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 business: 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 cash flow (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.