first west capital - mezzanine financing and subordinated debt

24
Lending Principles, Subordinated Debt and Funding Changes of Ownership Fraser Valley Chartered Accountants’ Association

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VP Kristi Miller presents financing from a banking and credit union perspective, focusing on alternative financing and business strategy,

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Page 1: First West Capital - Mezzanine Financing and Subordinated Debt

Lending Principles, Subordinated Debt and Funding

Changes of Ownership

Fraser Valley Chartered Accountants’ Association

Page 2: First West Capital - Mezzanine Financing and Subordinated Debt

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

Page 3: First West Capital - Mezzanine Financing and Subordinated Debt

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?

Page 4: First West Capital - Mezzanine Financing and Subordinated Debt

PRINCIPLES OF LENDING

Page 5: First West Capital - Mezzanine Financing and Subordinated Debt

#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

Page 6: First West Capital - Mezzanine Financing and Subordinated Debt

#2 - The Banker’s Dilemma

• Sales v Risk Management

– Who makes the lending decision?

– How has lending changed over the years?

Page 7: First West Capital - Mezzanine Financing and Subordinated Debt

THE FINANCING LANDSCAPE

Page 8: First West Capital - Mezzanine Financing and Subordinated Debt

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

Page 9: First West Capital - Mezzanine Financing and Subordinated Debt

WHAT IS SUB-DEBT?

Page 10: First West Capital - Mezzanine Financing and Subordinated 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

Page 11: First West Capital - Mezzanine Financing and Subordinated Debt

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

Page 12: First West Capital - Mezzanine Financing and Subordinated Debt

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

Page 13: First West Capital - Mezzanine Financing and Subordinated Debt

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

Page 14: First West Capital - Mezzanine Financing and Subordinated Debt

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

Page 15: First West Capital - Mezzanine Financing and Subordinated Debt

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

Page 16: First West Capital - Mezzanine Financing and Subordinated Debt

FINANCING CHANGES OF OWNERSHIP

Page 17: First West Capital - Mezzanine Financing and Subordinated Debt

Population Pyramid

Page 18: First West Capital - Mezzanine Financing and Subordinated Debt

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

Page 19: First West Capital - Mezzanine Financing and Subordinated Debt

A Case Study: Buy Me Inc.

• Adjusted EBITDA of $700K• Purchase price of $3 million (4.3X)

Page 20: First West Capital - Mezzanine Financing and Subordinated Debt

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

Page 21: First West Capital - Mezzanine Financing and Subordinated Debt

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

Page 22: First West Capital - Mezzanine Financing and Subordinated Debt

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

Page 23: First West Capital - Mezzanine Financing and Subordinated Debt

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

Page 24: First West Capital - Mezzanine Financing and Subordinated Debt

Thank you!

Kristi Miller, [email protected]

Desk: (604) 501 4264Cell: (604) 996 2685