Subordinated Debt/Mezzanine Capital
By EdgePoint
Subordinated debt, “sub-debt” or “mezzanine”, is capital that is located between debt and equity on the right hand side of the balance sheet. It is more risky than traditional bank debt, but more senior than equity in its liquidation preference (in bankruptcy). Since it is in the middle of the capital structure, the term mezzanine has developed.
Sub-debt is considered more risky by the lender than senior debt because the senior banks get a first lien right on any assets of the business and the total leverage is usually higher. The subordinated lender is just that – subordinated to the senior lender in its rights to the assets in a worst case scenario – bankruptcy. For that reason, sub-debt lenders demand a higher return for their capital, generally in the 18-22% IRR range, although recently competition from lenders flush with capital are pushing those return expectations into the mid to high teens.
The structure of subordinated debt has a current return component, or “coupon”, which is simply the cash interest rate that the borrower pays, plus some deferred return to derive the full expected return of the lender. Typical coupons range from 12-14%, but may also have some additional deferred interest rate of 2-4% called Paid in Kind (PIK) interest. PIK interest is not actually paid, but accrues to principal and is paid at a later time. Sub-debt loans usually have little to no amortization of principal, and are paid in full at maturity which can be anytime between 3-7 years, with an average of 5 years. At that time, most lenders will get an additional return on their debt in the form of warrants for some percentage of the company at a nominal strike price (penny warrants) that they sell back to the borrower for the appreciated value at the time exercise/maturity. More recently, lenders have alternatively structured success fees, which are fixed fee amounts that cap the lender’s return. Warrants, on the other hand, give the lender more upside as their value grows with the company’s equity, but also give them risk on the downside.
Although sub-debt may seem expensive at 18-22% return, it is less expensive than equity which can demand 25%-50% returns. As a lower cost equity alternative, there are several applications and uses of this form of capital. Transactions that need additional capital to satisfy Sellers’ need for cash at closing, senior bank capital demands, or capital for growth are the most common reasons for a company to borrow subordinated debt. Whereas senior banks may cap leverage rates at 3x EBITDA, subordinated lenders are generally willing to go as high as 4x EBITDA because they are compensated for their risk. Additionally, because the sub-debt is generally structured as interest-only, the payments of that debt are easier to make as the lender allows the senior debt to be paid first and waits for its money until maturity – which is also why sub-debt can be called “patient capital”.
Sub-debt can play an important role in transactions and growth capital. It can be expensive compared to senior bank debt, but is still less expensive than equity, especially when raising minority equity that frequently demands significant discounts in valuations of the equity investment. For companies that have strong cashflows, and those that may lack collateral (such as distribution or services companies), sub-debt can provide a good source of capital that is otherwise not available. For those transactions or other high growth capital needs, the return demanded by sub-debt lenders can be well worth the investment in order to get and keep higher equity returns for shareholders.
Weighing the risks and benefits of sub-debt in the capital structure is a choice that a borrower needs to make based on the expected outcomes and returns in the particular investment so that there is enough cashflow to service debt, as well as a plan to pay of the sub-debt and any warrants or success fees that may be owed at maturity.
Proper capital planning is the key to using this form of financing so that you can ideally boost equity returns while using the existing cashflow to service senior debt.
© Copyrighted by EdgePoint. Tom Zucker can be reached at 216-342-5858 or at tzucker@edgepoint.com
Selling the Story
By Tom Zucker,
President
The famous 1920’s quote by Elmer Wheeler, “People don’t buy the steak, they buy the sizzle” emphasizes the importance of appealing to the senses and emotions of the buyer to induce a desired action. The “sizzle” is especially important when convincing M&A buyers of an opportunity associated with an acquisition. The sharing of the facts surrounding a seller’s business is expected in a transaction but demonstrating the true synergistic opportunity for the buyer is ideal. The professional story teller who can sell the unique aspects and unique positioning of your business is a priceless M&A advisor.
Every business has a story to tell, but who should tell the story? For example, if I ask an accountant, they will share your financials and pontificate on the historical performance of your business. Stories that are retrospective and solely fact-based are often not truly representative of the premium value your business represents to a strategic buyer. The reality is that your business is multi-faceted, complex, and compelling from many perspectives. The story teller needs to reference the company’s facts and the past performance, but more importantly sell the strategic opportunities. The right story teller needs a diverse business background, the ability to identify and convey hidden value, and the credibility to ensure the message is not only heard but believed. Therefore, professional business sellers, such as private equity firms, as well as private business owners frequently utilize capable investment banking firms to tell their story and achieve above market valuations.
So why tell a story? So why not just share your legal and financial documents with a buyer? The simple answer is that premium buyers buy future cash flows. The nuance to this statement is that future cash flows may be different for every buyer. It is the investment banker’s job to uncover these hidden value drivers and build a compelling story for each buyer. This requires deep business and industry expertise to develop and convey these unique buyer story lines. The bridge to the company’s future financial performance and the historical numbers are essential to building a compelling story and enabling a buyer to pay full price for your business. The hectic pace of most corporate development professionals necessitates the investment banker clearly highlight and illustrate the synergistic opportunities that your business represents for the buyer. These sophisticated buyers need the story teller to provide the “sizzle” to justify the investment of their limited time.
Experienced story tellers can support their stories with successful and impressive outcomes. The following are just a few stories to illustrate the impact of a proven M&A advisor such as EdgePoint:
- The fintech business that had break even profitability that sold for 5X revenue required a story about the buyer’s cross-selling opportunities with the seller’s Fortune 500 clients.
- The industrial manufacturing company products were well positioned to complete the large buyer corporation’s product suite. The buyer’s fear of international competitors entering their markets needed to be emphasized and enlarged. The positioning and competition were important to above market purchase multiples.
- The business just emerging from a turn-around situation who had not realized their full economic potential required a story to sell their business for a high multiple of projections two years out rather than historical performance.
The accountants and attorneys play an important role in supporting the bridge. From an M&A perspective, the continuation of the past is fine, but we are more interested in what unlocked potential cash flows and value may exist. For example, a valuable patent which has been successfully leverage in your industry may have immense value if another entity can exploit this technology patent over a broader set of industries. How valuable is this patent to a larger organization with more established sales channels? In this situation, the value equation of two plus two might actual be higher than 4. This is one reason why a story teller is critical to bringing buyer interest but more importantly conveying to the buying market the full potential of your business.
Selling the “sizzle” is more than just fast talking and impressive word choice. It is developing and selling a compelling future for a business acquisition. If done well it can be lucrative and transformative for both the buyer and seller. As you build out your advisory team during your pre-sale planning, ensure that your team has a proven story teller.
© Copyrighted by Tom Zucker, President of EdgePoint Capital, merger & acquisition advisors. Tom can be reached at 216-342-5858 or on the web at www.edgepoint.com.
M&A Advisor Series: Working Capital
This episode is an excellent introduction to Working Capital and addresses many of the concerns business owners have when contemplating the sale of their company.
EdgePoint Adds Matt Bodenstedt As Healthcare Director
By Tom Zucker,
President
Cleveland, Ohio; October 2, 2018 – EdgePoint, a boutique investment banking firm located in Beachwood, Ohio, announced the appointment of MattBodenstedt as Director. In this role, Matt will be responsible for advising the firm’s healthcare clients in matters related to mergers, acquisitions and financing transactions.
Prior to joining EdgePoint, Matt’s 29-year healthcare career included nearly 16 years at ProMedica, a market-leading, fully-integrated health system headquartered in Toledo, Ohio, with over $3B in annual revenue. During his tenure at ProMedica, Matt held leadership positions in Finance, Strategic Planning, Corporate Development and Operations, most recently as General Manager of multiple post-acute care business lines with combined revenue in excess of $100 million. Before joining ProMedica, Matt co-founded and served as a Senior Partner at Vector Strategies Group, an Ann Arbor-based M&A advisory and strategy consulting firm specializing in healthcare. Early in his career, Matt served in a variety of roles with Health Care and Retirement Corporation (now HCR ManorCare), including as Executive Director, Development. His transaction experience includes buy and sell-side M&A, joint ventures, and strategic affiliations across a broad spectrum of healthcare services.
“We are delighted to welcome Matt Bodenstedt to the firm. Matt’s rare combination of M&A, development, planning and operations experience in a diverse array of healthcare sectors offers our clients a unique perspective which will help them optimize value,” said Mr. Tom Zucker, President and Founder of EdgePoint.
Mr. Bodenstedt earned his BBA in Finance, with honors, fromthe University of Toledo, and his MBA fromthe University of Michigan.
“I have been privileged to work with innovative, high integrity teams throughout my career; so I was very selective in my search for a new opportunity. At EdgePoint, I’ll not only be able to use my lengthy healthcare experience to attract and serve a new client base; but more importantly, I’ll be joining another high-integrity team recognized for their innovative approach. I look forward to building upon the momentum that Tom and the team have created,” said Matt Bodenstedt.
EdgePoint specializes in advising middle market businesses and owners regarding mergers, acquisitions, management buyouts, and corporate divestitures. EdgePoint completed more than 22 transactions in the past 18 months. The firm has 21 M&A professionals.
EdgePoint is a registered broker dealer and a member of FINRA.
Contact:
Tom Zucker, President | 216.342-5858 | tzucker@edgepoint.com
Matt Bodenstedt, Director | 216.342.5748 | mbodenstedt@edgepoint.com
Leveraging the Letter of Intent
By EdgePoint
You’ve just spent months preparing your business for sale. Completing lengthy diligence request lists, developing complex financial forecasts, creating extensive marketing materials, reviewing IOI’s, and spending time in management meetings and Q&A sessions with potential buyers. The amount of time and energy invested in the process has been great. But you’ve finally reached the apex of your negotiating power – the LOI.
The letter of intent (“LOI”, sometimes called the “term sheet”) serves as an outline of key provisions and is used to help facilitate the preparation and negotiation of a definitive purchase document. A non-binding LOI is often negotiated in good-faith, meaning any deviations from the terms stated in the LOI typically require justification.
In most circumstances, the LOI represents the last opportunity for the seller to fully exert his or her bargaining power in the transaction. This loss of leverage results from an “exclusivity-clause”, a common LOI feature precluding the seller from speaking with any other interested parties. Once an LOI is executed, a seller’s negotiating power often diminishes.
Private equity groups and other sophisticated buyers have a great deal of experience in utilizing an LOI to defer specific language on key transaction points. These groups will intentionally keep language on key issues vague in the LOI to preserve flexibility in drafting a final purchase agreement that weighs in their favor. Key phrases often used to preserve buyer flexibility include:“to be mutually determined”, and “subject to customary exceptions” or “obligations which are reasonable for transactions of this size and type.”An experienced advisor will guide their client by inserting specific, comprehensive language covering key negotiating points.
A common practice used by a transaction advisor is the comparison of key features of each bidder’s LOI to reveal potential shortcomings. By identifying unclear or ambiguous terms to relevant bidders, the advisor seeks to improve specific LOI terms within the backdrop of a competitive bidding process. This aids in negotiations and often works to improve key transaction terms.
Key terms such as transaction structure, working capital, financing arrangements, indemnification obligations, and deal timelines can often be modified to preserve transaction leverage in the seller’s favor.
Transaction Structure
A seller usually prefers a stock deal as it typically affords the most favorable tax treatment. Buyers typically prefer an asset deal, which gives them the ability to “cherry pick” preferred assets, avoid corporation specific liabilities, and provides them with a stepped-up basis on assets, producing a lower taxable gain in the event of a future sale of those assets. A well-informed seller with a clear picture of proposed tax implications resulting from both an asset sale or a stock sale is encouraged to specify the preferred transaction structure while negotiating an LOI.
Another important piece in negotiating the transaction structure is to clearly define which entities will be involved in the proposed transaction. Sellers must define the specific legal entities that will be involved in the transaction, along with the potential for the sale of any related real estate holdings. By having a clear picture of which entities will be involved in the transaction, sellers can achieve greater clarity in the allocation of purchase price amongst their portfolio of holdings.
Working Capital
A seller often has the most leverage in negotiating a favorable working capital outcome prior to signing an LOI. Under ideal circumstances, both parties would be able to agree upon a working capital target at the LOI stage. In the absence of an agreed upon target, both parties should at least agree upon a working capital methodology which defines the working capital accounts to be included in the working capital calculation. A common methodology is for buyers to agree to the target being determined by using trailing twelve month working capital average.
Financing Arrangements
When a transaction involves financing leverage, sellers should encourage buyers to provide potential financing commitments to improve the certainty of fulfilling funding obligations. The sources and timing of approvals for finance should also be disclosed to better assess the likelihood of closing.
Indemnification Obligations
The buyer of a business may offset a portion of potential risk related to breaches of seller reps and warranties by asking the seller to hold-back, or escrow, a percentage of the total transaction value. This enables the buyer to file a claim against the escrowed amount to recoup a portion of the purchase price if a material breach is found. The seller should seek to clearly define the amount required for escrow (usually 5-10% of the purchase price), the survival period of escrow (typically between twelve and eighteen months), and a quantification of specific fundamental representations during the negotiation of the LOI.
Alternatively, sellers and buyers can agree to use reps & warranties insurance in lieu of an indemnity agreement that requires escrowed funds. Reps & warranties insurance can provide the benefit to the seller of receiving a greater amount of purchase price at closing while reducing legal costs, collection concerns and increasing the indemnity period.
Deal Timeline
To prevent the disclosure of confidential information on a contemplated transaction to employees or key customers, a transaction advisor needs to be aggressive in negotiating a defined timeline for site visits, management discussions, and customer discussions. By having a pre-approved timeline, the seller minimizes unintended disclosure. The clearly defined deal timelines reduce the risk of disruptions in customer and supplier relations, employee satisfaction, and workforce morale. A speedy and efficient deal timeline is critical in limiting the chances of renegotiations, and often works to provide greater certainty of close.
Conclusion
For the seller, the LOI often represents the apex of his or her negotiating leverage in a transaction. Seeking the counsel of an experienced transaction advisor who can guide the seller in negotiating key transaction terms is critical in structuring the LOI to ensure a speedy deal timeline, reducing the risk of renegotiations which can erode value, and maximizes financial value to the seller.
© Copyrighted by EdgePoint. Tom Zucker can be reached at 216-342-5858 or at tzucker@edgepoint.com
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