This week's issue of BusinessWeek has a good article about how Monomoy Capital Partners, a private equity firm, uses operational improvements to improve underperforming companies.

http://www.businessweek.com/articles/2012-04-26/my-week-at-private-equity-boot-camp#p1

Despite the misleading cover, the article details how Monomoy rapidly implements lean manufacturing practices (based on the Toyota Production System) through a series of management "boot-camps".  Monomoy's goal is to make their companies more efficient - to use less capital to produce more goods or services.  Capital includes hard capital like equipment, fork lifts, and buildings; working capital like inventory and receivables; and human capital or payroll. When less capital produces more goods, profits rise and cash flow increases, resulting in increased value for Monomoy.

Hadley Capital has the same end goal - increasing the value of our companies. But, because we focus on small companies, we tend to take a different approach to achieving the end goal. First, we tend to buy high performing businesses so we apply a "first do no harm" approach to our early periods of ownership. Later, we work directly with management to design and implement 1 - 3 strategic initiatives per year. These strategic initiatives may focus on operating efficiencies, much like Monomoy's, or improving sales force management or developing new market strategies.

As the article suggests, improving any small business involves a solid plan, a focus on results and a lot of hard work. Hadley Capital works in partnership with the management teams at our companies to design and implement plans for improvement. And so do a lot of other private equity firms. The notion that private equity buyers are simply slash-and-burn owners is worn-out; the days of buying bloated companies, streamlining and then "flipping" them are long gone. The BusinessWeek article does a nice job of capturing one private equity firm's modern value creation strategy.

PDW

In recent months, there has been a fair amount of press about the practices of private equity firms and their use of debt when buying companies (thanks in no small part to Mitt Romney's presidential campaign).  Much of this press is focused on how private equity firms use 'too much' debt while buying companies, sometimes resulting in the failure of target companies.  There have certainly been plenty of private equity acquisitions that relied too heavily on debt financing and ended poorly.  However, there are also a number of private equity firms (including Hadley Capital) that use conservative capital structures when acquiring small businesses. At Hadley Capital, we try to use a prudent amount of debt and equity financing, allowing a small business the flexibility to grow while maximizing its capital structure. Through the years we have found that small businesses often don’t have a complete understanding of the types of debt and equity used in a small company private equity acquisition.  As a result we would like to do a small blog series to 1) help explain leveraged finance to small businesses and 2) create a counter argument to the sentiment that “PE firms always over leverage”.  In general, there are three primary capital sources that we use when acquiring a small business: traditional bank debt, mezzanine debt, and equity.  We are going to start with traditional bank debt.

Hadley Capital generally uses types of traditional bank debt when acquiring a small buiness: a senior term loan and a revolving line of credit. 

In a private equity acquisition a senior term loan is generally a cash flow based term loan.  This means that instead of physical assets the bank is lending against a company's consistent cashflow (or EBITDA).  Senior term loans also frequently involve personal guarantees from business owners; however, Hadley Capital operates without personal guarantees.  The term (or duration) of a senior term cash flow loan is usually around 5 years.  The rate of interest for a cash flow term loan is typically higher than an asset based term loan but pricing depends on current market rates and the company's financial performance.  The principal on senior term loans is typically paid in equal monthly (or quarterly) installments over the term. For example here is a typical amortization schedule for a $3 million term loan with a 5 year term:

The second type of traditional bank debt that we use in an acquisition is a revolving line of credit. A revolving line of credit is considered an asset-based loan because the bank has a lien on the assets that support the line of credit. The assets on the company’s balance sheet dictate the size of the line of credit. The lien on the assets, and the ease to realize the lien, allow banks to lend the money at lower rates than cash flow term loans.  The two main assets that support a line of credit are accounts receivable and inventory. Banks protect themselves when issuing lines of credit by requiring borrowers to submit a borrowing base certificate. The borrowing base certificate determines how much money is available to a borrower on an asset-based revolving line of credit by 1) using advance rates and 2) excluding assets that cannot be turned into cash quickly.  Advance rates are the amount of money a bank will lend against the face value of an asset - typical advance rates are 80% on Accounts Receivable and 50% on Inventory.  Excluding assets from a borrowing base means banks will not lend any money against the asset. A typical exclusion for Accounts Receivables is receivables that are 120 days past due.  A typical exclusion for inventory is “work in process” inventory, meaning inventory that is between a raw material and a finished good. Below is a simplified version of a borrowing base certificate:

A typical Hadley Capital transaction will use a cash flow term loan to fund a portion of the acquisition, leaving a revolving line of credit to help the company manage its' working capital and to provide some financial flexibility. We typically borrow about twice a company's annual EBITDA on a cash flow term loan - if the target company has $1 million in annual EBITDA, we borrow $2 million in senior term debt via a cash flow loan.  In finance lingo this is called "2x senior leverage". This amount of leverage is much less than the types of transactions that show up in the press.  During strong economic times, large private equity acquisitions were using senior term debt of 7x or more!

Next up Mezzanine Finance.

We have worked with a number of families to pass a family business from the first generation to the second generation. In each case, the families faced a familiar but intractable problem: generation one needs to sell the business for cash in order to comfortably retire but generation two does not have enough money to buy the business.

In our experience, the second generation also wants to keep growing and improving the business and, in many cases, has good, concrete ideas but lacks a partner that can help them execute the ideas.

Hadley Capital has helped multiple family business address this dilemma:

1. We partner with the second generation to acquire the business, funding the transaction with substantial cash at closing. The first generation is able to comfortably retire and the second generation participates as meaningful equity owners.

2. We work with the second generation to develop and implement a growth plan; as equity owners, the second generation benefits from the resulting increase in value.

3. The family business identity and legacy is perpetuated and the second generation gains an experienced and rational partner in Hadley Capital.

Hadley Capital has more than a decade's experience buying, owning and improving small businesses. Our ownership model is well aligned with many family businesses: we are good stewards of our companies with a long-term focus and an interest in improving and growing our companies, creating opportunities for management and employees and equity value for owners.

I was at dinner last night with a second generation family business owner. She said that she didn't know that "guys like you were out there" and that we might be able to help her family business. If you are an owner of a family business that is facing this dilemma, we are out here, give us a call and we can discuss how we might be able to help you.

PDW

Hadley Capital's deal flow was up more than 50% in 2011 – a substantial improvement from a 15% increase in the first half of 2011. But, upon further review, the increase is not as impressive as it might seem. 2011 was a tale of bifurcated deal flow:

1) A consistent number of good deals – where we submitted an Indication of Interest or Letter of Intent. These deals received A LOT of attention and many sold at premium valuations.

2) A substantial increase in marginal deals – companies that generally fit our criteria but, after initial review, were not attractive investment opportunities.

Our deal database confirms this divergence, we reviewed more than twice the number of "immediate kill" deals while Indications of Interest and Letters of Intent were about the same as 2010.

I suspect 2012 will be much of the same. Deal flow will remain bifurcated and will increase over 2011: a stabilized economy will allow small businesses that were pulled off the market in 2008 – 2010 to reenter the market and more baby boomers will decide it's time to sell their small companies.

Hadley Capital is off to a good start in 2012 - we have two new small company acquisitions under Letter of Intent and three additional Letters of Intent outstanding.

PDW