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David Jasmund
PCE Investment Banking |
Florida Dealmaking: Trends
& Deals
Sub Debt Funding
May 7, 2004
"The
Constitution guarantees you the pursuit of happiness...
...but doesn't guarantee to finance the chase."
With the senior lending markets tightening over the past few years,
Sub Debt is becoming an attractive alternative for capital. It is
an excellent capital source for businesses with strong cash flow,
limited asset base, and a positive growth trend.
What is Subordinated Debt? Those who deal in mergers
and acquisitions or with larger private companies may have used
“Sub Debt” or “Mezzanine” funding as a layer
of structured financing. The moniker comes from the geographic location
on a company’s balance sheet…subordinate to senior bank
debt, yet above equity in payment and liquidation. Therefore, Sub
Debt has characteristics of both debt and equity to protect and
reward the lender for the investment risk.
The purpose of mezzanine financing is to provide long-term capital
to support growth or acquisitions. Typically, companies need Sub
Debt when:
- Senior lenders will not extend additional credit
due to a shortfall in the collateral base, and
- Businesses have good cash flow with positive
growth trends, but retained
earnings are insufficient to finance working capital growth or
capital
expenditures.
Sub Debt is an alternative to equity. The terms and conditions
that come with outside equity investments can seem onerous to an
owner. Equity investors require board positions and special voting
rights on key issues. Sub Debt lenders usually ask for board visitation
rights and typically do not have voting privileges. Most owners
prefer the capital without the loss of control.
The cost of Sub Debt is less expensive than equity. This
reduced cost does come with increased risk to the owner in that
the company has increased leverage and debt service. The pricing
comes in two parts: (1) a current pay interest cost of between 10%
and 14% (debt cost); (2) the remainder is paid in the form of warrants
to purchase common stock of the company (equity cost) to provide
the overall desired return to the investor. Sub Debt lenders are
targeting a 18% to 22% investment return.
Underwriting of Sub Debt is focused on three primary areas.
First, does the company's historical performance demonstrate sufficient
cash flow to cover the Sub Debt interest costs? Second, does projected
cash flow meet future working capital and capital expenditure needs?
Third, do the projections provide the investors the expected equity
return?
The initial underwriting of Sub debt is straightforward. The complexity
appears when the discussion focuses on the amount and pricing of
the warrants. Therefore, Sub Debt can be challenging for companies
to understand and structure.
PCE
Investment Bankers is a member of the PCE family of companies that
provide investment banking, valuations, advisory services, research
and Indexes.
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