David Shoulders, Head of Consumer & Industrial Investment Banking, William O’Flaherty, Director, Matt Oldhouser, CPA, Associate, John Whalen, Head of Capital Advisory Investment Banking

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Business owners were confronted with a variety of operational and financial hurdles in 2020 and 2021 as a result of the COVID-19 pandemic. While the impact to the global healthcare infrastructure has been tremendous, the broader business community has also been forced to grapple with financial and operational uncertainty. The goal of this edition of the CMP is to create broader awareness of the unique and highly-customizable alternatives that exist to support private business owners in today’s economy.

While government assistance programs have helped stem the tide of the financial impacts of the pandemic, business owners are increasingly turning their focus to the future and evaluating capital infusion alternatives for their businesses. The Paycheck Protection Program (PPP) has been one of the most ambitious government programs in our nation’s history. The package, while only a small facet of the government’s overall response to business and individual needs during the pandemic, is perhaps the most widely known aspect of 2020’s fiscal stimulus platform. While ever-evolving, to date (through September 12, 2021), the dollar values and number of businesses impacted are staggering. Nearly six thousand lenders have approved over eleven million loans, totaling over $799 trillion net dollars in lending.

The program was initiated as a bridge to assist businesses in need of short term-capital solutions. In order to provide an equitable distribution of funds, the government established loan amounts based on a transparent and consistent formula. Components driving loan amounts (and forgiveness amounts) included payroll costs as well as select fixed costs (maintenance, utilities, etc.).

While the funding was allocated across many businesses of various sizes and functions, a few trends have become apparent. In 2020, companies operating in the middle-market and lower middle-market participated at exceptional rates, illustrated by the average loan size (approximately $100,000) and percentage of loans under $1 million (over 99%). Trends were also apparent in certain end markets, with the most dollars allocated to construction (12.3%), healthcare (12.0%), and professional services (11.9%). These industries were among those most severely impacted by the pandemic, and understandably received the highest proportions of funding. Distribution across states was generally what one would expect, where the most populous states (and also those with the most businesses in operation) received a proportional allocation of PPP funds. Perhaps the most critical takeaway across all of the data was simple: businesses of all sizes, across all industries, and in every geographic market that applied for PPP loan assistance will likely require additional capital moving forward.

As business owners emerge from the challenges of the past 18 months and anticipate confronting the fallout of the pandemic for the foreseeable future, the need to balance growth and liquidity remains ever-present. While governments around the world have been extremely supportive in providing capital to both individuals and businesses, it is unrealistic to expect that level of assistance to continue in perpetuity. At some point, small and medium-sized businesses will need to turn to traditional, private sector sources of capital to support ongoing operations and growth.

Today, many entrepreneurs continue to use adequate, but potentially inefficient forms of capital to support their companies. For example, traditional banking and senior lending relationships are useful tools for select business purposes, but are certainly not a one-size-fits-all solution for all business needs.

Capital Availability
Many entrepreneurs and business owners may not realize that there is more private capital available for businesses today than at any other point in recent history. This data can be measured in a number of different ways, but the trends have been present for the better part of the past decade.

First, let us examine the simplest and most direct metric: the number of groups making private business investments. From 2017 – 2019, the average number of private investment funds formed was approximately 33% higher than the preceding ten-year average. Today, there are approximately 7,100 private equity and debt capital funds actively investing capital in North American businesses [1]. Generally speaking, it is the sole focus of these entities to invest in the growth and optimization of private businesses domestically. And what these figures fail to capture are the wealthy and ultra-high-net-worth individuals that also make direct investments in businesses. These groups, generally referred to as family offices, are estimated to number nearly 10,000 investor groups globally and have grown ten-fold in the past decade [2].

Another prism for viewing available capital is to observe the number of dollars raised annually by these funds. With the rapid establishment of new funds, one would expect exceptional growth in dollars raised; however, pair that with “legacy” funds continuing to expand and raising more capital themselves, and the numbers are staggering. In 2019, just ahead of the pandemic, new capital raised for funds was $492 billion. This is a significant 310% increase over the $120 billion of new capital raised in the decade prior.

Perhaps most relevant to the topic of capital availability is the measure of dollars “undeployed” or waiting to be invested. Groups in the marketplace refer to these excess funds as “dry powder”, identified as money that has been raised and is readily available for investment. Today, in the U.S., that figure stands at over $1 trillion. The competitive landscape that exists between today’s private equity and debt capital funds to put that “dry powder” to work yields exceptional benefits to the private business sector.

The prevalence of capital can also be viewed through a simple supply/demand analysis. As with any good or service, when demand increases and supply remains steady, prices increase. This is the same for both debt and equity capital today. Purchase multiples for businesses have remained significantly above historical averages for several years, as demand (capital available) has outpaced supply (number of businesses in existence or being sold). Similarly, for debt capital, interest rates have remained lower than historical averages due to the availability of capital from traditional lenders and other sources (as well as several macroeconomic influences). It is important to recall that while it may seem counterintuitive, interest rates going down is a reflection of higher prices in the debt markets. It is more difficult for lenders to put capital to work, and therefore they are willing to accept higher prices/lower rates to do so.

Forms of Capital
How do business owners take advantage of this situation to enhance their business or to provide personal liquidity? The answer to that question begins with a more rigorous understanding of the needs of the owners and the business itself. The differing types of funds exist in order to address the unique needs and desired outcomes for the capital being employed. Therefore, we will take a brief look at several different forms of capital to provide a high-level illustration of use cases, benefits, and potential drawbacks.

Impressively, the private capital markets have crafted different forms of capital tailored to fit the specifications of extremely precise business needs. There are numerous levers (pricing, guarantees, covenants, business/financial controls, etc.) that can be dialed up or down to suit even the most specific business/owner conditions. Below are some of the most prevalent forms of capital that business owners can utilize for growth and/or liquidity.

With a figurative ocean of capital possibilities, we believed it would be best to start with an analysis of what is most familiar to business owners: traditional senior, secured capital.

Well-Known Capital Options: Senior, Secured Capital
Nearly all established, middle-market businesses have at one point or another, formed a relationship with a regional or community bank in order to borrow capital. Most likely, this came in the form of a revolving line of credit or loan, the scope of which was determined by a mix of need, and more importantly, the size of the assets on the firm’s balance sheet.

The amount of capital a business is eligible to receive from a lender, commonly referred to as a borrowing base, is dependent on the type, amount, and value of collateral the business pledges. Accounts receivable, inventory, equipment, and real estate are the most common asset classes used for collateral, which are valued by a lender and multiplied by a discount factor to determine the maximum borrowing base. Each asset class has both eligible and ineligible components that can limit the amount of capital available to the business, although lenders are typically willing to apply their discount factor to an aggregation of components from various asset classes.

Senior, secured capital is most traditional and established for a reason: it serves a broad market that addresses many common business requirements. The most common form of these lending relationships comes in the form of an asset based loan, or ABL. Most ABL’s are structured as revolving lines of credit and allow a business to borrow from assets on an ongoing basis to cover expenses. The primary benefit is lower pricing, as the funds are supported by the concrete assets of the business. They are also generally easier to understand and are the most widely available. Despite the existence of some of the securities listed on this page, they are not all good fits/offered to every business/owner.

The primary drawback of traditional lending tends to be limited “creativity” to migrate outside of the formula established by the borrowing base, therefore limiting capital available to the business and its owners. In particular, this can be limiting to businesses that are either presently, or aspiring to be, achieving rapid growth. Additionally, the arrangement can often be somewhat restrictive and require cumbersome reporting to support the ongoing tabulation of the outstanding loan balance in comparison to the borrowing base. Lastly, depending on the size of the loan or facility, personal guarantees from the borrowers (in addition to the collateral pledged by the business) may be required.

Over time, the ability for traditional banks (both regional and national) to service the needs of middle-market clients has diminished. Generally speaking, increased regulation of these institutions, paired with bank consolidations, has oriented traditional lenders to focus on the needs of larger corporate clients. That gap has been filled largely by private lenders.

For businesses without an entrenched relationship with a banking institution from which senior, secured capital can be sourced, there exists a multitude of alternative options to inject cash into the entity. In the following section, we will explore the alternative borrowing and capital raising options that are available to business owners and discuss the benefits and drawbacks of each. Given the vast number of potential capital sources, tranches, combinations, and crossovers between types, it should be noted that the descriptions discussed here are the most likely set of circumstances seen for each. However, an almost infinite number of unique options are available for business owners in search of a financing resource.

• Cash Flow Lines of Credit and Loans

Cash flow loans are commonly utilized as short-term instruments to finance the day-to-day operations of a business and are repaid through future cash flows of the borrowing business. Due to a refined set of criteria lenders use when underwriting cash flow loans, they are more-widely available to smaller or newly established businesses that lack proven credit history or significant assets to back a loan. On the other hand, these factors allow underwriters to establish higher interest rates and origination fees due to an elevated repayment risk. Additionally, although the loan will not be secured by specific business assets, often a general lien will be placed on the entire business, and in some scenarios, especially in the lower middle market, the loan is required to be personally guaranteed by the business owner. Given these characteristics, cash flow loans lend themselves to certain asset-light industries such as software businesses and distribution providers.

Borrowers tend to fall into two categories: (i) start-ups with an insufficient asset base to justify the use of the traditional loans discussed above; and (ii) extremely established and growing businesses that have a proven track record of consistent cash flow generation. In both categories, the needs of the borrower exceed the formulaic needs of asset-based lending. While excess lending capacity is provided to the borrower, they often come attached to higher pricing and a healthy list of covenants regarding financial performance and operation of the business.

Funds provided through a cash flow mechanism are typically limited by lenders, who oftentimes restrict permissible expenses and operations that the financing can be applied towards, including requiring the cash to remain in the business to support operations and growth (i.e. they’re not available for owner compensation). Further, lenders typically require that a certain portion of excess free cash flow be earmarked to pay down the loan.

As the name would indicate, cash flow loans determine debt capacity based on free cash flow of the enterprise. While the limits are highly dependent on the industry and scale of the borrower, lenders will typically focus on the following financial metrics when underwriting the loan: total debt to EBITDA; cash interest coverage ratio; EBITDA minus capital expenditures interest coverage ratio; and fixed-charge coverage ratio. Similarly, the loan is enforced throughout its term by financial covenants that must be met on an ongoing basis.

Cash flow loans are most widely available with terms lasting between one and five years and with rates ranging from as low as 6.0% all the way up to 20.0% in select cases. The varying term lengths and interest rates are influenced by the characteristics of the borrower, including its operational and credit history, cash flow trends, and near-term projected revenues, among others. Financing is generally completed within one week of lender approval, an attractive characteristic for many owners.

Occasionally, if loans reach a sufficient scale, the originating party will sell or distribute a portion of the loan amount to other institutions. This is typically done to diversify the balance sheet risk of the lending institution so they are not forced to hold a loan higher than their actual risk appetite. This is called loan syndication. These circumstances do not typically apply to businesses in the lower middle market, but are beneficial opportunities for businesses seeking larger loan amounts.

• Mezzanine and Subordinated Loans

In the sequencing of the capital structure, from highest claim priority to least, subordinated debt falls beneath senior, secured capital but ranks above all equity. In other words, in the event of bankruptcy, these loans will be paid out only after all unsubordinated debt has been made whole. As a result, these loans typically carry higher interest rates than senior debt. Underneath the greater subordinated loan umbrella, there exist a number of different instruments available to business owners, including high yield bonds, Payment in Kind (PIK) notes, vendor notes, and most commonly, mezzanine debt.

Mezzanine debt is a hybrid security that is viewed as either, like most subordinated loans, expensive debt or, due to the presence of warrants or other options, cheap equity. These warrants, often called “equity kickers”, allow lenders to purchase equity, at a predetermined rate and quantity, within the borrower’s capital structure. The amount of equity ownership surrendered is dependent on the lender’s required return, the risk and projected growth of the business, and other factors, and is generally less than 20%, which allows business owners to gain access to liquidity beyond what’s available at the senior or second lien level while still retaining their majority ownership. Mezzanine debt is typically offered in 5-year terms with annual interest rates between 10% and 16%, with businesses with EBITDA greater than $20 million sometimes being able to obtain rates below 10%. Amortization of the loans is typically 1% or less per year with a balloon payment at maturity. Rates for mezzanine financing tend to move along with the risk free rate and is also greatly influenced by business size and industry. Another benefit of mezzanine financing includes a distinct lack of (or minimal) collateral requirements or personal guarantees, although this can be offset by restrictive covenants including financial maintenance covenants (such as required minimum coverage ratios), affirmative covenants (such as paying required taxes or maintaining financial records), and negative covenants (such as prohibiting additional borrowing or paying of dividends), all of which can substantially limit the operations of a business.

Mezzanine and other types of subordinated debt are the final tranches of debt available to a business before more dilutive equity is pursued. The lender’s risk due to positioning within the capital stack drives up the interest rates offered for these types of loans. Likewise, the presence of prepayment penalties are common, creating a long-term liability that cannot be eliminated in the event of excessive cash reserves. Therefore, mezzanine debt is an effective tool for borrowers that anticipate operational acceleration will outpace the costly nature of the subordinated instrument.

Subordinated loans are typically utilized by business owners seeking more favorable terms than can be found with conventional line of credit financing. Use cases for mezzanine debt tends to be for things beyond a business’s core operations, simply because of the cost of capital. The use cases include financing acquisitions; leveraged, management, or shareholder buyouts; recapitalizations; or refinancings. In general, mezzanine financing is an extremely flexible form of capital. A company is able to obtain growth capital at a lower interest rate, albeit at the potential cost of losing a portion of ownership equity.

• Unitranche Loans

Unitranche loans are another type of hybrid security that combine senior and subordinated debt into a single instrument. This provides simplicity when compared to traditional credit facilities and allows a hybrid capital solution with a single issuance, resulting in decreased costs and time commitment to the borrower. Lenders likewise benefit from the increased amount of capital that is able to be deployed along with enhanced returns when compared to traditional instruments. Due to the non-traditional entities that commonly partake in the underwriting of these securities, financing terms are highly flexible and can be negotiated.

Similar to mezzanine and subordinated loans, unitranche loans provide businesses that don’t have a traditional banking relationship from which senior loans can be sourced another alternative to increase liquidity and support working capital. The allocation between different levels of debt is consolidated into a single, blended interest rate paid by the borrower and eliminates intermediary agents that arise when multiple stakes of capital are involved. However, the simplicity created by the lender for this type of instrument comes at a cost, as the blended interest rate is typically higher than the weighted average of rates that could be obtained for each tranche on its own.

Unitranche loans are most often utilized as part of a leveraged buyout, in which the assets of a company are acquired using a significant amount of borrowed funds. This type of capital is generally not a replacement for conventional line of credit financing.

• Minority and Majority Equity

For business owners seeking additional liquidity beyond what can be sourced through debt instruments and willing to sell a portion of their ownership, there exists a broad universe of institutions eager to partake in such a transaction. Investors, including both private equity groups as well as corporations, actively seek opportunities to trade excess cash for a “piece of the pie” of a company pursuing additional capital. In addition to the inflow of liquidity, investors often provide resources, including human capital, benefits of economies of scale, and industry experience, to help grow the business.

Equity transactions can be classified as either majority (greater than 50%) or minority (less than 50%). Naturally, majority transactions provide greater liquidity; however, they do so at the sacrifice of losing control over the business. While many business owners will view this as a significant “cost” on multiple levels, certain individuals would actually prefer this dynamic, as it allows them to take a step back from the day-to-day business operations and lessen the concentration of their financial resources.

Another factor to be considered when contemplating an equity transaction is the control premium. As a general rule of thumb, a controlling interest in a business is considered to have greater value than a minority interest in the same business due to the purchaser’s ability to implement changes in the overall business operations and structure. The control premium is the additional consideration that an investor would pay for a controlling interest, the magnitude of which can be further influenced by numerous factors, including the business’s non-operating assets, discretionary expenses, management team, and underexploited business opportunities. In the first half of 2020, the average control premium for U.S. businesses ranged between 23.5% and 33.2%, a range which has likely increased in 2021 due to the broader economic recovery and favorable investor outlook trends [3].

In exchange for an investment that lacks voting or operational control of the enterprise, minority investors will often seek certain rights that protect their contribution and ownership. To start, those investors are likely to request some level of board participation (including the ability to appoint directors and/or observers) as well as the ability to access the company’s financial information and budgets. Additionally, minority equity investors are prone to require approval (or veto) rights for certain meaningful changes in the company, such as changes to shareholder documents, sale of the company, significant investments, or the issuance of debt. Lastly, there are a number of mechanisms that safeguard minority investors from possible dilution (such as pre-emptive rights) and ensure fair liquidity options for their ownership (including tag along rights and put rights). Similar to the tag along rights, which give minority investors the right to participate in the sale of equity (either in its entirety or proportionally) under the same terms as others, minority equity owners are likely to be obligated to drag along rights, a reciprocal set of rights that requires minority investors to participate in a sale under certain circumstances. While there is hopefully alignment on most topics amongst the ownership group, these rights put in place pre-established mechanisms that protect the interest of each party.

Equity transactions are typically classified as mergers or acquisitions and should not be viewed as short or medium term solutions to improve liquidity. The ramifications of an equity transaction are long-lasting and significantly alter the trajectory of a business. While the effects can be extremely beneficial, the costs must be carefully considered before proceeding.

Conclusion
While traditional senior lenders can be an excellent resource for many business needs, it is clear that differing objectives can sometimes require a more catered and nuanced solution. Undoubtedly, each capital tranche comes with a distinct set of advantages and considerations for business owners.

As stated earlier, it is worth noting that we have made some generalizations about the forms of capital included in this analysis. The very benefit we site for many of them, such as flexibility/customizability, runs contrary to the idea of sweeping generalizations. As such, it is our strong recommendation to engage an investment banking advisor to assist in weighing the tradeoffs that exist with each form of available capital. That assessment should be balanced with a detailed analysis of the unique characteristics, needs, and challenges of the individual business contemplating liquidity needs.

We hope this topic prompts thought and additional discussion with our valued former and prospective clients, as well as other industry professionals. In a future issue of Capital Markets Perspective, we will provide insights into how these forms of capital often work together to provide business owners liquidity and additional business upside, when we examine the Anatomy of a Recapitalization.

Disclaimer
The contents of this publication are presented for informational purposes only by Matrix Capital Markets Group, Inc. and MCMG Capital Advisors, Inc. (“Matrix”), and nothing contained herein is an offer to sell or a solicitation to purchase any of the securities discussed. While Matrix believes the information presented in this publication is accurate, this publication is provided “AS IS” and without warranty of any kind, either expressed or implied, including, but not limited to, the implied warranty of merchantability, fitness for a particular purpose, or non‐infringement. Matrix assumes no responsibility for errors or omissions in this presentation or other documents which may be contained in, referenced, or linked to this publication. Any recipient of this publication is expressly responsible to seek out its own professional advice with respect to the information contained herein.

About Matrix Capital Markets Group, Inc.
Founded in 1988, Matrix Capital Markets Group, Inc. is an independent, advisory focused, privately-held investment bank headquartered in Richmond, VA, with additional offices in Baltimore, MD and Chicago, IL. Matrix provides merger & acquisition and financial advisory services for privately-held, private-equity owned, not-for-profit and publicly traded companies. Services include company sales, recapitalizations, capital raises of debt & equity, municipal advisory, corporate carve outs, special situations, management buyouts, corporate valuations and fairness opinions. Matrix serves clients in a wide range of industries, including automotive aftermarket, building products, business services, consumer products, convenience retail, downstream energy, healthcare and industrial products.

[1] Sebastian Segerstrom, A Decade of Growth for U.S. Private Equity (Factset, 2020)

[2] Ernst & Young, EY Americas Family Office Guide

[3] BVWire News, Get a Sneak Peek at Control Premium Data on Acquired Companies (Business Valuation Resources, 2020)

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