When we last left off, our valiant private equity firm had just signed a letter of intent to buy their favored widget company for 7.0x EBITDA and was off trying to find the financing.
The company, with $300.0 million in sales and $20.0 million of EBITDA, did have a few blemishes. It had some customer concentration, 2009 was a down year (but who didn’t after the throes of a recession), and 2010 earnings were after $3.0 million in adjustments for the elimination of some unprofitable business lines and a plant closing. But with a substantial equity contribution and a good backlog heading in to 2011, the PEG was confident that obtaining 3.0x senior debt and 4.0x total debt was a cake walk.
Or so they thought!!
The private equity firm first contacted their favorite senior lenders. What – several were out of business and others had laid off their favorite lending officer! And those that still had capital to lend just couldn’t get over the customer concentration. And those 2010 proforma adjustments! And it only had 6% EBITDA margins, less than their threshold requirements of 10%! What did they know? We’ll just find some new relationships.
So they contacted some new providers and, what did you say – you like the credit but can only provide a $15.0 million participation so you want me to cobble together 4 lenders for my $60.0 million senior tranche. Ok, I can live with that but I need to get all of you on the phone to finalize terms and, wait, someone wants more amortization, and someone else wants a higher prepayment penalty, and still someone else wants a higher up front fee. And then I need to add a layer of mezzanine at 15% interest with a co-investment right!!
Hold on – this is way more that I bargained for. What is a private equity firm to do!!
So the private equity firm contacted their friendly investment banker who told them about this new structure that combined a senior asset based facility with a unitranche term loan. ABL lenders were lining up down the street to provide the company with advances of 85% on accounts receivable and 60% on inventory at a rate of L+ 275 with no libor floor.
But that still left a sizable hole to fill. So the investment banker introduced the PEG to a unitranche lender who, after visiting the company, provided the company with a term sheet that completed the capital structure, without the need for additional participants. The unitranche lender understood that the restructuring costs the company incurred resulted in more consistent and predictable earnings. He also knew that, in the widget industry, customer concentration was inevitable and margins never exceeded 8.0%. And the PEG was surprised that he was actually able to talk to the unitranche lender rather than to a senior debt marketing officer who had to relay the information back to a faceless credit committee.
Yes, the unitranche had a first lien on all the company’s assets other than accounts receivable and a second lien on the accounts receivable and inventory behind the senior lender. Pricing was a little more expensive at 10 – 11%, but when they compared the weighed average cost of capital to the traditional senior cash flow plus mezzanine pricing, it was almost identical. And with modest first year amortization, a 103, 102, 101, prepayment penalty, 2.0% upfront fee and covenants set at 80% of base case projections, the PEG knew they had a new best friend.
The moral of the story? While senior cash flow is becoming more readily available, credit screens continue to be tight. Meanwhile, asset managers, BDCs, and hedge funds have found that the unitranche structure is a great way to compete with their senior debt and mezzanine brethren by providing large hold sizes, a competitive cost of capital with better terms. And a face that private equity firms can see and talk to!!
Ronald A. Kahn helps buyout firms secure debt for acquisitions and related transactions. Reach him at firstname.lastname@example.org