Dealing with frozen bank lending

The entire landscape of how banks lent money and how companies could depend on them has changed. Granted, there are many troubled companies with limited options. But what do you do when you are a company that is growing and still profitable, or, as one client puts it, "nothing has changed" at the company -- the bank just changed the rules midstream? Add in the fact that the opportunities to acquire companies are everywhere, but nobody will lend money for such transactions, and you as a company owner have a real dilemma. Seller notes are increasing both in size and in frequency, but an equity down-stroke is still needed. If your bank is not willing to lend, what can you do?

There are creative solutions out there that you may want to consider. The following case study is an example of an option that may work for you.

The client is a middle-market company with 10% growth in 2008 and 8% in 2009. The company is profitable, has a solid Ebitda and has made some acquisitions, all funded with bank debt. The bank liked the assets, the cash flow and the management, but the game has changed. The Ebitda to debt ratio for the company is at 5-to-1. The bank loans, specifically the company's line of credit, is up for renewal, and the bank is no longer happy with the ratio and has asked the company to reduce the ratio to no more than 3-to-1. (Many banks are pushing for a 2-1 ratio.) The owners could choose to sell the company, but after debt, the net proceeds to the owners would not amount to much. More importantly, the company sees numerous opportunities to acquire competing companies.

This is where mezzanine/capital funds come into play. Mezzanine/equity funds provide the necessary capital to reduce the leverage and are a ready source for growth through acquisition. Here is what we proposed for our client: The company needs about $5 million of capital/mezz debt to pay down the bank and bring the ratios into line. The company also figures that it will then need about $10 million to do acquisitions going forward.

Sounds good. Now the price of doing the deal.

Capital groups, assuming an all-mezzanine deal, are going to require 30% of the company's equity to get the deal done. Letting go of equity is never an easy sell to a client. If we examine the cost of the deal and compare the outcome to the "go it alone" approach, however, the benefit of working with private equity/debt becomes clearer. Without the capital, the company is on the bank's watch list and is forced to grow organically. If we flash forward five years and compare what the owners' equity stake would be worth with the capital group deal versus without, the owners end up with twice as much value from working with the capital group.

Problem solved?

Not yet. Now we need to get creative with the funds. Since the company does not need the money right away, it would be beneficial to stagger the investment to come in as needed, thus reducing the equity given up. So if we stagger the investment of equity over the next few years, the capital group's overall equity interest in the company can be reduced to about 20%. But even with this structure, there are two options: (1) Price the deal today; (2) or price the first installment today, and each new installment is then negotiated based on its merits. A tough call and one which requires further analysis. We are working under the assumption that banks will resume lending at more traditional levels in the future. We need to add one more twist to this option. Even mezzanine funds are moving away from leverage and are capping the bank and mezzanine ratio to Ebitda at 3.5-to-4.0 to 1.0. In this case we will likely take the initial investment and split it between mezzanine debt and equity, thus reducing the ratios for both the capital group and the bank.

All in all, we end up with a scenario that gives the capital group 25% of the company. If our plan works and the banks loosen up, we may be able to keep that percentage under 20%.

Tom Kintis is president of CGK Investment Banking.