The Pros and Cons of Leveraging Debt
Back in 2007/08 at the heart of the financial crisis you can imagine the word ‘leverage’ was only ever whispered in the corridors and meeting rooms of banks for fear it might be considered too high a risk. However, with the passage of time and reflection on the risk and monitoring structures in place, the realisation was that ‘Leveraged Finance’ still has its place in many of the banks markets, including for some, the SME sector. Some of this space has also been filled by new challenger banks and funders.
So what is Leveraging Debt?
Leverage, in the true sense of the word is a business’s debt to asset ratio – the higher the ratio the higher the leverage. By definition, all debt is leveraged and lenders will consider the leverage position of any business when lending. However, it tends to come under a closer microscope when being used for Management Buyouts and Acquisitions and therefore, specialist Leverage Finance bankers will often be called in to structure and review the transaction. In such transactions, there tends to be a strip of unsecured debt which is leveraged purely against the ‘goodwill’ of the business rather than any underlying asset e.g. secured by property or a debtor book. As with all lending decisions Leverage Finance comes back to quality of the Management Team, USP of the business, strength of the cash flow and the ability of the borrower to repay.
Sounds very high risk?
With any borrowing there is a risk, however, funders and businesses can mitigate much of that risk through sound due diligence to establish confidence in future cash flows. By leveraging debt businesses can raise finance for acquisitions and growth or, allow shareholders to exit and retire, without giving up unnecessary equity to external parties. With a strong market position, a good management team in place and sound historical and forecast cash flow, then the benefits of an acquisition or MBO through leveraged debt, can be significant and the pitfalls safely navigated through.
What are the benefits of Leveraging?
Firstly, outside of Trade Credit or discounts, and some deferred structures, debt is generally the most cost effective form of capital for any business to raise. Of course, unsecured Leveraged Debt is more expensive than traditional asset backed debt however, it is still a ‘debt risk’ and not an ‘equity risk’. What determines ‘debt risk’ is its ability to be repaid typically from a level of cash flow historically generated by the borrower. Consequently, a key benefit is that it provides cash for growth without having to dilute shares or tie up existing cash in the business.
“Tomorrow we will be millionaires!”
We’ve heard that somewhere before! – unlike equity, debt often needs to start to be repaid immediately from ongoing cash flow and therefore accurate and detailed forecasting is vital (not that they shouldn’t be all the time!). There are, as ever, exceptions to this rule such as with ‘bullet loans’ and ‘mezzanine finance’ however, that is for another day and ultimately even then cash flow or potential to refinance needs to be evident from the start, so the principles are similar.
Equity, on the other hand, is often exited on sale of the business, so has less of an impact on cash flow and relies on future value creation and longer term success of the business. That’s not to say in many transactions a combination of all forms of capital may need to feature. The key is to remember – debt often starts to repay within a month or so of drawdown, therefore the business must be generating the cash necessary to meet repayments at the point of lending and not at some point in the future – the latter is ‘equity risk’, not ‘debt risk’. Banks will often throw cold water on the ‘hockey stick’ forecasts and the promises of great results down the line. Conversely, equity investors are often looking for the ability of a business to grow fast.
What are the downsides?
With any business that uses debt for an acquisition or an MBO, the business is then in a period of, what I refer to as, ‘an unnatural state’ of finance. In many cases the cash from the funding has been raised not for investment of assets into the business (i.e. to buy a property or piece of equipment), but has instead been paid straight out to an external party (the Seller / Vendor) for the ‘goodwill’ of their business. As a result, the level of debt in the business is not necessarily in line with its asset base or that of its competitors. Instead the business has high levels of, as yet, unrealised ‘goodwill’. It is therefore vital that the business focuses on repaying this debt as quickly as possible and regains its ‘natural state’ of leverage.
Too much debt can be exhausting on a business. What if there is a ‘sector’, ‘market’ or ‘general economic’ shock, loss of supplier or customer? How would the business compete if a competitor dropped their prices? You can’t always just sell an asset to deleverage, particularly if that asset is ‘goodwill’ that has not materialised. What if interest rates rise?
The leveraging of debt therefore needs to make greater commercial make sense, e.g:
- allows management to take control of the business from non-active shareholders or;
- the acquisition delivers greater returns through synergies;
- reduces competition;
- provides access to new markets or skills;
- creates a greater valuation multiple as a combined entity;
- can be repaid within an acceptable period;
- does not over-stretch the cash flow of the business.
if so, it can be a very powerful tool.
When will the banks provide Leverage Finance?
Given this is higher risk debt, it is typically only available for businesses who have a sound level of historic cash generation, capable management team with a clear strategy, a robust and defendable business model with strong USPs and barriers to entry. Typically, funding requests of this nature are a minimum of £1m. Banks will also want to exhaust all other sources of finance such as Invoice and Asset Finance, Commercial Mortgages etc. before placing in a strip of Leveraged Finance. Consequently, banks will be looking for businesses with a cash flow capacity to fund such structures. The cost of providing such debt can not always be economically viable given the potential need for external due diligence, but that is not always the case.
What are my alternatives?
In many cases, proper structuring of the deal through deferring payments to vendors and traditional sources of debt such as Asset or Invoice Finance can ensure a successful transaction without need to seek highly leveraged finance. However, if there is a funding gap this is where Challenger Banks, Peer to Peer and Investment Funds such as those announced recently by the British Business Bank come in to play. However, the principles are the same:
- will it deliver the benefits to the business?
- is it the right funding partnership?
- how will the funder behave if the business has a problem?
- is it the right funding instrument for purpose needed?
- is my business structured correctly?
- what are the alternatives?
- how do I repay / exit?
- and what equity, if necessary, are you prepared to give up.
- etc etc etc…..
Leverage Debt has its place to allow your business to grow or allow shareholders to exit. It is often less expensive but less flexible than equity. It needs carefully planning and forecasting and also needs to be seen as a part of a wider strategy, considering other potential funding solutions and where possible, repaid as quick as possible.
Why do I need Advisors?
Well here’s just a few reasons:
- given the potential risks, the funders will require a greater level of scrutiny and diligence in the preparation of the detail they require.
- the deals also need to be structured correctly with the right balance of risk and areas such as plan B’s and sensitivity analysis considered.
- before all of that, it is also important the business is in the right place and its key risks are mitigated, the board structure has the necessary skills for the future and the business has a clear strategy and rationale for the proposed transaction.
- the deal needs to be negotiated properly and an external party will help negotiate the terms such as vendor deferred payments and warrantees.
- the business is likely to be going through a major event in its history and so it is important to get it right and get the best structure from the outset.
- there will inevitably be a demand on Senior Management time, but nonetheless they need to focus on the existing business and to start planning for integration or a future without the former owners.
- business owners often focus on the cheapest and not the right structure for the business. This can cause significant problems down the line and potentially can be even more expensive or cause a poor relationship with its funders in the long-term.
- finally, but not least, it’s a confusing and complicated market and can often lead to a poorly capitalised or structured financial package.
So, take your time and take some advice.
Hanlon Corporate Advisory Ltd
I would be delighted to assist you in your fund-raising requirements, be that for an acquisition, management buy-out or for general growth and cash flow management. I can tailor my support to the needs of your business, be that a full advisory service, preparation of a funding proposal or an initial review and comment.
Please give me a call or email me at – email@example.com / 07899 982877 and we can discuss what is appropriate for your business.