If we have learned anything during the COVID-19 pandemic, the 2008 financial crisis and every other major disruption in the world economy, it’s that the availability of capital and liquidity are always top priorities for businesses. Strong business models and competent management teams have suffered immensely from capital constraints during these events and even modest forward-planning with a focus on the “right” variables could have prevented catastrophic outcomes for some great operating companies.
Let’s start with a basic premise: Capital is a commodity and, like any critical raw material in a production process, it’s subject to volatility and supply chain disruptions. Whether it be equity capital to address the unique needs of an early-stage growth company, traditional working capital to sustain the performance of a more mature business or any type of capital in between, the key to ensuring that a company’s product/service thrives is hedging against unexpected and exogenous events. Preparing for disruption may sound intuitive, but when the environment is stable and capital is plentiful, it’s arguably the most overlooked component of most otherwise well-conceived strategic plans.
In this article, we will review how companies can best navigate the broader capital markets with the specific goal of gaining and maintaining capital access, availability and options and why “the trade” between the cost of capital and flexibility must be carefully balanced. And here’s a spoiler alert: The best time to raise capital is before you actually need it.
Access: Maintain at All Cost (of Capital)
Depending on scale, business owners and C-suite executives frequently default to commercial banks when contemplating capital needs. Senior secured bank financing represents the lowest cost capital and a quick call to your “relationship” banker typically generates an immediate response; however, like any other component of the supply chain, commercial banks are also vulnerable to disruption. Coming out of the Great Recession, regulators imposed restrictive risk tolerances on traditional lenders and, whether intentional or not, created a greenfield for alternative debt capital providers to fill the void when banks completely exited the middle market. In the past 10 years, banks’ share of the primary loan market has declined from 51.4% to 10.3% as institutional investors and unregulated non-bank financial companies (aka “direct lenders”) proliferated to form dedicated credit strategies and, more importantly, offered critical access to capital when markets experienced severe dislocation.
Fortunately, banks recovered nicely and, at present, are enjoying some of the most issuer-friendly conditions observed in decades. Translation: opportunity. With historically low default rates as a tailwind, banks are flush with cash, fundraising for direct lenders remains stable and institutional inflows continue unabated, resulting in demand for quality issuance. Respectfully, while many borrowers may feel comfortable with their liquidity position and ability to lean on lenders, let’s take the contrarian view: Now may be the perfect time to expand access by raising both maintenance and growth capital.
Availability: Minimizing Cost is Only One Consideration
Experience dictates that the exclusive and sometimes myopic focus on minimizing the cost of capital sometimes comes at the expense of maximizing shareholder value. After all, what is the benefit of a low-cost, unfunded bank revolver if a company is restricted from drawing and deploying it in the form (and with the substance) necessary to grow the business? Herein lies the benefit of marrying different providers and structural components in the context of a company’s overall capital structure. Whether public, private, sponsored or nonprofit, an unwavering focus on maintaining availability, even if more expensive, generates the greatest return for shareholders. To be clear, commercial bank loans are an important funding mechanism, but they should serve as one component of a company’s liquidity resources, not the only component. Layering in resources such as direct lender or institutional term debt, junior capital (subordinated and mezzanine debt), secured and unsecured bonds, sale-leaseback financing and/or preferred equity provides balance and, as referenced earlier, serves to hedge against fluctuations in any one area of the capital markets. Similarly, identifying the right partners upfront and working to properly manage expectations on risk/return can expand the availability of capital and create alignment between borrowers and creditors, a crucial element to building a scalable base.
In short, many borrowers often dismiss the impact of focusing exclusively on the nominal cost of capital and, in doing so, neglect the value proposition of flexibility (remember “the trade”). Ensuring access and availability by employing multiple capital types/providers accomplishes many things, not the least of which is the structural stability and freedom to grow the platform at the pace and on a scale of a company’s choosing.
Options: The Key to Unlocking Liquidity
Markets are efficient and offer a variety of debt and equity tranches that co-exist in harmony on a company’s balance sheet and, in fact, often complement each other. Beyond simply arriving at the most efficient ratio of debt and equity, enhancing shareholder value by expanding the provider base addresses the key priorities of staggering maturities and, as referenced earlier, hedging against disruption and events that are beyond a company’s control. For example, a fairly basic layering of three-year to 10-year tranches of debt capital with investors ranging from banks to insurance companies almost guarantees that a borrower isn’t faced with a significant debt maturity at a difficult point in a cyclical downturn and effectively forced to raise capital when the markets are compromised. Crafting a sustainable cap structure with a combination of working capital financing via commercial banks or asset-based shops (three years), permanent capital financing through banks, non-banks and/or institutional term loan providers (five to seven years), and longer-term funding for long-lived assets such as real estate (10 or more years) not only staggers maturities but offers the tangential benefits of managing interest rate risk and diversifying a company’s funding sources.
Increasing optionality runs in direct contrast with the more common approach of relying too heavily on commercial banks for a simple pro-rata structure (a fancy moniker for a bank revolver and term loan). Albeit a generally reliable source, the whales of the industry (JPMorgan Chase, Wells Fargo and Bank of America), as well as the smaller regional and community banks, are bound by internal credit tolerances, regulatory restrictions and tenor limits. These constraints are in addition to the fact that bank financing, while perhaps less expensive and easier to understand, also burdens borrowers with rigid maintenance covenants, limitations on permitted uses and restricted payments and onerous prepayments. There is no doubt that banks occupy an important place on a company’s balance sheet, but exploring alternatives such as private credit, structured equity (minority and preferred), unregistered private placements and sale-leaseback financing not only provides flexibility and diversity, but they also unlock liquidity by limiting contractual amortization requirements, thereby allowing a company to deploy more cash in support of growth. Who wouldn’t want more control of their free cash?
Having non-bank, private credit and rated institutional term debt as part of a company’s capital stack can bear structural advantages beyond just free cash flow. First, in addition to modest contractual amortization, providers offer greater leverage tolerance and wider permitted uses. Second, investment guidelines typically allow this group to structure bespoke credit facilities and “cross over” into other parts of a company’s cap structure (i.e. providers cross over by investing in both the senior secured and second lien, senior and mezzanine debt, term loan B and bonds or subordinated and preferred equity tranches). Granted, the structural workability comes at a higher price, but when deployed in combination with bank financing, the blended cost is an extremely compelling trade-off for the latitudes provided.
Aside from alternative lenders, sale-leaseback financing, capital and operating leases, rated bonds and private placements all have a place in thoughtful capital planning and should be used in concert with bank financing to mitigate risk. With respect to sale-leasebacks, the opportunity to unlock capital trapped in real estate while still controlling the fee simple asset is compelling and the execution commonplace. The argument is fairly simple: sell the real estate to a third party and lease it back on a triple net basis for an extended period, utilize the proceeds for acquisitive and/or organic growth and retain control of the property, improvements and uses while also negotiating the option to repurchase the asset if/when it makes sense. While counterintuitive to those who prefer owning real estate, the prevailing myth in a sale-leaseback structure is loss of control, but nothing could be further from the truth. Control is maintained, capital is unlocked, maturities are extended and the seller has the potential option to buy back the property — a great tool for everything from growth to estate planning to a qualified dividend.
It’s important to clarify that the previously mentioned alternatives for access, availability and options are not an endorsement for any structure or investor class; rather, the themes are meant to highlight the advantages of forward-planning, diversification and preparing for disruption. When advising clients on capital raising activities, one general rule always prevails (especially when times are this good): Securing as much capital you can, for the longest tenor available, on the most competitive terms offered, will prove to be very advantageous.
John Whalen serves as head of the capital advisory investment banking group at Matrix Capital Markets Group and is responsible for client development, all facets of capital intermediation and transaction execution, as well as advising clients on capital structure and efficiency, liquidity and go-to-market strategy.