Permanent Equity Weekly #48

Debt: risks, types, and sources. The most important benefit of minimal debt is flexibility — optionality to reinvest, stockpile cash, or wait. Then a taxonomy: traditional debt (bank, high-yield, mezzanine) versus creative forms (seller financing, factoring, asset-backed).

Notes

• Debt: Risks, Types, and Sources
• The most important benefit of keeping debt to a minimum is the flexibility it affords. With little or no debt and healthy cash flow, a company has the optionality to reinvest for growth, stockpile cash for a rainy day, make distributions to shareholders, self-fund acquisitions, decrease prices, gain favorable terms from suppliers, or spend on employees. With lots of debt options decrease and quickly, which is why most business owners carry minimal debt.
• That being said, debt, prudently applied, can magnify outcomes – both good and bad – and it is worth exploring how various forms of debt function for business owners contemplating selling their business. As a business owner, when you are selling your business, the more leverage employed in buying your business, the greater number of parties involved, and the more financing risk you introduce into the transaction.
• Generally, you can think of debt falling into two categories – traditional debt (bank debt, high yield debt, and mezzanine debt) and more creative forms of debt (seller financing, factoring, asset-backed financing). Traditional sources range from senior debt that has a shorter term (4-8 years) and is secured by the assets and cash flows of the company to more junior forms of debt that can be non-recourse, sport longer terms (7-10 years), and allow much more flexibility in terms (interest-only, paid-in-kind, warrants). The more creative forms of debt can be used to bridge valuation gaps, increase liquidity for working capital needs, and leverage hard assets on the balance sheet.
• As a seller potentially exploring the sale of your business, the main risks to a transaction falling through on the financing side are 1) how much leverage will be used and 2) what types of debt will be employed, besides the obvious fundless sponsor who doesn’t have the equity available. Higher leverage may mean a higher purchase price, but always comes with a lower chance of closing and greater post-close stress.
• In challenging economic times, credit markets tend to tighten or lock up, like they are now, and limit the amount of lending that occurs. The Fed’s unprecedented actions in the debt markets have spurred record debt issuances in the public markets by acting as a ‘lender of last resort’ and assuring credit investors of their role as a ‘purchaser of last resort’. But availability of transaction debt in the private markets is largely non-existent. Recently a friend tried to finance a transaction for a sub-$10M earning business that was positively affected by COVID. He was using low leverage and the business prospects were strong. They went to get bids from over 30 banks and had zero responses. Zero. The markets are frozen.
• Permanent Equity typically uses little or no debt because we want surety of close, simplicity post-close, and the optionality to use cash flow in whatever way best positions the business long-term. That’s our way, but certainly the odd way.
• Traditional Sources
• Revolving Credit Facility
• • Senior debt (top priority in the case of a liquidation)
• • Capped at a maximum amount
• • Generally acts as a working capital line of credit to be accessed when a company needs short term funding
• • Typically this form of debt is non-amortizing, interest-only
• • LIBOR-based (plus a premium) rate
• • Sources: Banks
• Bank Debt
• • Senior debt (top priority in the case of a liquidation)
• • Based on asset value as well as cash flow
• • Can take the form of Term A (amortizing, 4-6 year term) or Term B (non-amortizing, with a bullet payment at the end of the life, 6-7 year term)
• • LIBOR-based (i.e. floating rate) term loan
• • Secured by all assets and equity
• • Sources: banks, syndicated investment groups
• High-Yield
• • Generally unsecured
• • Fixed payments with no amortization and a bullet payment
• • Can be senior (top of the capital stack), senior subordinated (next to top of capital stack), or junior subordinated (bottom of the debt stack, but before the equity)
• • Longer maturity than bank debt (7-10 years, with no amortization and a bullet payment)
• • Sources: institutional investors, hedge funds, private investors
• Mezzanine Debt
• • Can be convertible into equity
• • Can come with warrants for the right to purchase equity at a certain price
• • Can come with PIK features
• • Sources: institutional investors, private equity funds, hedge funds, credit funds
• Creative Sources
• Seller Notes
• • Buyer issues a promissory note to seller to repay the portion of the business that is financed
• • Generally fixed period of time
• • Generally cheaper than other forms of junior debt
• • Can be attractive to a seller when credit markets are not as leverage-friendly or where obvious risk should be shared
• • Sources: seller
• Asset-based financing
• • Can utilize fixed assets on the balance sheet as collateral for fixed, amortizing payments that will reduce the need for cash equity as well as other forms of debt
• • Generally can be in the form of fully-amortizing debts with balloons at the end of a specified term
• • Sources: banks
• Factoring
• • Securitization of cash flows that are attributable to assets such as receivables that can be liquidated for quick cash in a business transaction
• • Generally these will not account for a large portion of the business transaction and may be used to provide early working capital and liquidity needs for the buyer
• • Sources: factoring companies