Coronavirus makes a strong case for structured capital
Businesses in the lower middle market and mid-market are facing unprecedented challenges as the Covid-19 pandemic continues to unfold. It shouldn’t surprise anyone that these segments of America’s businesses – many of which are owned by private equity sponsors as portfolio companies – are particularly vulnerable. Depending on industry focus and value proposition, these businesses have experienced a more rapid, precipitous decline in revenues and Depression-era job losses greater than in any previous market downturn, and greater uncertainty about future earnings.
The Government’s recent $310 billion in Paycheck Protection Program financing available under the Small Business Administration (Coronavirus Aid, Relief, and Economic Security (“CARES”) Act) was designed to provide much-needed relief to the millions of small and middle market businesses that make up the country’s economic fabric – but the vast majority of lower middle market and mid-market companies owned by private equity firms have been unable to access this crucial financing due to the affiliate rules.
For middle market private equity deal-making groups that invest in these companies, the prospect of diminishing returns is far different than the vibrant growth many of these businesses experienced following the global financial crisis. Executives at these private equity firms and their investment banking advisors have pivoted from doing deals to focusing on shoring up their portfolio companies, even turning to specialized business advisory firms.
Now, half way through 2020 and after the U.S. economy began on an upswing at the beginning of the year – in growth mode and seemingly near invincible – the global pandemic has hit American businesses hard. U.S. businesses lost a mind-boggling 20.5 million jobs in April and unemployment spiked to 14.7 percent, according to Labor Department data. Businesses worldwide – including the large universe of small to middle market-sized businesses have taken measures to cut costs domestically and worldwide. Private equity deals are largely on hold, if not for businesses that want rescue financing, and the direct lending market that makes deal making possible has virtually ground to a halt as founders, deal-makers, M&A bankers, private equity sponsors and law firms that serve the mid-market community grapple with the new normal economic environment.
What tends to happen in economic downturns is that traditional sources of capital – bank loans, term debt, revolving credit facilities and asset-based lending – dry up or, at best, the terms are significantly tightened. That, in turn, feeds into deal activity and valuation levels. Facing increased volatility, diminishing earnings prospects and a potential lack of visibility over clients and end markets, private equity sponsors have largely delayed their deal making activities that would have been supported by direct lenders.
These developments, coupled with the lack of debt financing, raise an interesting question: as private equity sponsors sit on the sidelines, what private investment strategies are left to fill the void amid the heightened market volatility?
Finding the right capital solution
There isn’t a one-size fits-all approach available to meeting the capital needs of every company – small, middle market or otherwise – during a market dislocation or economic downturn. However, in a rapidly de-accelerating market environment, the ability to obtain creative, flexible capital solutions that support a company’s growth in its target industry as well as address small business owners’ concerns and priority objectives should be considered more closely.
Structured Capital – often structured as a combination of 75 percent subordinated debt and 25 percent equity in a typical transaction – is a form of growth financing that can serve as a lifeline for smaller and mid-sized businesses, while allowing a founder or management team to retain significant equity.
For growth-minded entrepreneurs concerned about ownership stakes and governance rights, non-sponsored structured capital is an especially appealing option because it helps them avoid the dilution that occurs in connection with investments made by growth capital funds and traditional private equity deals, which both require more equity. Structured capital, on the other hand, leaves stakeholders with more equity and governance rights, and is less dilutive.
Unitranche and mezzanine financing are often talked about, but both lack the features of structured capital. The former is constructed with different types of debt financing, while mezzanine providers are primarily focused on providing debt to support private equity acquisitions.
Structured capital is advantageous because of its flexibility which enables it to be made up of a variety of different investments, such as the inclusion of pay-in-kind (“PIK”) debt along with subordinated debt, junior term debt, senior debt and/or common and preferred stock. One reason PIK notes are helpful to a company is because they enable a business to preserve cash by allowing it to make interest payments through the issuance of additional debt securities instead of cash. This lets the borrower preserve cash for other uses, including future debt payments. As such, structured capital is an attractive alternative even to the lending program proposed under the CARES Act.
Because of the different way these investments can be structured, a company that undergoes a structured capital investment is typically left with lower leverage levels. Generally speaking, this works out to about four times cash flow (“EBITDA”) as compared with private equity-sponsored transactions that often leave a business with 5.5 or more time debt-to-EBITDA. That means a company has more flexibility and less debt to pay down than it would from a private equity investment.
That should also be attractive for smaller businesses, especially for many of today’s asset-lite and high demand companies spanning the business services, healthcare IT, information and digital education sectors. These companies typically don’t have the same access to term loan, revolving credit facilities or asset-backed debt as larger consumer products or manufacturing businesses.
In short, structured capital financing is unique in that it is a whole solution for growth-minded entrepreneurs, founders and management teams at lower mid-market and middle market businesses as compared with large cap companies that would typically turn to banks for financing.
It was at the start of 2020 that some market observers began discussing a potential recession in spite of solid economic growth rates coming into the new years. Over the last few months that talk now seems dated in light of current circumstances.
Goldman Sachs estimated that global GDP has declined by 16 percent since January, but noted optimistically that it expected GDO to grow and rebound on a quarterly basis. In the meantime, policy makers and businesses are still struggling to return furloughed workers and employees abiding by stay-at-home orders back to work. Some states have moved forward with reopening in spite of continued concerns about the spread of Covid-19.
Private capital investors that have experienced difficult market cycles like the current one understand the natural impulse to take flight from risk during economic dislocation or when facing strong macroeconomic headwinds. Even so, it’s important to remember that volatility in the capital markets is one reason why there’s been a big flight of capital towards the private markets over the past decade where the perspective is long term and not easily swayed by whipsawed public markets.
To be sure, the demand for flexible capital solutions will only continue to grow as founders and management teams of small and mid-sized businesses pursue funding for growth and learn more about the benefits of this little discussed type of capital. What may make the difference in the road to economic recovery post-pandemic is better understanding one corner of the private markets that’s been long overlooked – until now.