Alternative Lending - Junior Capital & SLBs

Current Market Rates:

Prime Rate - 8.50%

Prime Rate 1 yr. Ago - 8.50%

Secured Overnight Financing Rate (SOFR) - 5.33%

Good afternoon,

As we continue into the later part of summer, we hope that everyone is experiencing a prosperous year. The levels of activity continue to intensify in the transaction world, though nowhere near the levels reached in 2021.

We continue to have conversations with closely held business owners and they are seeking solutions to issues surrounding transfers of ownership and succession planning.

We have talked to business owners looking to grow through acquisition and seeking solutions to fund those acquisitions, business owners seeking to fund operations as they stabilize after an "off" period, developers looking to build new projects and seeking lenders who are actually interested in ground up development from new customers, and borrowers who are just exploring their options. Although funding can be difficult to come by from traditional sources, at least with reasonable advance and interest rates, there are alternatives available to fill the gaps.

On the M&A front we continue to talk to business owners looking for a solution to their lack of a well-developed succession plan. Many are interested in exploring a reasonable valuation for their business in anticipation of their desire?to retire. That being said, we are not seeing sellers recklessly going to market. They are being strategic, evaluating their next best step, and when they do move forward they are well informed and cautiously optimistic.

Buyers remain interested in qualified opportunities. Private equity, family offices, and search funds continue to seek both platform investments and strategic add-ons to existing portfolio companies. Corporate buyers continue to seek opportunities for growth and sometimes the easiest path to growth is through acquiring a company with a book of business. We are finding strategic buyers to be more prominent than the industry generalists we have seen in years past. In general, there's significant opportunity for companies to find good partners and qualified buyers.

As previously mentioned, based on the amount of activity we are seeing we expect the latter half of the year to be vigorously busy. Our conclusions are further?bolstered by the conversations we are having with our many friends and colleagues in the transaction world.

In this month's newsletter, we discuss a couple of alternative lending sources that can be used for growth or acquisition financing. In today's competitive market, having a solution to bridge a funding gap in a transaction other than just a seller note can be the difference between winning a transaction and losing it to a competitive bid. Junior capital and sale leasebacks can be those solutions.

Alternative Forms of Lending

Junior Debt

As Consolidation continues within the banking world, and bank regulators penalizing anything other than a conservative approach to commercial lending, a multitude of non-traditional lenders have emerged to fill the vacuum formerly occupied by creative commercial bank lenders.?That’s not to say that bankers today do not want to get creative, but rather the box they are trying to fit deals into have shrunk from even a few short years ago.?Today we will focus on a couple of unique alternatives, second lien and cash flow lenders, as well as proceeds generated from a sale lease back of equipment or real property.

Subordinated or junior debt falls into two categories.?Second lien (stretch)?lenders and cash flow lenders.??

Stretch lenders, those that will lend up to 100% of the value of the collateral - usually orderly liquidation value, took a beating in the Great Recession that began in 2008 and lasted through much of 2010.?As a result, there was a move towards “safer” investments and there are fewer stretch lenders today.?Those remaining fill the gap left by senior lenders, commercial banks and asset based lenders, that might be unwilling to extend an ”overline” needed to close a loan using formulas related to advances against accounts receivable, inventory, and equipment.?

This is junior debt and requires a subordination or interparty agreement between the two lenders.??Intercreditor agreements can be a problem for the borrower as the discussion does not involve them, just the senior and junior lenders.?While intercreditor agreements are common, sometimes lenders and their attorneys have different thoughts about how the agreements should work and who has what rights in the transaction.?We do commonly, but not always, see the parties work it out in the end as everyone wants to see the transaction come to fruition.

True Cash Flow lending has evolved today to encompass providing not only loans but minority positions in the borrowers’ shares.??We will limit this discussion to the providing of junior debt, but the due diligence process is similar for unsecured junior debt or minority equity.?

These lenders are providing funds based on management’s ability to consistently show returns sufficient to service the debt and repay the loan.?

Earnings may result from the Intellectual Property (IP) owned by the borrower or simply the workings of an outstanding management team.?Borrowers are showing renewed interest in this type of funding as many of today’s most profitable businesses are not heavily dependent on plant and equipment to produce a profit.??Thus, they have little to provide for collateral required by a traditional lender.?

The due diligence process encompasses lending formulas, the evaluation of intangible assets, the history of profitability, and the ability and character of the management team.?When it comes to cash flow lending the lender has to really have trust in the borrower as they don’t have much to fall back on in terms of collateral.

In addition to an interest rate, the lender expects to receive Equity in the form of stock options or outright grants.?If the borrower is unwilling to provide equity, the lender can accept a participation in revenue or some other equally safe return.?The equity or shares acquired by the lender can be redeemable at some future date.?Frequently the lender has a “put” for the shares it has acquired.?

If there is a senior lender there will be a third party or subordination agreement between the two lenders.?Costly money but a good alternative for many of today’s borrowers.

A Uni-Tranche lender provides both senior and junior debt.?They may also provide additional capital by purchasing minority shares.?This type of lending has become more normalized as the blended rate of the equity, junior debt and senior debt can be more competitive than just one of either junior debt or equity.?We have numerous sources for this type of funding and believe it to be a tool that is often overlooked.

If you would like to learn more about how we can assist in locating junior capital, call or e-mail one of our associates whose numbers and addresses are listed elsewhere in this Newsletter.

SALE AND LEASE BACK OF REAL PROPERTY (SLB)

We are experts in creating liquidity solutions for our clients.?That means locating funding from all available sources.?Having said that, rest assured that Mid-States Advisors is not a proponent of over-leveraging a business.?So what are the alternatives??

Quite different from cash flow lending, Sale Lease Backs are utilized mostly by Buyers needing to extract the maximum amounts of Cash from the available collateral.

There is often hidden value in the real property acquired when purchasing asset heavy business such as manufacturing businesses.?Many of these buildings are older, and while still useful, owners are valuing their businesses using the common practice of determining a sales price based a multiple of EBITDA and part with these properties at a discount from their real value.?

The sale price of the real property in this kind of financing, is a function of both the Appraised Value and the Returns offered due to a lease executed by the new owners in favor of the SLB buyer.???SLBs allow the buyer of the business to part with the building in exchange for a market rate lease (likely above market), creating additional “equity” for the transaction to go through.?While this kind of funding has been quiet for years, we have seen a resurgence of “buyers” willing to provide it in recent years.?

Sale Lease Backs are not for everyone.?But there are instances when it is appropriate and relatively risk free, i.e. a management buyout where the acquirers who are already running the business do not have the available capital to complete a transaction.?This is only one example.?

We know SLB buyers and can quickly assist in arranging this kind of funding.???

If you are interested in learning more about this funding source, give one of us a call and we can share more details.

We welcome discussion and commentary on this or any of our Newsletter articles. If you would like to discuss our services in more detail or to discuss the content in today's newsletter, please contact us to learn more about how we can assist your company or client.?

Below are the direct phone numbers and emails for a Mid-States team member who would love to connect.

Joseph P. Alam III - Managing Director

[email protected] | (313) 670-5713

Joe Alam Sr. - Senior Advisor

[email protected] | (313) 215-1700

Fadi Sadik - Senior Analyst

[email protected] | (248) 808-1055