Coronavirus makes a strong case for structured capital


Businesses in the lower middle market and mid-market are facing unprecedented challenges as the Covid-19 pandemic continues to unfold. It shouldn’t surprise anyone that these segments of America’s businesses – many of which are owned by private equity sponsors as portfolio companies – are particularly vulnerable. Depending on industry focus and value proposition, these businesses are facing a more rapid, precipitous drop in revenues than in any other previous market downturn, as well as greater uncertainty about future earnings.

While help is underway — the Government’s new round of $310 billion in Paycheck Protection Program financing available under the Small Business Administration, as part of the (Coronavirus Aid, Relief, and Economic Security (“CARES”) Act), is designed to provide much-needed relief to the millions of these businesses that make up the vast proportion of the country’s economic fabric – but it is questionable how much relief these lower middle market and mid-market companies owned by private equity firms can actually expect to receive.

For middle market private equity dealmaking groups that invest in these companies, the prospect of diminishing returns is far different than the vibrant growth many of these businesses experienced following the global financial crisis. Executives at these private equity firms and their investment banking advisors have pivoted from doing deals to focusing on shoring up their portfolio companies, even turning to specialized business advisory firms.

Now, four months after the U.S. economy was on the upswing at the beginning of the year – in growth mode and seemingly near invincible – a global pandemic has hit America hard. Global businesses – including the large universe of small to middle market-sized businesses have taken measures to cut costs domestically and worldwide, and private equity new deals are on hold and the direct lending market that makes dealmaking possible has nearly ground to a halt as founders, deal-makers, M&A bankers, private equity sponsors and law firms that serve the mid-market community grapple with uncertainty.

What tends to happen in economic downturns is that traditional sources of capital – bank loans, term debt, revolving credit facilities and asset-based lending – dry up. That, in turn, feeds into deal activity and valuation levels. Facing increased volatility, diminishing earnings prospects and possibly being able to acquire companies at lower valuations, private equity sponsors have delayed deals that would have been supported by direct lenders.

These developments, coupled with the lack of debt financing, raise an interesting question: as private equity sponsors sit on the sidelines, what private investment strategies are left to fill the void in capital amid the heightened market volatility?

Finding the right capital solution
There isn’t a one-size fits-all approach available to meeting the capital needs of every company – small, middle market or otherwise – during a market dislocation or economic downturn. However, in a rapidly de-accelerating market environment, the ability to obtain creative, flexible capital solutions that support a company’s growth in its target industry as well as address small business owners’ concerns and priority objectives should be considered more closely.

Structured Capital – often structured as a combination of 75 percent subordinated debt and 25 percent equity in a typical transaction – is a form of growth financing that can serve as a lifeline for smaller and mid-sized businesses, while allowing a founder or management team to retain significant equity.

For growth-minded entrepreneurs concerned about ownership stakes and governance rights, non-sponsored structured capital is an especially appealing option because it helps them avoid the dilution that occurs in connection with investments made by growth capital funds and traditional private equity deals, which both require more equity. Structured capital, on the other hand, leaves stakeholders with more equity and governance rights, and is less dilutive.

Unitranche and mezzanine financing are often talked about, but both lack the features of structured capital. The former is constructed with different types of debt financing, while mezzanine providers are primarily focused on providing debt to support private equity acquisitions.

Structured capital is advantageous because of its flexibility which enables it to be made up of a variety of different investments, such as the inclusion of pay-in-kind (“PIK”) debt along with subordinated debt, junior term debt, senior debt and/or common and preferred stock. One reason PIK notes are helpful to a company is because they enable a business to preserve cash by allowing it to make interest payments through the issuance of additional debt securities instead of cash. This lets the borrower preserve cash for other uses, including future debt payments. As such, structured capital is an attractive alternative even to the lending program proposed under the CARES Act.

Because of the different way these investments can be structured, a company that undergoes a structured capital investment is typically left with lower leverage levels. Generally speaking, this works out to about four times cash flow (“EBITDA”) as compared with private equity-sponsored transactions that often leave a business with 5.5 or more time debt-to-EBITDA. That means a company has more flexibility and less debt to pay down than it would from a private equity investment.

That should also be attractive for smaller businesses, especially for many of today’s asset-lite and high demand companies spanning the business services, healthcare IT, information and digital education sectors. These companies typically don’t have the same access to term loan, revolving credit facilities or asset-backed debt as larger consumer products or manufacturing businesses.

In short, structured capital financing is unique in that it is a whole solution for growth-minded entrepreneurs, founders and management teams at lower mid-market and middle market businesses as compared with large cap companies that would typically turn to banks for financing.

Economic Deterioration
At the start of 2020, market observers were discussing a potential recession. That talk seems quite dated in light of current circumstances. Goldman Sachs issued a report in mid-March that noted America’s GDP could shrink by 5 percent in the second quarter.

Private capital investors that have experienced difficult market cycles understand the natural impulse to take flight from risk during economic dislocation or when facing strong macroeconomic headwinds. It’s important to remember that volatility in the capital markets is one reason why there’s been a big flight of capital towards the private markets over the past decade where the perspective is long term and not easily swayed by whipsawed public markets.

To be sure, the demand for flexible capital solutions will only continue to grow as founders and management teams of small and mid-sized businesses learn more about the benefits of this little discussed type of capital. What may make the difference in the road to economic recovery post-pandemic is better understanding one corner of the private markets that’s been long overlooked – until now.