In the wake of the COVID-19 stay-at-home orders, business owners should examine their company’s liquidity position and assure availability of staying power, whether or not there are additional waves of shutdowns. In this environment, it is critical to have sufficient liquidity to be both offensive and defensive with a business.
Planning for an Uncertain Future
Owners should first reassess strategic plans and adjust them for various scenarios, both the current and possible new realities. Create a variety of different scenarios to determine where both downside risks and opportunities are in the plan. Once completed qualitatively, owners will have a firmer and more flexible view of how this new plan could play out over the next 12 to 18 months in the form of a financial forecast; this forecast can be used to put the plan to life. Along with an objective assessment of team’s abilities and fit, companies often find that capital will be required to execute a new plan.
Below is how capital structures look:
Capital Structures: Liquidity Options
From the top to bottom of the right-hand side of the balance sheet, the tradeoff in capital structure is one between security of repayment and cost of money.
| Cost of Capital | Term | Underwriting Process | Other | |
|---|---|---|---|---|
| Line of Credit | Lowest of alternatives, interest rate tied to LIBOR or Treasuries | Less than one year | Diligence into Borrowing Base of Collateral, forward looking forecast less important | • Must be renewed every year • Availability limited to a Borrowing Base, which might fluctuate month to month |
| Term Loan | Lowest of alternatives, interest rate tied to LIBOR or Treasuries, although slightly higher because of longer term length | As long as 30 years for Real Estate, otherwise three to seven years | Full diligence into history, future cash flows, asset appraisals | Availability will take ratios of Adjusted EBITDA and coverages of debt service into account |
| Mezzanine Loan | • High single digits, low double (7-10 percent) for a current pay • May have a warrant attached to sweeten return | Five to seven years | History of sufficient cash flow availability to service and repay loan. Process will examine prospects and forecast | • Interest only until maturity, may have a cash flow sweep feature • Availability will take ratios of Adjusted EBITDA and coverages of debt service into account |
| Preferred Equity | • May have a dividend coupon (5-7 percent) to provide ongoing servicing • All in return forecast to investor in the low to mid-20 percent | Five to seven years | Full diligence process into company history and prospects and financial forecast | • Sits above common equity in liquidation or exit • Appropriate structure for growing companies without historical cash flows • Company taking on a “partner” • Availability will consider current market valuations |
| Common Equity | No current coupon, investor targeting mid-30 percent returns | No term, but most investors have fund life that can force liquidity event | Full diligence process into company history, prospects and forecast | • Company taking on a “partner” • Availability will consider current market valuations |
Regulated Credit Markets are Inwardly Focused: What Does this Mean for Businesses?
How urgent is the need? If capital is necessary for survival or to weather a storm of unknown length, then the price of money becomes less important than securing capital to hang in there. Business owners should analyze how their business will be prepared for whatever may come their way – positively or defensively – and position the business to stay at lowest end of the cost-of-capital range as they can.
While the regulated capital markets have been in a freeze since the beginning of the stay-at-home orders, a select few regulated banks have voiced that they aggressively want to look at deals. Regulated banks are both keeping a wary eye on their loan portfolio’s customers and they have also been at the front lines on the PPP programs, all at the same time. Not only are they taking a wait and see attitude on the broader picture, staying available to existing customers is a prudent bank strategy.
Until its expiration date on August 8, there are still funds available under the PPP loan program designed to provide immediate liquidity to challenged businesses. This program provides generally forgivable loans for short-run needs. A new CARES Act program, the Main Street Lending facilities are specifically designed for companies that will be able to demonstrate a recovery after shutdown orders begin lifting.
Because regulatory-backed credit is still less generally available than before the stay-at-home orders, interest rates (long and short) have increased for the sudden changes in the markets. There has been recent contraction in availability ratios for lending as well as multiples for valuation. Consequently, companies seeking credit in the near term, will pay more for money than by waiting out a general reemergence of regulated credit into the market; it is uncertain when and if there will be a return to valuation multiples that existed prior to the onset of the pandemic.
Other Considerations
How much capital is needed? The more capital owners want to raise at any one time, the more alternatives exist. With fewer capital providers focused on smaller tranches (e.g., less than $10 million), those deals tend to cost more than larger size deals. Over $10 million in issue size opens up additional private markets that may otherwise be unavailable. It is the same with absolute $Adjusted EBITDA. Having LTM Adjusted EBITDA greater than $5 mm is perceived to be a less risky bet, so an articulated COVID-19 analysis will go a long way if there is tangible evidence of sales and EBITDA margin improving as businesses ramp back up.
Business plans that show the following will access lower costs of capital than those that do not:
- Strong management
- Low customer concentration, not in businesses that have experienced substantial change with the shutdowns (e.g., brick and mortar retail, dine-in restaurants, etc.)
- Good reporting systems
Does your business have an articulated Use of Proceeds?
- Why do you need the money? Is it a well thought out strategy that is being presented?
Be prepared to answer the question:
All capital providers are looking to get their capital back plus a return, so have a proposed exit strategy for their money articulated. For equity capital, a sale of the business will always be on the table.
Where Will Business Owners Find the Liquidity Needed?
Regulated banks as well as alternative lenders are good sources for secured lending at the top of the stack; while alternative lender cost of capital might be higher than a regulated bank. These funds usually have lighter covenant requirements and more flexibility than a regulated bank. There are private funds dedicated to providing Senior, Mezzanine, Preferred or Common Equity. These funds are always on the lookout for solid investing opportunities. Some regulated banks offer mezzanine loans from the non-regulated lending side of their balance sheets.
In general, particularly if capital requirement is >$10 million, business owners should engage an investment banking advisor. While owners will pay a fee that is heavily weighted toward the successful closing of the deal, a good advisor will know all of the best, targeted sources of capital and use their experience to secure the best terms. Additionally, the advisor will run an “auction” among capital sources to ensure business owners get the most competitive cost of capital and terms. Not all advisors have dedicated private placement teams; seek one out that does.
What Should Business Owners Do Now?
Planning where liquidity in the capital stack can be secured will dictate the level of preparation that will be required. As owners move down the capital stack, the more forward-looking owners will need to be to secure greater risk priced capital. As well, business owners will need to be prepared for a more and more invasive diligence process. Lack of preparation will increase time-to-close, cost of capital and maybe even an ability to close the deal.
The GHJ Transaction Advisory Team have backgrounds as former investment bankers and are uniquely qualified to both understand the markets owners are seeking as well as providing the necessary preparation for an efficient capital raise.
Additionally, if you have any questions on the above, GHJ’s COVID-19 Response Team has as an experienced team of consultants specializing in COVID-related laws and programs and can provide the tools your business needs to help it recover from this business disruption. We are here to assist organizations to succeed in these very challenging times.
