First West Capital - Mezzanine Financing and Subordinated Debt

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VP Kristi Miller presents financing from a banking and credit union perspective, focusing on alternative financing and business strategy,

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First West Capital - Mezzanine Financing and Subordinated Debt

  1. 1. Lending Principles,Subordinated Debt and Funding Changes of Ownership Fraser Valley Chartered Accountants’ Association
  2. 2. Kristi Miller, MBA• Vice President, First West Capital – 16 years in specialized commercial finance roles – Founding partner of First West Capital, a $60 million subordinated debt / mezzanine finance fund owned by First West Credit Union – Previously: • Investment Manager, Vancity Capital • Commercial Account Manager, CIBC • Investment Officer, EBRD
  3. 3. Today’s topics• Principles of Lending• The Financing Landscape – Risk / reward profiles – Who does what• What is ‘Subordinated Debt’ and how does it work?• How are Changes of Ownership generally financed?
  4. 4. PRINCIPLES OF LENDING
  5. 5. #1 - The 5 C’s of Credit• Character – Sense of responsibility, integrity, honour, ‘face’• Capacity (Cash Flow) – Can the borrower repay the loan? – Is this loan sound?• Capital – Net worth, outside resources• Collateral – Secondary source of repayment? – Is this loan safe?• Conditions
  6. 6. #2 - The Banker’s Dilemma• Sales v Risk Management – Who makes the lending decision? – How has lending changed over the years?
  7. 7. THE FINANCING LANDSCAPE
  8. 8. What to expect and from whom 25% HighCost of Capital Risk Level 15% FWC sweet-spot Med. Low 6% Senior Debt Subordinated Debt Equity (Op. credit, secured term, etc) (First West Capital) Unsecured & Fully Secured & Proven Earnings Unsecured & Unproven Cash Flow Proven Cash Flow
  9. 9. WHAT IS SUB-DEBT?
  10. 10. Cost of Capital• Senior debt – P+3% or less• Subordinated debt / mezzanine – prime + 9-12%, IRR of 15-20% all-in• Equity – target yields vary by age/stage/risk profile – Dilutive, not tax efficient
  11. 11. Types of Facilities• Short-Term & Working Capital Financing: – Line of Credit (Operating Line), Trade Credit, Leasing• Medium and Long-Term Financing: – Term Loans, Commercial Mortgages, Debt-Equity Hybrids (Subordinated / Mezzanine Debt)• Long-Term Financing: – Equity
  12. 12. A Do-Able Deal• Senior Debt: • Equity: – profitability & cash – Compelling market flow opportunity – Good quality security – Exceptional management• Subordinated Debt: – Range of opinions on: – Cash flow • Revenues – Strong & committed management • Cash flow – Interesting market • Profitability opportunity • Age / stage
  13. 13. Key Ratios• Importance of trends – consistent, strong, improving• Cash Flow – cash flow coverage - income statement approach • net income + non-cash items + discretionary items / debt service requirements • Min generally 1.15X, preference for > 1,25X – liquidity - balance sheet approach • current assets / current liabilities • Absolute min 1:1, stronger is better, preference > 1.2:1
  14. 14. More Ratios• Leverage – Debt to Effective Net Worth • ‘effective net worth’ = retained earnings + shareholder loans - goodwill - amounts due from related parties • lower is better : implies more risk assumed by principals – Max generally 3:1 • importance of relationship / history / profitability of group of accounts / potential for additional business
  15. 15. Due Dilly• Time Required • Subordinated Debt• Senior Debt – Profitability & Cash – Profitability & Cash Flow Flow • Three years’ financial statements (statement quality) – Management • Interim, in-house results – Market (management’s analysis) – Particularly important if FYE > September 30th – Security • Value of personal guarantee(s) • Real estate assessments • Aged A/R
  16. 16. FINANCING CHANGES OF OWNERSHIP
  17. 17. Population Pyramid
  18. 18. Financing Changes of Ownership• Includes MBO’s, Acquisitions and Shareholder Buy- Outs• A word on valuations• Capital structure elements: – Purchaser’s cash (or sweat) equity – Vendor take-back financing (VTB) – Bank debt – Subordinated debt • The ‘glue’ in buy-out transactions
  19. 19. A Case Study: Buy Me Inc.• Adjusted EBITDA of $700K• Purchase price of $3 million (4.3X)
  20. 20. Buy Me Inc., cont’d Uses Sources A/R $500,000 LOC (75% of A/R) $375,000 Equipment $2,000,000 Term Loan (50%) $1,000,000 Goodwill $750,000 Vendor (negotiated) $625,000 Payables ($250,000) Equity (purchaser’s) $500,000 Purchase price $3,000,000 Total financing $2,500,000• $3,000,000 - $2,500,000 = $500,000 shortfall• NO DEAL
  21. 21. Buy Me Inc., cont’d Sources Debt Servicing LOC (75% of A/R) $375,000 LOC interest at 6% $22,500 Term Loan (50%) $1,000,000 blended, 4 yr amort., 7%) $290,000 Vendor (negotiated) $625,000 interest only @ 8% $50,000 Equity (purchaser’s) $500,000 $0 Total financing $2,500,000 Total Debt Servicing $362,500• EBITDA is $700K so plenty of free cash flow left• But asset base fully encumbered
  22. 22. Buy Me Inc., cont’dSources Debt ServicingLOC (75% of A/R) $375,000 LOC interest at 6% $22,500Term Loan (50%) $1,000,000 blended, 4 yr amort, 7% $290,000Vendor (negotiated) $625,000 interest only @ 8% $50,000Equity (purchaser’s) $500,000 $0Sub-Debt $500,000 Blended, 4 yr amort, 15% $167,000Total financing $2,500,000 Total Debt Servicing $529,500• Sufficient CF to service additional sub debt• 4 year average return on shareholder equity of > 55%
  23. 23. The Perfect Deal• Reasonable valuation• Vendor inactive and drawing significant remuneration• Purchaser knowledgeable of industry / business• Vendor willing to carry some financing (signaling)• Senior lender supportive
  24. 24. Thank you! Kristi Miller, MBAkmiller@firstwestcapital.ca Desk: (604) 501 4264 Cell: (604) 996 2685

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