Gear Up for the Refinancing Wall

Posted by John Slater on November 14, 2011

Remember the fall of 2009? We had just survived the worst financial crisis since the Great Depression and the stock market was enjoying the early stages of a very powerful bear market rally. We could all breathe a great sigh of relief. Of course a few party poopers were still around to remind us in articles like this one published by the Wharton School that a mountain of debt built up during the bubble years of 2006 and 2007 would need to be refinanced by the middle of the next decade. This debt, measured in the trillions of dollars, encompassed both commercial loans–many generated to support highly leveraged buyout financings–and commercial real estate funding.
Chart: Distribution of leverage loan maturities, 2010-2018
Source: Ancala.com

No need to worry, 2012 was a long way in the future. Well that future is now and Wall Street is again teetering on the brink of panic. Many firms that survived the crash have seen their profits–if not their revenues–return to past highs. Large profitable corporations have successfully refinanced much of their debt with very low cost long term bonds. For much of 2010 and the first half of 2011, strong high yield and leveraged loan markets enabled even middle market firms to stabilize their debt with relatively low cost funding as well. So the question is, “Have we dodged the bullet?”

Unfortunately, two recent reports answer the question with a resounding NO. The Financial Times, in an article entitled “Door Slams Shut for Corporate Have-Nots,” describes a two tier world in which a few very strong companies like Apple Inc. have taken advantage of the recovery to build up tremendous hordes of cash. On the other hand, weaker firms remain overleveraged and at extreme risk in the event of another financial crisis or a material rise in interest rates.

To accentuate the depth of the problem, KPMG recently published an in depth study entitled “The Refinancing Wall,” estimating that corporate debt maturities from 2011-2015 total $5 Trillion worldwide and that LBO maturities from 2011-2016 total almost $1 Trillion. Add to this approximately $2.75 Trillion in commercial real estate maturities and a market experiencing strong worldwide competition for funds to finance government deficits. We can reasonably anticipate that there will not be enough chairs in the circle when the music stops.

What does this mean for the lower middle market? Traditionally, commercial banks have been the primary source of funding for firms under $100 million of revenue. Since the crash, many banks have been merged out of existence or have exited commercial lending. The commercial lending capacity that remains, including both human and capital resources, will be heavily focused on workouts and restructurings for the next two to three years and will not be available to assist smaller companies with financing, no matter how promising their opportunities for growth.

Now is the time to prepare for the day when you, as a business owner, excitedly call your friendly and fresh faced loan officer, “Alexandra Silvermore,” only to find that she has been replaced by “Gustaf Bonbrecker,” who was recently assigned to commercial lending following a four-year stint in special assets. So what are the alternatives for a sound, growing lower middle market manufacturer, distributor, or service firm?

  1. Asset Based Lenders (ABL)have traditionally filled the void left when traditional commercial loans are no longer available or adequate for the needs of a growing company. ABL providers rely primarily on the liquidation value of their collateral to provide assurance against loan losses and are not overly focused on the borrower’s profitability.  In recent years ABL providers have become much stricter in underwriting the credit of their borrowers and in assuring the quality and value of their collateral. Additionally most ABL providers are not fond of fixed asset collateral such as equipment and real estate. Term loans collateralized with such assets are generally financeable by ABL providers only as a small percentage of a larger loan facility comprised primarily of inventory and receivables.  

    The cost of ABL financings in the current market ranges from highly competitive interest rates in a range of 2-3 percent over the London Interbank Offered Rate (Libor) for the strongest borrowers with larger financing requirements ($10-15 million and up) to all in costs, including interest and various fees, that can range into the high teens for overall financing costs and we have seen even higher rates charged to clients with great cash flow, but limited financing flexibility. Most ABL providers want to see a minimum funding need of $5 million plus, with leading players like PNC, Wells Fargo, and USBank targeting needs in the $15-125 million range. A few specialized lenders will provide funding down to the $2-3 million range, but price their offerings accordingly. For more details on the ABL market, read Bob Beard’s in depth coverage at www.capmatters.com. 

  2. Mezzanine Lenders have traditionally filled the gap where asset based loans do not fill the entire need. The term mezzanine is derived from the positioning of these loans in a borrower’s capital structure between senior debt (frequently ABL) and equity. Mezzanine lenders generally look to the cash flows of a business as their primary source of repayment, though some mezzanine lenders will take second lien positions as well to enhance their potential for recovery in a bankruptcy. Mezzanine loans are traditionally structured with a five year term, interest only with a principal bullet at maturity. Current pay interest is generally in the range of 12-13 percent with additional yield in the form of payment in kind (PIK) interest of 2-3 percent.Depending on the credit quality, the size of the facility, and other factors, the mezzanine lender may or may not require equity warrants to enhance their yield. Generally in the lower middle market, mezzanine lenders target total annual returns ranging from the mid-teens to low 20 percent range. Larger facilities can be more competitive with targeted yields in the low teens. Several billion dollars of new mezzanine capital has been raised in the past twelve months, providing adequate liquidity for those borrowers for which this type of funding works.The most important constraint is that the mezzanine lenders generally are very rigorous in demanding that their borrowers have good histories of adequate cash flow to cover anticipated debt service. This can pose a challenge to firms hit by the down cycle in 2008-2009. Also, for lower middle market firms, this means that total leverage (senior and mezzanine) cannot exceed 3-3.5 times cash flow with outliers at either end of the range depending on credit quality, growth prospects, etc.

  3. Tranche B or second lien financing developed in the late 1990s to meet a desire on the part of many borrowers to minimize equity dilution from mezzanine warrants. These structures often piggyback on the senior loan structure, but carry a full subordination to the senior. In the current market, such subordinated debt will typically carry a yield premium of 4-6 percent over senior debt. Tranche B loans were commonplace in the 2005-2007 timeframe as billions of hedge fund and CDO funding poured into the market. With the collapse of the shadow banking system in 2008, only a few of these funds remain active today and many of those that do are more focused on unitranche funding as described in item six below.

  4. Growth Equity financing is increasing filling in gaps for quality firms for which senior debt plus mezzanine is not sufficient. Many mezzanine firms have recently included such financing as a standard part of their package, in some cases as well as to enhance the credit quality of the mezzanine piece. Growth equity usually takes the form of preferred or common stock (or a member’s interest with equivalent priority positions in pass through entities). The preferred stock will generally carry an expected dividend coupon, often with a PIK feature to minimize the cash flow impact. In general growth equity financiers are seeking annual returns ranging from the mid 20s to the mid to high 30s depending on perceived risk, opportunity for growth, etc.

  5. A variety of governmental programs are in place for smaller companies to fill the needs served by growth equity as well as mezzanine financing. These include federally subsidized SBICs as well as a variety of state sponsored programs generally described under the category of business development companies. Financing structures and cost of funds are not dissimilar from the cost of commercial fundings, with federally mandated yields caps sometimes generating lower costs of funds than the commercially funded vehicles.

  6. “Unitranche,” a term for a relatively new category of lender, ends our list. Unitranche lenders have raised billions of dollars to fill the gap left by the cutbacks in traditional bank commercial lending. In many cases, today’s unitranche lenders evolved from the remnants of the tranche B market. These firms simply reallocated the funds previously deployed to subordinated lending and moved them into senior debt structures (often without reducing their pricing) because the market allowed them to do so. Their borrowers benefit from increased flexibility and shorter underwriting times as compared with bank loans, but the price paid is a higher funding cost than senior bank loans.Depending on the credit quality of the borrower, unitranche lenders generally seek current yields in the 9 percent range at the low end and more typically carry current coupons in the 12-13 percent range. Additional PIK features and/or warrants may drive total funding costs to the mid-teens or even higher depending on credit quality of the borrower. Unitranche transactions are generally secured by all the borrower’s assets and may or may not be monitored on an ABL basis.

We’ll be publishing more details on each of these categories in coming months at www.capmatters.com. With the challenges that lie ahead for the commercial loan market, we anticipate rapid evolution in the alternative lending markets.

ABOUT THE AUTHORS: John Slater, a FOCUS Partner and Team Leader of the FOCUS Capital Financing Team, has spent more than thirty years assisting private companies in meeting their alternative financing needs.

Bob Beard, a FOCUS Managing Director and a member of the FOCUS Capital Financing Team, spent twenty-five years as an asset based lender.

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