Here we go again – the lenders are out in full force, aggressively marketing to borrowers and eager to deploy capital. It wasn’t that long ago when we dreamed that these days would return and now they are upon us. Interestingly, with the advent of unitranche debt and the increasing number of hedge funds and BDCs that have recently entered the market, it seems like there may be even more options for a borrower today than there were before the crash.
Asset based loans, senior cash flow debt, unitranche debt, second lien debt, and mezzanine debt are all available to middle market companies. Each product has its own advantages and disadvantages and knowing which one to use can sometimes be a challenge for borrowers. Unfortunately, while most borrowers opt for the lowest interest rate product, other terms and conditions may have a larger impact on whether a company achieves its strategic objectives. So borrowers should consider some of the other more salient terms when deciding what structure to pursue:
Leverage Multiple: Senior lenders get paid less interest because they take less risk. So it should come as no surprise that they are more restrictive on a borrower’s total debt leverage then their junior capital brethren. In fact, it’s often the senior lender who restricts the amount of junior debt they will allow below them rather than the junior lender themselves. But keep in mind that senior lenders will also increase the amount of senior debt they will provide if there is no junior debt below them and, as a result, total leverage decreases.
Amortization: Compared to interest rates, the amount of mandatory amortization a loan requires may be one of the more important considerations in selecting a capital structure. The reason is obvious – the less required amortization, the more capital the company has to redeploy for growth, and the easier it is to achieve the required fixed charge coverage. Unfortunately, other than revolvers, which have the lowest interest rates and normally require no amortization, most other loans have amortization that range from nothing (bullet amortization) to full five year, straight-line amortization. Paying a higher interest rate, but maintaining a company’s earnings for growth, may be well worth the trade-off. And be careful of those mandatory excess cash flow recapture provisions. They can be as lethal as mandatory amortization.
Prepayment Penalties: This is often a particularly hot topic for private equity funds who, although expecting a 5-7 year investment horizon, also want the flexibility to exit an investment early in case the perfect strategic buyer comes along and offers a great price. Different types of debt vary widely with respect to prepayment penalties, with some debt instruments having no prepayment penalties at all, while others don’t allow the borrower to call any portion of the debt for a certain period. Keep in mind that lenders who have recycle provisions, like banks, BDCs or hedge funds, are more inclined to negotiate away a prepayment penalty then those funds that have no recycle provisions.
Covenants. Both senior and junior lenders all want covenants as a mechanism to monitor a company’s progress and test its adherence to plan. But, here again, if you are getting paid less interest, you want less risk and your covenant package is likely to be tighter than a lender with a higher interest rate. So while senior debt lenders often discount projections by 10-15% in deriving covenants, junior lenders’ discounts can approach 25% while unitranche lenders often “split the baby” and shoot for a 20% discount. Opting for more junior debt, while more expensive, may give the company greater flexibility, a particularly important consideration for borrowers operating in cyclical industries.
We’re always surprised when sponsors opt for the lowest interest rate product for their portfolio companies without fully considering the impact of the other terms and conditions mentioned above. It’s hard to believe that a 100-200 basis point difference in interest rates can make or break a fund’s equity returns. Plus, focusing on issues other than interest rate might make it easier for portfolio companies to achieve their strategic objectives and ultimately lead to higher IRRs.
Ronald Kahn is a managing director with Lincoln International. The opinions expressed here are entirely his own.