Expensive debt can cost the owner less than giving shares to a fund

A company generates PLN 15 million of EBITDA and is worth PLN 120 million. A partner who holds 40 percent of the shares wants to leave, so PLN 48 million has to be found. The bank agrees to lend at most PLN 30 million, or two times EBITDA, and refuses the missing PLN 18 million. The figures in this example are illustrative.

An owner whom the bank has turned down usually concludes that the company is not yet ready for debt financing and invites in a private equity fund. That is the most expensive mistake he can make at that point. It leads straight to giving up shares in a situation where paying interest would have been enough.

Why banks turn down companies that could carry the debt

The cause often lies with the bank. A bank is a supervised institution and has to hold equity capital against every loan it grants. The required amount depends on how the regulations assess the risk of the particular loan. A loan secured by a mortgage on an industrial building puts less strain on the bank’s capital. A loan to a company whose assets are people, contracts and a brand puts more strain on it. It is also subject to the bank’s internal limits on loans not secured on real estate or machinery, because in a bankruptcy the bank has nothing to sell. The bank may then refuse or demand a price at which the transaction no longer makes sense for either side.

Hence a situation that seems absurd to owners. A company with recurring revenue, a high margin and predictable cash flows is turned down, while a clearly weaker plant with a fleet of machinery gets a loan without discussion.

On top of this come rigid lending rules. The bank relies on fixed ratios, requires repayment of principal from the first year and allows a narrow range of solutions. A transaction that does not fit these rules loses out to procedure, even when its risk is acceptable.

After the 2008 crisis, capital requirements rose and banks cut back on financing higher-risk companies. Debt funds filled the gap. They lend businesses money entrusted to them by insurers and pension funds looking for a higher return than bonds offer.

Bank loans, private debt and mezzanine

An owner whom the bank has turned down can choose between two kinds of non-bank debt. The difference between them determines what the owner gives up.

A bank loan is the cheapest money on the market. In a partner buyout, or in a company without real estate and machinery, it usually reaches about two times EBITDA. It requires strong security and repayment of principal from the first year. The bank writes covenants into the agreement, meaning conditions the company must meet, for example a maximum permitted ratio of debt to EBITDA, and checks them every quarter. The bank does not take shares and does not sit on the company’s governing bodies. If the company’s needs fit within a bank loan, every other source of capital is more expensive.

Private debt is a loan granted directly by a debt fund. It usually replaces the bank loan. Often a single lender finances the whole amount under one agreement, known in the market as unitranche. This removes the split between a bank loan and more expensive subordinated debt, that is debt repaid only after the bank. A debt fund assesses the company mainly on its future cash flows. Security usually takes the form of pledges over the shares and the company’s bank accounts. The principal is often repaid in full or mostly at the end of the term, and in the meantime the company pays mainly interest. As a result, cash stays in the company when it needs it for growth.

There are fewer financial ratios in the agreement than with a bank, usually one or two that determine the company’s ability to service the debt. Breaching any of them triggers a quick reaction from the lender. A debt fund does not demand shares and rarely joins the supervisory board, although it sometimes sits on it as an observer without voting rights. The interest rate is higher than a bank’s and lower than on mezzanine.

Mezzanine is added on top of a bank loan, above the bank’s limit. It is repaid after the bank loan, so if things go wrong the mezzanine fund is the last of the lenders to get its money back. For this risk it charges the highest interest rate among debt instruments, usually an annual rate in the teens. It also demands a premium for the growth in the company’s value, known as a warrant. Formally, a warrant gives the right to take up a small block of shares, but in practice the parties often settle it in cash when the debt is repaid. A mezzanine fund usually also expects a seat on the supervisory board or observer status.

Part of the interest is paid as it falls due, and part is added to the debt and repaid only at the end of the agreement. That is why, in companies with the most predictable results, total debt including mezzanine can reach about 4.5 times EBITDA. The current burden on cash flow is therefore lower than the size of the debt alone would suggest. I wrote about mezzanine in more detail in June.

Private debt, then, replaces the bank loan entirely. Mezzanine supplements the bank loan when the last part of the money is missing.

Why more expensive debt can be cheaper than shares

At this point the owner always asks why he should pay interest much higher than a bank would charge. A comparison with a bank loan for the whole amount is misleading, however, because the bank refused such a loan. The real choice is between expensive debt and selling shares.

In the opening example, private debt for the full PLN 48 million at an interest rate of about 12 percent means PLN 5.76 million of interest a year. Over five years that adds up to PLN 28.8 million in interest alone. At the end of the term the company still has to repay the PLN 48 million of principal, so it will spend a total of PLN 76.8 million on the partner buyout and debt service. This amount is known in advance and fixed. After repayment the owner holds 100 percent of the company and has no debt.

In the second scenario a private equity fund buys the partner’s stake and pays him PLN 48 million from its own resources, that is 40 percent of PLN 120 million. The company spends nothing. For the owner, however, the account will be settled only when the company is sold. The fund will then receive 40 percent of the company’s value. If in five years the company is worth PLN 250 million, that is PLN 100 million. If it is worth PLN 400 million, that is PLN 160 million. The better the company does, the more the fund’s entry will cost.

Both solutions cost the owner the same when the company is worth PLN 192 million, because 40 percent of that amount is exactly PLN 76.8 million. The company therefore has to grow by 60 percent in five years, or by just under 10 percent a year on average. If it grows more, debt will prove cheaper. If it grows less, the fund will be cheaper. The calculation ignores the time value of money and assumes that the company grows at the same rate in both scenarios, although with debt it has less cash for investment. It also ignores taxes. Whether the interest reduces tax depends on the legal structure of the buyout. When the acquisition of shares is financed with debt, the rules often limit this benefit, so it needs to be checked with a tax adviser. At Capital One Advisers, when the bank has said no, we calculate this threshold before the owner starts talking to any investor.

The higher cost of debt gives the owner certainty about how much he will pay. The price of debt, the interest, is known in advance. The price of shares will be set only by the future.

The same calculation works the other way. If the company does not grow, or hits two weak years, the private equity fund will prove cheaper, because as a shareholder it shares the weaker result with the owner. Its return depends on the value at exit, so a weaker result hits it too. A lender shares nothing. Interest is paid the same in a good year as in a weak one, and a covenant breach in a weak quarter may give the lender the right to demand early repayment.

There is also the question of repaying the principal. If only the PLN 5.76 million of interest were deducted from PLN 15 million of annual EBITDA, PLN 46.2 million would remain in the company over five years. That is less than the PLN 48 million to be repaid, and the company still has to pay taxes and invest. A one-off repayment therefore requires EBITDA growth or new financing at the end of the term.

By choosing debt, the owner bets on his own company. It is a sensible bet for someone who has hard reasons to believe in his plan, and a bad bet for someone who is merely hoping it will work.

Three ways to finance the same PLN 48 million

A private equity fund buys the partner’s stake. The owner pays nothing out of his own pocket, and the company takes on no debt. He is left with 60 percent of the shares, a financial investor on the supervisory board and the prospect of selling the company in four or five years. If the company needs capabilities it does not have, this can be the best decision. I wrote a week ago about when a fund brings more than money. If the company lacked only money, the owner has given away 40 percent of its future value for something he did not need.

A PLN 30 million bank loan and PLN 18 million of mezzanine together give PLN 48 million. That is 3.2 times EBITDA, below the market ceiling for such a combination. The bank has to consent to the mezzanine in a separate intercreditor agreement. The company then services two agreements and two repayment schedules owed to lenders with different priority. The owner gives up a warrant and brings a representative of the mezzanine fund onto the supervisory board. He still manages the company himself, but he now discusses important decisions with someone else as well.

Private debt for the full PLN 48 million means one agreement with one lender and repayment of principal at the end of the term. Interest comes to PLN 5.76 million a year, or 38 percent of EBITDA. EBITDA covers it 2.6 times, but out of the rest the company still has to pay tax and fund ongoing investment, so the cushion for a weaker year is moderate. The owner keeps 100 percent of the shares and full control. The supervisory board keeps its current members. The total cost of private debt is often close to the cost of a bank loan plus mezzanine, and the owner has a single agreement and gives up no warrant.

The three scenarios produce the same amount and three different companies five years on. They differ in what the owner gives up. In the first he gives up shares and part of his control. In the others he gives up cash from future cash flows.

When private debt is a good choice

The first case is a partner buyout, because this is where owners most often give up shares unnecessarily. If the company generates enough cash to service the debt, it can pay out the departing partner, and the owner does not have to let in a new investor.

The second case is the acquisition of another company when time is short. When financing an acquisition, a bank usually needs at least a quarter for analysis and a credit committee decision, and the seller rarely wants to wait that long.

The third is growth beyond what the bank can finance, when the owner does not want to reduce his stake and does not need a partner.

The fourth is a company without real estate or machinery that could secure a loan, operating for example in services, software or distribution. The bank sees an empty collateral box, while the debt fund sees recurring cash flows.

The fifth is bridge financing before selling the company. It makes it possible to complete an investment that will raise the price before the company goes to market.

There are also three situations in which private debt is a bad choice. The first is a company whose needs fit within a bank loan, because every other source is more expensive. The second is large swings in EBITDA. High debt combined with volatile earnings does not survive the first weaker year, so the predictability of cash flows matters more here than their level. The third is a company that has to rebuild its business model or is going through a deeper decline in results. Debt will not fix that. A private equity fund can bring the missing know-how and ride out a temporary decline without demanding its money back, because its profit will be decided at exit. In return it will demand more influence over the company. A lender has a return agreed down to the date and will not wait that long.

Who checks the plan

Between a cheap bank loan and selling shares to a fund there are two more kinds of debt. They make it possible to finance a transaction without giving up control of the company when the bank offers too little or refuses a loan. In a partner buyout, we at Capital One Advisers talk to the bank and to debt funds in parallel, before the owner starts talks about selling shares.

It is hardest when the owner’s plan assumes a company value close to the threshold, in the example about PLN 192 million in five years. At that value, debt and the fund cost the same, and they differ in who bears the risk. With debt, the owner bears all of it. With a fund, he shares it with the investor, but he also shares the growth. The forecast on which this choice depends is usually written by the owner himself. Before buying shares, a private equity fund will check whether the company can grow as the forecast assumes. A debt fund will check above all whether, in a weaker year, the company will run out of cash for interest and principal repayment.

Service: Debt and mezzanine financing