July/August 2016

View from the Mezzanine: How Structured Finance Can Spur Growth for Middle Market Companies

A structured capital strategy, combining debt and equity securities, can give smaller businesses more flexibility in the current lending environment where traditional bank finance remains constrained and restrictive. David Bainbridge explains how this approach can spur growth for middle market companies.



David Brainbridge, Managing Director, Veronis Suhler Stevenson

David Brainbridge, Managing Director, Veronis Suhler Stevenson

The combination of a rebounding economic climate with heightened regulations and a tighter lending environment has made it harder for small- to mid-sized business owners to obtain funding to support growth. Current economic restrictions have made the senior debt and revolving credit lines traditionally used to fund strategic initiatives largely unavailable for North America’s lower mid- to middle-market businesses.

That’s where structured capital — an amalgamation of securities such as subordinated notes, preferred stock, common stock and/or warrants — can be used to support acquisitions and growth. When compared with traditional bank loans, this form of private funding typically provides more capital with less restrictive terms, (PIK interest, non-amortizing principal, no personal guarantees) and borrowers can have access to input from directors exclusively focused on their market.

Structured capital occupies a priority position in the borrower’s capital structure and provides potential for significant equity gains with the inclusion of warrants. Against the backdrop of the challenges facing today’s borrowers seeking traditional sources of financing to drive their growth, a hybrid securities investment can serve as the bridge pairing an equity investment with subordinated debt and can offer more flexibility than a traditional bank loan.

Revolving lines of credit or senior term loans offered by banks may sound appealing in this low interest rate environment. However, though borrowing costs are low, the Volcker Rule and leveraged lending guidelines have caused bank loans to be largely unavailable in the small- and mid-markets.

Private equity sponsors and private midmarket lenders have stepped up to fill the dearth of financing, but the former is an option that doesn’t
leave business owners interested in maintaining their independence and existing equity ownership with many options. For many entrepreneurs, the idea of selling out to a control-oriented private equity firm isn’t an appealing solution when it comes to driving long-term business growth.

In contrast, structured capital leaves the majority of common equity ownership in the hands of existing shareholders and founders. The proceeds from a flexible equity and debt investment incorporating subdebt with a payment-in-kind interest feature has the added advantage of allowing the borrower to avoid making cash interest payments, unlike a traditional loan. Instead, the borrower pays the lender back in the form of accrued interest. In short, capital that would be used to make interest payments can instead be funneled back into the business to support acquisitions, product development or geographic expansion.

A Hybrid Investment

What makes a hybrid investment strategy especially empowering for owners, entrepreneurs and management teams is the minimal dilution to their existing shareholders, unlike a pure private equity and growth capital investment. In addition, structured capital is available for information services and tech-enabled business service companies that often lack the hard assets to serve as collateral for asset-based loans that a manufacturer could obtain.

A recent example is a VSS transaction with aviation software developer Navtech. The Waterloo, Ontario-based company with 250 employees was acquired by Airbus in March, following an investment three years earlier by VSS that was used to refinance the business and provide expansion capital. As a result of the transaction, comprised of subordinated debt, warrants and a small equity co-investment, the software developer was left conservatively leveraged at just 1.5 times senior debt — significantly lower than a typical private equity acquisition would have left the company on a debt-to-cash flow basis.

The structured investment was predicated on the company’s attractive platform for growth in the flight operations industry, based on its stable, recurring and subscription-based business model with high customer renewal and long-term contracts. Furthermore, VSS’ transaction enabled one of Navtech’s minority equity investors to realize liquidity on an aging investment. But, perhaps equally important, it helped finance further development of Navtech’s SaaS and Electronic Flight Bag software used by aircraft pilots and crews to manage their flight planning and related activities. It simultaneously allowed Navtech’s controlling shareholder, Cambridge Information Group, to continue maintaining its majority ownership in the business.

The funding also helped Navtech support a strategic acquisition that would augment its suite of performance-based navigation software offerings, leading it to acquire UK-based DW International, a provider of software for flight navigation, air communications and air traffic-related management tasks, in April 2015.

That deal, in turn, paved the way for Navtech’s acquisition one year later by Airbus.

Market Opportunities

The lending landscape may have made this market segment less appealing to banks, but it hasn’t diminished the value of structured capital for the institutional investment community. Many institutional backers of hybrid capital funds are aware of the attractive risk-adjusted performance of structured mezzanine financing. The ability to provide un-sponsored companies with preferential capital is compelling to today’s limited partners looking for downside protection and upside equity appreciation.

A hybrid securities investment model is not only appealing to small business owners, but to private equity sponsors as well. Sponsors have found the availability of structured financing useful in supporting their leveraged acquisition activities.

A New York private equity group turned to VSS to support its acquisition of a Hollywood entertainment payroll and back office support company, Cast & Crew Entertainment Services, in December 2012. VSS arranged a structured financing package — subordinated debt with PIK interest and a common equity investment for a non-control investment — from its $312 million VSS SC II fund to support the financial sponsor’s acquisition of the Burbank, CA-based company. The investment helped finance Cast & Crew’s organic business initiatives, but perhaps more importantly, laid the cornerstone for another transformative period of change for the technology-enabled payroll services business. Last year, a west coast private equity group acquired the company.

The Road Ahead

There’s no question that in today’s restrictive bank lending environment, numerous plain vanilla private capital investment groups have taken notice, and competition for deals remains stiff. The ability to provide a tailored, structured capital solution, however, ensures that even in a challenging and competitive environment, companies that are able to leverage an investment across their capital structure will enjoy a distinct advantage over businesses that choose to finance their business plans with one type of private investment.