Talking Points

Mezzanine Finance

My last post on acquisition financing covered senior debt. This post will cover Mezzanine debt. Specifically, I would like to talk about how mezzanine debt is structured and what the implications are for small businesses that use it.

The word mezzanine is defined as the “partial story between two main stories of a building”. In this case, the two main “finance stories” of a company are senior debt and equity. Mezzanine debt then is the middle level or “mezzanine” between senior debt and equity. From a borrower’s perspective, mezzanine finance is more expensive than senior debt and less expensive than equity. Mezzanine debt is more expensive than senior debt because 1) it is subordinate to senior debt (meaning in a liquidation the senior debt lender will be paid in full before the mezzanine lenders sees a dollar) and 2) it typically does not require any principal payment until the end of the term loan. This structure obviously creates more risk for the mezzanine lenders and as a result they charge higher interest rates.

Mezzanine loans are typically priced anywhere between 15–20%. There are three main components off mezzanine debt: 1) current interest 2) PIK Interest and 3) Warrants. As mentioned, Mezzanine loans are typically interest only with the principal due at the end of a five or seven year term. Current interest payments are typically due monthly or quarterly. For example, a $3 million 15% current pay interest mezzanine loan with a 5 year term would look something like this:

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In some cases mezzanine lenders will PIK (Payment-in-Kind) a portion of the interest payment and add it to the principal payment of the loan. In this case, there will be two buckets of interest: current cash interest and PIK interest. Here is what it would look like if a mezzanine lender offered a $3 million with 14% current cash interest and 2% PIK interest:

Screen Shot 2015-10-13 at 2.38.44 PM

Mezzanine debt can also frequently include warrants, which are very similar to equity options. Warrants give lenders equity upside when the borrower performs well. Warrants typically represent 1–5% of the fully diluted ownership of the company.

Due to the high interest rates associated with mezzanine debt, we work with management to pay it off sooner rather than later. If a company is performing well and has plenty of cash, we will use some cash to pay down the mezzanine debt. We typically use 1x–1.5x EBITDA (or cash flow) of mezzanine debt in an acquisition. So if we buy a company for 5x EBITDA, a typical capital structure might be 2x senior debt, 1x mezzanine debt and 2x equity. We feel 3x total leverage (2x senior + 1x mezzanine) is an appropriate amount of debt for a small company.

Financial Reporting

Small business owners are often apprehensive about the changes that may occur when their business is acquired by a private equity firm.  When Hadley Capital acquires a company we do not look to make immediate changes to the business. However, financial reporting is something that does change after the deal closes. This typically means two changes for a business: 1) monthly reporting is completed in a more timely manner and 2) additional financial reporting is required.

Timely Monthly Reporting.

Hadley Capital receives monthly financials (income statement and balance sheet) from our portfolio companies within 30 days after month end. Most small businesses are not used to producing monthly financials this quickly. While this can be adjustment, our portfolio companies eventually see the benefits of timely reporting. It is much easier to manage a business when you have timely data.

Additional Financial Reporting.

Borrowing Base Certificate. All of our portfolio companies have a revolving line of credit to manage working capital. A line of credit is supported by a borrowing base certificate. A borrowing base lists a company’s eligible accounts receivable and inventory and dictates how much the company can borrow. Many small businesses are not accustomed to providing monthly accounts receivable aging reports and monthly inventory reports. However, the benefits of access to additional capital (via a line of credit) are greater than the administrative burden of creating these reports.

Financial Covenant Calculations. Banks and mezzanine lenders use financial covenants to monitor the performance of a borrower. These lenders receive quarterly financial covenants calculations from the borrower. Financial Covenants give the lenders a heads up if the financial standing of the borrower has changed over a given period of time. For example, one common financial covenant is Total Leverage. The Total Leverage covenant measures the Total Debt (senior debt + mezzanine debt) in relation to the trailing twelve months (TTM) of EBITDA. So if the Total Leverage covenant is Total Debt must be less than 4.0x TTM EBITDA, the borrower has to perform this calculation each quarter and send the results to the lender in a covenant compliance certificate. If the Total Leverage is less than 4.0x then the borrower is in compliance with the covenant. However, if Total Leverage goes above 4.0x, the borrower is not in compliance and the lender will want to sit down with borrower and understand why things have changed. Covenant calculations are not difficult, but most small businesses are not used to completing them so it can take some time getting used to.

Individually none of these financial reporting requirements are a big deal, but collectively they can seem like a lot to a small business. However, we have been through the process many times and we work with our portfolio companies to make it a smooth transition. The lenders that work with our portfolio companies typically require our companies to submit a monthly borrowing base certificate and quarterly financial covenant certificates.

Salary Versus Draw and the Impacts on Small Company Valuation

Earlier this week, I had a long conversation with an owner of a small business regarding his annual draw and how this draw, unlike a salary, is not reflected in his company’s income statement and why the difference is important in valuing a small business. This issue frequently arises when a small business owner is involved in running her company and someone needs to fill her role (whether the owner or someone new) when she sells the business.

A salary is a wage that is paid to an employee (whether an owner or not). Salary is an expense that is deducted from revenue to arrive at net income as reported on the income statement.

A draw is a cash distribution paid to a business owner and reflected on the balance sheet as a reduction in cash and a reduction in shareholders equity. A draw is not reflected on the income statement and has no impact on net income.

Below is a simple income statement that reflects the accounting treatment of a draw vs. a salary.

$110,000 Draw $110,000 Salary Change
Revenue $2,500,000 $2,500,000 $0
Expenses 1,995,000 2,105,000 (110,000)
Net Income $505,000 $395,000 $110,000

The difference between a salary and a draw is important in valuing a small business because most businesses are valued based upon a multiple of earnings. If an owners’ compensation is not included as a salary expense, but rather taken as a draw, it will artificially increase earnings and, thus, valuation. The table below illustrates this valuation impact.

$110,000 Draw $110,000 Salary Change
Net Income $505,000 $395,000 $110,000
Purchase Multiple 4.25x 4.25x 4.25x
Enterprise Value $2,146,250 $1,678,750 $467,500

If an owner’s compensation is paid via a draw, it will not be included in her company’s earnings so we must adjust her company’s income statement to reflect this expense, reducing earnings. The reduced level of earnings is now reflective of the earnings a new owner will receive from operating the business. And, since most businesses are valued based on a multiple of earnings this will adjust the valuation of the company.

Hadley Capital Portfolio Company Completes Add-On Acquisition

Packaging Specialists, Inc. recently expanded its crating capabilities by purchasing a local crating competitor, doubling PSI’s capacity and making the company the largest crating operation in the Phoenix metro area. PSI is a protective packaging and crating business in Phoenix, AZ and acquired by management and Hadley Capital in 2008.

Hadley Capital Sells JRI Holdings

Hadley Capital is pleased to announce that it sold JRI Holdings in April 2015. Terms of the transaction were not disclosed.

JRI Industries is a leading manufacturer of aqueous parts washing equipment. Hadley Capital, via JRI Holdings, acquired JRI Industries in 2004. JRI is a good example of Hadley Capital’s philosophy of true long-term value creation.

During the eleven years of Hadley Capital’s ownership and guidance, JRI completed several major initiatives including moving into a new facility, expanding its product line, acquiring two complimentary businesses, establishing international sales channels, and transitioning management leadership from the founder to a new management team.

JRI was a successful investment for Hadley Capital, JRI’s employees, and JRI’s customers.

Hadley Capital Supports Management Buyout of Centare Group

In late August, Hadley Capital and the management team of Centare partnered up to acquire the assets and business of Centare Group from its founders. Centare has grown very rapidly over the last three years thanks to innovative services that are in high demand from its customers and a highly talented workforce led by a dedicated management team.

Together with our management team partners we plan to build on Centare’s past successes while making the investments and improvements necessary to support its future growth.

Centare is another example of Hadley Capital successfully partnering with small company management teams to buy out founders or inactive owners. In 2012, Hadley Capital also supported the management buyout of Bluff Manufacturing. If you are a manager considering a buyout of a company that you run, please contact us to learn more about how we might be able to help you.

More information about the Centare transaction is available here.

Additional Benefits of Leverage

In our previous post we outlined how using debt in a transaction is often maligned by the media and gave one benefit of leverage. Here we finish off the topic with 3 additional benefits we see with using debt in a transaction.

Benefit #2:  Less Equity At Risk – So Equity Returns Can Be Higher

This is just simple math. Let’s assume you buy a company for $2 and sell it for $3 in 5 years. (To make this problem simpler, let’s also assume there are no distributions at all during the 5 year period and that the debt is not amortized.) If you financed this transaction with 100% equity, you generated a 50% return over five years, or an annualized return of about 8.5%.

Now, let’s assume that when you buy the company for $2, you borrow $1.50 from a bank and invest $0.50 in equity. When you sell the company in 5 years for $3, you take $1.50 of the proceeds and pay back the bank, leaving $1.50 for the equity owners. Since you invested $0.50 and the equity is now worth $1.50, this is a 200% return over 5 years, or an annualized return of about 24.5%.

Obviously a 24.5% annual rate of return is significantly better than an 8.5% annual rate of return.

Benefit #3:  Debt Reduces Bad Decisions by Management / Governor on Cash

While Hadley Capital provides active oversight of its portfolio companies, it does not manage any of its companies on a day to day basis. Day to day management of each business is the responsibility of each company’s management team.

We implicitly trust our management teams and we believe we have some of the best operators out there running our companies. However, we also believe that the obligation to meet a defined principal amortization schedule is an excellent motivational tool and helps management teams prioritize uses of capital.  Projects with a potentially low rate of return are not funded – only the best uses of capital receive funding.

Benefit #4:  Portfolio Company Lenders Are Our Partners – Deal Confirmation

Hadley Capital has established many excellent and long-term relationships with debt financing partners. We view these organizations as our partners in each transaction. If we are excited about a deal, 9 times out of 10, so are our debt partners. However, occasionally our lending partners balk at a transaction we find attractive. We trust our financing partners and we know they have good judgment. If they don’t like a deal it makes us ask what they see that we don’t. While we can still complete the transaction without them (either by finding other lenders or putting in more equity) we have learned over the years that supportive lenders usually signal a good transaction.

The Benefits of Leverage

Using debt (borrowing) to finance a leveraged buy-out is often maligned by the media or politicians and frequently positioned as risky, destructive, or even dangerous. Others view the tax deductibility of interest payments to be unfair or bad for society. (I never hear these same people saying the taxes paid on interest income to be destructive or bad for society – but that is a discussion for another post.)

Sayings like: “Neither a borrower nor a lender be” ring true to many people. Great Americans like Benjamin Franklin and Andrew Jackson have been quoted as saying “I’d rather go to bed supper-less than rise in debt” and “when you get in debt you become a slave.”

Hadley Capital believes that debt, when properly used, is an important and useful tool. If the capital structure is poorly organized and if the business unexpectedly underperforms, leverage can compound problems. But if done right, there are benefits to leverage.

[Note: This post does not look at the negatives of leverage or how to determine the proper capital structure. This post simply looks at the benefits of leverage assuming that it is the right capital structure and that the business performs to expectations.]

As proponents of leverage, Hadley Capital sees four main benefits of using term debt to finance a portion of a transaction’s purchase price. I will talk about the first benefit in this post and benefits #2–4 in a follow up post.

Benefit #1: Interest Tax Shields.

Because interest expense is deductible for income tax purposes, paying interest lowers your income tax liability. Sophisticated financiers can determine the expected net present value of the income tax shield associated with the interest payments.

While Hadley Capital’s portfolio company gets to deduct the interest tax expense, it is important to note that this benefit does not really accrue to the portfolio company – it generally accrues to the person who sold the business to Hadley Capital. Why? Because the tax deductibility of interest payments is universal and available to all buyers. Since all buyers have access to the value of the interest tax shield, all buyers are willing to increase their purchase price by a like amount. So the interest tax shield benefits accrue to the business seller. Don’t believe me? There are many excellent academic studies confirming this point. Here is an abstract from an Oxford Business School study for your enjoyment. Following the abstract is a link to the full study.

“Tax savings associated with increased levels of debt are often thought to be an important source of returns for private equity funds conducting leveraged buyouts (LBOs). However, as leverage is available to all bidders, the vendors may appropriate any benefits in the form of the takeover premium. For the 100 largest U.S. public-to-private LBOs since 2003, we estimate the size of the additional tax benefits available to private equity purchasers. We find a strong cross-sectional relationship between tax savings and the size of takeover premia; and on average the latter are around twice the size of the former. Consequently, the tax savings from increasing financial leverage essentially accrue to the previous shareholders rather than the private equity fund that conducts the LBO. It is, therefore, unlikely that (ex ante predictable) tax savings are an important source of returns for private equity funds. Furthermore, policy proposals that aim to restrict leverage or the tax deductibility of debt are likely to have their impact mainly on existing owners of companies.”

Investing in Existing Portfolio Companies

Business investment can take many forms. Hiring or upgrading personnel, purchasing additional equipment, expanding IT systems, etc.  Each business is different and has different needs at different times.

Hadley Capital understands that businesses need continued investment to succeed. Two of Hadley Capital’s portfolio companies (PSI and ISS) recently moved into new facilities custom designed and built for their specific needs. These facilities will help each company continue to expand and serve their clients for many years to come.

Occasionally you hear stories about private equity owners that stop investing in companies and strip them of assets and sweep every penny out of the business. That might work in the short-term, but not in the long-term. Hadley Capital wants to create true long-term value and we recognize that continued on-going investment in portfolio companies is an important part of the equation.

Is It Time to Sell Your Business?

We often talk with small business owners who are struggling with the decision of selling their business. It is a very difficult and emotional decision to make and as a result business owners spend a lot of time thinking it through. We see people who sell for all different kinds of reasons, but certain patterns have developed over the years. Here are a few reasons that we have seen:

Health Problems

This is never a good one to see, but it is fairly common. As people get older, health problems tend to pop up. Health problems usually result in an exit when a business is really dependent on the owner for its success.

No Passion

As business owners get older, the passion for the day to day management often fades. This may mean they are ready for retirement or they are just burnt out from leading the business for 20+ years.

New Interests

Some serial type entrepreneurs will want to move on to another venture. Once the business is built and is stable, we have seen business owners sell in order to build new businesses or start new projects.

Holding it Back

The skills you need to start a business and get it to $10 million in sales are not necessarily the same skills you need to get it to $20 million in sales. Some owners realize they don’t have the necessary skills to get the company to the next level. They feel like they are holding the business back and look to sell.

No Transition Plan

Mom was working under the assumption that her son would want to run the business some day. When mom finally asks her son, she realizes he wants to be a baker and has no interest in running the business.

Spouse Says So

Here the spouse has usually seen their husband or wife obsessed with the business for 20+ years. The business owner promised that one day they would quit and spend more time with the family. That day has come.

Need to Diversify

Business owners often put all their money back into the business. When it comes time for retirement, any financial planner will tell you it is never good to have all your net worth tied up in one asset.

Partnership Differences

In this example there are usually two owners with significant ownership in a business and one is ready to retire. When the owner who is retiring wants to sell his shares that means the business needs to be valued. After the business is valued the business is more likely to be sold.

These are just some of the reasons we have seen over the years. Sometimes it can be a combination of the above reasons. When considering whether to sell a business, a business owner should do what is best for them. If you are business owner facing one of the challenges above, please let us know. We would love to talk to you.

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