Team Leader of the FOCUS Capital Financing Team, and Bob Beard, FOCUS Managing Director
Remember the fall of 2009? We had just survived the worst financial crisis since the Great Depression and the stock market was enjoying the early stages of a very powerful bear market rally. We could all breathe a great sigh of relief. Of course a few party poopers were still around to remind us in articles like this one published by the Wharton School that a mountain of debt built up during the bubble years of 2006 and 2007 would need to be refinanced by the middle of the next decade. This debt, measured in the trillions of dollars, encompassed both commercial loans--many generated to support highly leveraged buyout financings--and commercial real estate funding.
No need to worry, 2012 was a long way in the future. Well that future is now and Wall Street is again teetering on the brink of panic. Many firms that survived the crash have seen their profits--if not their revenues--return to past highs. Large profitable corporations have successfully refinanced much of their debt with very low cost long term bonds. For much of 2010 and the first half of 2011, strong high yield and leveraged loan markets enabled even middle market firms to stabilize their debt with relatively low cost funding as well. So the question is, “Have we dodged the bullet?”
Unfortunately, two recent reports answer the question with a resounding NO. The Financial Times, in an article entitled “Door Slams Shut for Corporate Have-Nots,” describes a two tier world in which a few very strong companies like Apple Inc. have taken advantage of the recovery to build up tremendous hordes of cash. On the other hand, weaker firms remain overleveraged and at extreme risk in the event of another financial crisis or a material rise in interest rates.
To accentuate the depth of the problem, KPMG recently published an in depth study entitled “The Refinancing Wall,” estimating that corporate debt maturities from 2011-2015 total $5 Trillion worldwide and that LBO maturities from 2011-2016 total almost $1 Trillion. Add to this approximately $2.75 Trillion in commercial real estate maturities and a market experiencing strong worldwide competition for funds to finance government deficits. We can reasonably anticipate that there will not be enough chairs in the circle when the music stops.
What does this mean for the lower middle market? Traditionally, commercial banks have been the primary source of funding for firms under $100 million of revenue. Since the crash, many banks have been merged out of existence or have exited commercial lending. The commercial lending capacity that remains, including both human and capital resources, will be heavily focused on workouts and restructurings for the next two to three years and will not be available to assist smaller companies with financing, no matter how promising their opportunities for growth.
Now is the time to prepare for the day when you, as a business owner, excitedly call your friendly and fresh faced loan officer, “Alexandra Silvermore,” only to find that she has been replaced by “Gustaf Bonbrecker,” who was recently assigned to commercial lending following a four-year stint in special assets. So what are the alternatives for a sound, growing lower middle market manufacturer, distributor, or service firm?
- Asset Based Lenders (ABL)have traditionally filled the void left when traditional commercial loans are no longer available or adequate for the needs of a growing company. ABL providers rely primarily on the liquidation value of their collateral to provide assurance against loan losses and are not overly focused on the borrower’s profitability. In recent years ABL providers have become much stricter in underwriting the credit of their borrowers and in assuring the quality and value of their collateral. Additionally most ABL providers are not fond of fixed asset collateral such as equipment and real estate. Term loans collateralized with such assets are generally financeable by ABL providers only as a small percentage of a larger loan facility comprised primarily of inventory and receivables.
The cost of ABL financings in the current market ranges from highly competitive interest rates in a range of 2-3 percent over the London Interbank Offered Rate (Libor) for the strongest borrowers with larger financing requirements ($10-15 million and up) to all in costs, including interest and various fees, that can range into the high teens for overall financing costs and we have seen even higher rates charged to clients with great cash flow, but limited financing flexibility. Most ABL providers want to see a minimum funding need of $5 million plus, with leading players like PNC, Wells Fargo, and USBank targeting needs in the $15-125 million range. A few specialized lenders will provide funding down to the $2-3 million range, but price their offerings accordingly. For more details on the ABL market, read Bob Beard’s in depth coverage at www.capmatters.com.
- Mezzanine Lenders have traditionally filled the gap where asset based loans do not fill the entire need. The term mezzanine is derived from the positioning of these loans in a borrower’s capital structure between senior debt (frequently ABL) and equity. Mezzanine lenders generally look to the cash flows of a business as their primary source of repayment, though some mezzanine lenders will take second lien positions as well to enhance their potential for recovery in a bankruptcy. Mezzanine loans are traditionally structured with a five year term, interest only with a principal bullet at maturity. Current pay interest is generally in the range of 12-13 percent with additional yield in the form of payment in kind (PIK) interest of 2-3 percent.
Depending on the credit quality, the size of the facility, and other factors, the mezzanine lender may or may not require equity warrants to enhance their yield. Generally in the lower middle market, mezzanine lenders target total annual returns ranging from the mid-teens to low 20 percent range. Larger facilities can be more competitive with targeted yields in the low teens. Several billion dollars of new mezzanine capital has been raised in the past twelve months, providing adequate liquidity for those borrowers for which this type of funding works.
The most important constraint is that the mezzanine lenders generally are very rigorous in demanding that their borrowers have good histories of adequate cash flow to cover anticipated debt service. This can pose a challenge to firms hit by the down cycle in 2008-2009. Also, for lower middle market firms, this means that total leverage (senior and mezzanine) cannot exceed 3-3.5 times cash flow with outliers at either end of the range depending on credit quality, growth prospects, etc.
- Tranche B or second lien financing developed in the late 1990s to meet a desire on the part of many borrowers to minimize equity dilution from mezzanine warrants. These structures often piggyback on the senior loan structure, but carry a full subordination to the senior. In the current market, such subordinated debt will typically carry a yield premium of 4-6 percent over senior debt. Tranche B loans were commonplace in the 2005-2007 timeframe as billions of hedge fund and CDO funding poured into the market. With the collapse of the shadow banking system in 2008, only a few of these funds remain active today and many of those that do are more focused on unitranche funding as described in item six below.
- Growth Equity financing is increasing filling in gaps for quality firms for which senior debt plus mezzanine is not sufficient. Many mezzanine firms have recently included such financing as a standard part of their package, in some cases as well as to enhance the credit quality of the mezzanine piece. Growth equity usually takes the form of preferred or common stock (or a member’s interest with equivalent priority positions in pass through entities). The preferred stock will generally carry an expected dividend coupon, often with a PIK feature to minimize the cash flow impact. In general growth equity financiers are seeking annual returns ranging from the mid 20s to the mid to high 30s depending on perceived risk, opportunity for growth, etc.
- A variety of governmental programs are in place for smaller companies to fill the needs served by growth equity as well as mezzanine financing. These include federally subsidized SBICs as well as a variety of state sponsored programs generally described under the category of business development companies. Financing structures and cost of funds are not dissimilar from the cost of commercial fundings, with federally mandated yields caps sometimes generating lower costs of funds than the commercially funded vehicles.
- “Unitranche,” a term for a relatively new category of lender, ends our list. Unitranche lenders have raised billions of dollars to fill the gap left by the cutbacks in traditional bank commercial lending. In many cases, today’s unitranche lenders evolved from the remnants of the tranche B market. These firms simply reallocated the funds previously deployed to subordinated lending and moved them into senior debt structures (often without reducing their pricing) because the market allowed them to do so. Their borrowers benefit from increased flexibility and shorter underwriting times as compared with bank loans, but the price paid is a higher funding cost than senior bank loans.
Depending on the credit quality of the borrower, unitranche lenders generally seek current yields in the 9 percent range at the low end and more typically carry current coupons in the 12-13 percent range. Additional PIK features and/or warrants may drive total funding costs to the mid-teens or even higher depending on credit quality of the borrower. Unitranche transactions are generally secured by all the borrower’s assets and may or may not be monitored on an ABL basis.
We’ll be publishing more details on each of these categories in coming months at www.capmatters.com. With the challenges that lie ahead for the commercial loan market, we anticipate rapid evolution in the alternative lending markets.
Top500 Internet Retailers Ready to Rrrroll Up
While conducting research related to the possible financial impact of the Main Street Fairness Act on web only Internet retail clients, Abe Garver, who is an M&A expert focused on the sector for Focus LLC, determined that new costs associated with collecting tax (as a percentage of collected tax) could range between 1.5 percent for large retailers and 13.5 percent for small retailers.
Within moments Garver realized the time was ripe to pose a very important question to his network of 252 Top500 CEOs and 132 private equity groups who had made investments in the sector (PEGs).
The hypothesis was simple. Strategics, PEGs, and consumers might benefit from a series of roll up IPOs delineated by high average order value categories (e.g. electronics and home furnishing). Possible benefits could include:
- Reduction of cost of collection expense contemplated under MSFA;
- Access to new revenue opportunities in international markets;
- Access to additional capital to acquire new top level domain names (e.g. $185K to apply for category based domains such as .electronics, as much as $350K for others);
- Opportunity to create new economies of scale with peers in marketing, distribution, stock-keeping unit (SKU) count, and vendor costs;
Against that backdrop, Mr. Garver asked the group of 252 Top500 CEOs whether they would be interested in pursuing a roll up IPO in consideration of the possible benefits (summarized above). The first seven responses were:
- “Sounds like fun: count me in.”
- “As for looking for outside investments, we would pass on that. We just reinvested 2 million back into the company for a new web platform and better vendor integration. We are hoping to double the size of our business, every year for the next five years. Maybe in year three or four we would be looking for outside support.”
- “I would add seven items to your list of potential benefits of a roll up IPO. They include: the ability to cross-sell products on our websites; ability to use EDI across all companies to fulfill orders in the most efficient way; access to buyer financing programs such as “Bill Me Later” that won’t deal with smaller companies; fetch back capabilities; ability to include complimentary catalogs and inserts for inclusion in all packages that are shipped out; unified IT efforts; and patent sharing. I don’t know if the other companies have patents on web methods, but we do and they could be useful to everyone in the group. It can also be a revenue source from competitors not in the group.”
- “I'd say my interest level is a 9 on a scale of 1-10. Our company has been rolling up internet retailers since 2008. We've also been in merger discussions with two other IR 500 retailers this year.”
- “Very interesting. The comment from one CEO about patent synergies was right on target. Frankly, the sales tax issue pales in comparison to the patent issue.”
- “Checked with my private equity owner who is a board member. He would like to discuss this further with you.”
Mr. Garver then asked the 132 PEGs whether they would like to sponsor a roll up IPO of strategics in the several high average order categories (e.g. electronics/home furnishing). The first three responses were:
- “Compete with Amazon? No thanks!! Interesting investment thesis - it's good to see these ideas.”
- “It’s always intriguing to see how these roll-ups get done. We have historically not invested in roll-ups and related strategies. While we know that many people have made lots of money doing industry roll-ups, it’s not been our cup of tea. We wish you every success with this project.”
- “We are investors in strategic which is very large already...would seem to make sense to use them as a platform.”
Given their foresight on the roll up IPO opportunity, a vast network of CEO and PEGs relationships in the sector, and a number of active discussions under confidentiality agreements, Garver and his firm FOCUS LLC, appear to have captured the first mover advantage to advise the industry in its orderly consolidation.
In regard to timing, Garver believes FOCUS will have most web only strategics organized by the end of October. Meetings with those groups and selected PEGs have been scheduled for December 12thto14th in New York City.
Each founding company then will be appraised to determine its proportional ownership share. The advisor will ask for non-binding indications of interest from large strategics, PEGs, or combination of both. Due diligence, letters of intent, a definitive acquisition agreement, and IPO would follow shortly thereafter.
In the past eight months, FOCUS Managing Director Jeff Hooke visited China twice to provide M&A seminars to large Chinese investment banks and corporations. The M&A business in China today roughly approximates the early 1960’s M&A environment in the United States.
Volume is low relative to the level of economic activity, and neither domestic lenders and domestic equity investors, nor the potential acquirers themselves fully understand the fundamental principles involved. Most of the recent M&A volume is tied to Chinese state-owned corporations going abroad to acquire a handful of natural resource companies in order to feed the country’s growing appetite for oil, gas, coal, and iron ore.
Nevertheless, the Chinese government and the private sector are exploring the possibility of more M&A. In theory, the government would like to consolidate a number of Chinese industries in order to develop a few global players in industries such as steel and automobiles. However, it is mindful of the layoffs that accompany ‘same industry’ acquisitions, and it wants to avoid the stock market speculation that often occurs in U.S. M&A activity.
Because of the high degree of government paternalism in Chinese M&A, the local private industry is severely hampered relative to firms in the U.S. and Western Europe. Chinese domestic lenders aren’t much help either, as they tend to loan only against “hard assets” rather than “cash flow.” Since most acquisitions trade in excess of historical book value, a lender that focuses on hard assets rather than cash flow restricts the process.
For the most part, Chinese firms do not have the government’s “green light” to hunt for deals abroad. That permission might be in the cards a few years down the road, and the Chinese M&A environment could jump from the 1960’s to a more modern 1980’s version.
The inaugural issue of this new quarterly report from the FOCUS Telecom Technology and Services Group notes that the Telecom Business Services sector is an attractive (and often overlooked) segment of the telecom market. The companies in this sector perform services such as distributing communications-related products, designing and installing communications infrastructure, and providing repair and other logistics services for both communications service providers and businesses.
Market conditions in the last several months have been difficult, and the Telecom Business Services sector was certainly impacted by the general market downturn. The FOCUS Telecom Business Services Index declined 7.0 percent over the last twelve months, with a particularly steep decline taking place in the last three months.
The current M&A environment for Telecommunications Business Services companies is mixed. When looked at from the perspective of numbers of transactions completed, we are on pace to have more than 90 announced transactions in 2011. Download now
► Capital Financing -- www.focusbankers.com/capitalfinancing
► Education & Human Capital Development -- www.focusbankers.com/education
► Energy Production & Distribution-- www.focusbankers.com/energy
► General Middle Market Businesses
► Government, Aerospace & Defense -- www.focusbankers.com/gad
► Healthcare & Life Sciences -- www.focusbankers.com/health
► Information Technology -- www.focusbankers.com/technology
► Telecom Technologies & Services -- www.focusbankers.com/telecom
About FOCUS, LLC
Founded in 1982 in Washington, D.C., FOCUS, LLC provides a range of investment bank services tailored to the needs of middle market businesses and their executives. Today, we are a national firm serving clients from offices in major cities across the United States. FOCUS specializes in serving business units with revenue or transaction sizes between $5 and $300 million, serving entrepreneurs, corporate owners and various types of investors. FOCUS clients include large corporations and private equity firms that engage the firm for middle market transactions.
FOCUS has achieved a very high close rate on accepted buy side, sell side and corporate finance mandates because of the unique resources, process and perspective that we bring to middle market investment banking. FOCUS has developed a systematic, research driven, open and proven transaction process. It is the driving force of our firm and distinguishes us from other investment banks serving the middle market.
With extensive investment banking transaction experiences and a group of seasoned operating and financial executives, our firm provides a unique value proposition. We bring a strong operating perspective, a wealth of practical experience and a unique research and transaction process to our middle market clients. Our knowledgeable resources include seasoned partners managing directors, principals, research staff, internal databases of national and international contacts and deal experience in a range of industry sectors.