Wednesday, May 17, 2023
Given today’s economic uncertainty—and all the focus on rising interest rates, bank failures, and market conditions—business owners and financial executives may find that debt markets are top of mind. Indeed, the credit and debt capital markets are essential to the global financial system, providing access to capital so businesses and individuals can fund operations, investments, and personal purchases. As you've seen over the past few months, however, these markets are susceptible to unpleasant volatility—and lending institutions are more cautious now than in the past seven years.
That’s the bad news. But savvy observers believe the overall banking market is financially sound, notwithstanding a few failed banks that neglected to address specific underlying issues in a rapidly changing interest rate environment. In fact, prudently reviewing your debt financing options now—whether that means borrowing new capital or refinancing—is an important approach that can ensure your company withstands future fluctuations.
The good news is, to avoid the urge to panic during credit fluctuations, you just need to study the long-term trends instead. Despite the recent volatility, interest rates are relatively consistent compared with the historical average since 1970: the prime rate stands at 8.25% against an average of 8.75%, while today’s 30-year mortgage rate of approximately 7% isn’t far off the historical average of 7.75%.
In fact, now could be the right time to pursue your debt financing options. As you explore which institutions are willing to extend loans, you’ll want to consider three types of capital providers: commercial banks, mezzanine lenders, and unitranche lenders.
When providing debt financing to borrowers, commercial banks enjoy a first-priority claim on their collateral in the loan. These financial institutions specialize in lending to businesses and supply funding for various purposes, including working capital, capital expenditures, and acquisitions. On the one hand, they offer lower interest rates compared with other types of debt financing (such as mezzanine or subordinated debt, described below). On the other hand, to minimize risk in the event of a default, these senior debt lenders typically require underlying assets as collateral and require strict lending criteria (covenants) that may be unsuitable for your needs.
Commercial banks play a vital role in the debt market by providing businesses with access to lower-cost debt financing, not to mention any other banking needs your company might have. If you do choose to borrow from a senior debt lender, however, having a solid repayment plan in place is essential. Be absolutely certain that you can meet the lender’s requirements, and remember: if you default, the commercial bank is first in line to be repaid. To protect your business assets, you’ll need to monitor your cash flow and financial performance carefully to ensure that you can make the required payments.
Mezzanine financing fills the gap between senior debt and equity financing, serving as a valuable resource for companies seeking additional debt that a commercial bank cannot deliver. This can make it an attractive option if your company is looking to fund growth, acquisitions, management buyouts, and other such ventures. Capital from mezzanine lenders is subordinated to senior debt but allows for monitoring and possible covenants to ensure the company’s financial stability.
Because they are not regulated by the OCC or the FDIC, mezzanine lenders often are far more flexible than commercial bank lenders and can provide customized financing solutions to meet your specific needs. Structured as “patient” debt, mezzanine loans often offer no principal payments for a period of time and then longer amortization, which ensures that enough cash flow is available for the company’s needs.
However, mezzanine financing also comes with higher interest rates and fees than commercial bank debt. The all-in return for the lender—including a monthly interest rate, plus a closing fee and possibly an exit fee or stock warrants—can be nearly double that of a commercial bank. If you consider borrowing from a mezzanine lender, be sure to evaluate whether the terms and conditions and the required repayment structure are right for your business.
A third type of debt financing, the unitranche loan, combines senior and mezzanine debt into a single loan facility, which offers a number of benefits over traditional financing options. Unitranche lenders are a one-stop shop, with financing solutions that can be tailored to meet your specific needs. Furthermore, unitranche lenders are not subject to regulation, which affords them the same general flexibility as mezzanine lenders. In addition to accommodating terms and conditions, they often propose a faster, simpler underwriting process than commercial lenders do.
What’s more, unitranche financing may be a cost-effective way for you to borrow money. Its all-in interest rate is higher than that of a senior loan but lower than for a mezzanine loan, making it an attractive option for companies that need financing for normal business operations and secondary needs that do not fit commercial banking requirements.
Unitranche financing is not appropriate for all businesses, particularly when you have to trade higher interest rates and fees—and more participation within your company—for that flexible financing structure.
Recent bank failures, the Federal Reserve’s interest rate increases, and greater scrutiny in lending may turn away some people from today’s capital debt markets. But when you stay focused, perform your due diligence, and weigh the advantages and disadvantages of various debt financing options, you may find that borrowing from a commercial bank, a mezzanine lender, or a unitranche lender can achieve a number of benefits for you and your company.
PCE has deep relationships with a vast range of debt providers and will be happy to assist you in analyzing your options. Turn to us for help in evaluating your needs, considering various repayment structures, marketing to multiple capital providers, and securing the best financing for your situation.
Investment Banking | ESOP