first west capital - mezzanine financing and subordinated debt
DESCRIPTION
VP Kristi Miller presents financing from a banking and credit union perspective, focusing on alternative financing and business strategy,TRANSCRIPT
Lending Principles, Subordinated Debt and Funding
Changes of Ownership
Fraser Valley Chartered Accountants’ Association
Kristi Miller, MBA
• Vice President, First West Capital– 16 years in specialized commercial finance roles– Founding partner of First West Capital, a $60 million
subordinated debt / mezzanine finance fund owned by First West Credit Union
– Previously:• Investment Manager, Vancity Capital• Commercial Account Manager, CIBC • Investment Officer, EBRD
Today’s topics
• Principles of Lending• The Financing Landscape– Risk / reward profiles– Who does what
• What is ‘Subordinated Debt’ and how does it work?• How are Changes of Ownership generally financed?
PRINCIPLES OF LENDING
#1 - The 5 C’s of Credit
• Character– Sense of responsibility, integrity, honour, ‘face’
• Capacity (Cash Flow)– Can the borrower repay the loan?– Is this loan sound?
• Capital– Net worth, outside resources
• Collateral– Secondary source of repayment?– Is this loan safe?
• Conditions
#2 - The Banker’s Dilemma
• Sales v Risk Management
– Who makes the lending decision?
– How has lending changed over the years?
THE FINANCING LANDSCAPE
What to expect and from whom
Senior Debt (Op. credit, secured term, etc)
Fully Secured & Proven Earnings
Subordinated Debt (First West Capital)
Unsecured & Proven Cash Flow
EquityUnsecured &
Unproven Cash Flow
Cost
of C
apita
l
6%
25%
15%
High
Med.
Low
Risk
Lev
el
FWC sweet-spot
WHAT IS SUB-DEBT?
Cost of Capital
• Senior debt– P+3% or less
• Subordinated debt / mezzanine– prime + 9-12%, IRR of 15-20% all-in
• Equity– target yields vary by age/stage/risk profile– Dilutive, not tax efficient
Types of Facilities
• Short-Term & Working Capital Financing: – Line of Credit (Operating Line), Trade Credit, Leasing
• Medium and Long-Term Financing:– Term Loans, Commercial Mortgages, Debt-Equity
Hybrids (Subordinated / Mezzanine Debt)• Long-Term Financing:– Equity
A Do-Able Deal
• Senior Debt:– profitability & cash flow– Good quality security
• Subordinated Debt:– Cash flow– Strong & committed
management– Interesting market
opportunity
• Equity:– Compelling market
opportunity– Exceptional management– Range of opinions on: • Revenues• Cash flow• Profitability• Age / stage
Key Ratios
• Importance of trends – consistent, strong, improving
• Cash Flow– cash flow coverage - income statement approach
• net income + non-cash items + discretionary items / debt service requirements
• Min generally 1.15X, preference for > 1,25X
– liquidity - balance sheet approach• current assets / current liabilities• Absolute min 1:1, stronger is better, preference > 1.2:1
More Ratios
• Leverage– Debt to Effective Net Worth• ‘effective net worth’ = retained earnings + shareholder
loans - goodwill - amounts due from related parties• lower is better : implies more risk assumed by
principals– Max generally 3:1• importance of relationship / history / profitability of
group of accounts / potential for additional business
Due Dilly
• Time Required• Senior Debt
– Profitability & Cash Flow• Three years’ financial
statements (statement quality)
• Interim, in-house results (management’s analysis)– Particularly important if FYE >
September 30th
– Security• Value of personal guarantee(s)• Real estate assessments• Aged A/R
• Subordinated Debt– Profitability & Cash
Flow– Management– Market
FINANCING CHANGES OF OWNERSHIP
Population Pyramid
Financing Changes of Ownership
• Includes MBO’s, Acquisitions and Shareholder Buy-Outs
• A word on valuations• Capital structure elements:– Purchaser’s cash (or sweat) equity– Vendor take-back financing (VTB)– Bank debt– Subordinated debt• The ‘glue’ in buy-out transactions
A Case Study: Buy Me Inc.
• Adjusted EBITDA of $700K• Purchase price of $3 million (4.3X)
Buy Me Inc., cont’d
• $3,000,000 - $2,500,000 = $500,000 shortfall• NO DEAL
Uses Sources
A/R $500,000 LOC (75% of A/R) $375,000
Equipment $2,000,000 Term Loan (50%) $1,000,000
Goodwill $750,000 Vendor (negotiated) $625,000
Payables ($250,000) Equity (purchaser’s) $500,000
Purchase price $3,000,000 Total financing $2,500,000
Buy Me Inc., cont’d
• EBITDA is $700K so plenty of free cash flow left• But asset base fully encumbered
Sources Debt Servicing
LOC (75% of A/R) $375,000 LOC interest at 6% $22,500
Term Loan (50%) $1,000,000 blended, 4 yr amort., 7%) $290,000
Vendor (negotiated) $625,000 interest only @ 8% $50,000
Equity (purchaser’s) $500,000 $0
Total financing $2,500,000 Total Debt Servicing $362,500
Buy Me Inc., cont’d
• Sufficient CF to service additional sub debt• 4 year average return on shareholder equity of > 55%
Sources Debt Servicing
LOC (75% of A/R) $375,000 LOC interest at 6% $22,500
Term Loan (50%) $1,000,000 blended, 4 yr amort, 7% $290,000
Vendor (negotiated) $625,000 interest only @ 8% $50,000
Equity (purchaser’s) $500,000 $0
Sub-Debt $500,000 Blended, 4 yr amort, 15% $167,000
Total financing $2,500,000 Total Debt Servicing $529,500
The Perfect Deal
• Reasonable valuation• Vendor inactive and drawing significant
remuneration• Purchaser knowledgeable of industry / business• Vendor willing to carry some financing (signaling)• Senior lender supportive