To remain competitive, middle-market companies in the U.S. are seeking financing solutions that offer greater flexibility in structure and price, as well as certainty and ease of execution.
While traditional financing options are well suited to most companies, they don’t fit the needs of every business. As a result, lenders are increasingly providing financial products that offer new levels of flexibility.
This rising tide of creative financing vehicles is giving companies more options. The advantage to businesses is clear: They can enhance their working and growth capital to fuel business plans and help maintain a competitive edge.
For short-term financing needs, mid-market companies — those with US$50 million to $1 billion in annual revenues — have traditionally relied on either asset-based revolvers or cash-flow lines of credit, depending on the nature of their business. For financings of $10 million to $20 million, a single lender was generally sufficient. For larger and more strategic financing needs, companies turned to syndicated and structured loan facilities.
Asset-based lending, structured as a line of credit, has been used by companies that have large inventories, receivables or fixed assets. This applies to industries such as heavy manufacturing, metals and mining and retailing, to name a few. The amount of credit extended by lenders is based on the liquidation value of the assets owned by the business. Asset-based revolvers help companies bridge the gap between the cash flow they’ll eventually receive from sales, and the amount of their current expenses.
On the other hand, cash-flow lending is based on the company’s projected future cash flows. It’s usually structured as a funded term loan and a revolver. The lending limit is based on the enterprise value of a company, including its ability to generate cash, rather than the value its assets would garner if liquidated. Companies such as service providers — those that are light on assets but heavy on process and enterprise value — use this approach. It’s also commonly used by companies employing leverage to finance acquisitions and recapitalizations and to pursue high-growth initiatives.
Yet in the current economic landscape, many mid-market companies can’t rely on just one type of credit facility. Dynamic shifts in the economy have increased the need for even more flexible financing options. As the economy continues to become more service-based, many companies are considered integrators rather than pure manufacturers. Integrators assemble products from various suppliers, leaving the raw manufacturing to others. Their true worth lies in a mix of both assets and proprietary capabilities. So it stands to reason that these companies may require a blend of both asset-based and cash-flow-based lending.
Meanwhile, the timing of the economic cycle also plays a part in changing borrowing needs. Companies may have weaker present-day cash flows than they did three to four years ago, but they are again ramping up and forecasting stronger sales down the road. Asset- or cash-flow-based lending alone may not be enough for them to finance a growth spurt.
To meet customer needs in the new economy, lenders are providing a combination of both asset- and cash-flow-based lending in one credit facility. With a hybrid structure, a borrower can have an asset-based revolver that’s based on its inventory and receivables along with a credit line and/or term loan based on the company’s cash flow.
Here are two examples of hybrid lending solutions and situations in which they might function:
- An apparel manufacturer that has inventory of raw materials such as fabric, thread and zippers may also have some essential equipment, such as sewing machines. In this case, the inventory and equipment could back the asset-based portion of the credit facility, while anticipated cash flows from apparel sales could back the cash-flow portion.
- A company implementing a turnaround that has a significant asset base but lacks dependable cash flows could benefit from a hybrid loan, which would help provide working capital until the company gets back on track.
There are different types of hybrid products offered by financial institutions across the U.S. Borrowers should discuss their financing needs with their lenders to determine the best structure all around.
The Unitranche Option
For greater and longer-term borrowing needs such as recapitalizations and acquisitions, unitranche loans offer another alternative for borrowers. These loans bundle several debt tranches — or levels — into one, with a single blended interest rate, one set of closing documents and one lender. On top of the unitranche loan, lenders may offer a revolving credit facility as well.
These loans are often administered by joint ventures composed of a senior lender and another lender that has an appetite for unsecured debt, such as a hedge fund or private equity firm. By design, the joint venture spreads the risk over a pool of assets, virtually eliminating the need for syndication. That means the entire closing process is greatly simplified.
The interest rate on a unitranche product is slightly higher than with separate tranches but borrowers have the benefit of certainty on pricing, avoiding the possibility of upward pricing adjustments that can take place when syndicating loans to outside investors. The result is a workable solution for companies going further out on the leverage curve.
Here are two examples of unitranche loans and situations in which they might work best:
- A private equity firm uses a unitranche facility to recapitalize a manufacturer of conveyer belts. It is structured as an $80 million senior secured term loan. There is also a $10 million senior secured revolving credit facility. A more conventional approach may have called for a $50 million syndicated term loan, $10 million revolver and $20 million tranche of subordinated debt.
- A private equity firm uses a $200 million senior secured term loan to purchase a premier national provider of claims handling, specialized loss adjusting, and other risk management services. It also receives a $25 million credit facility. Traditionally, this might have required a syndicated $150 million senior term loan and a $25 million revolver, along with $50 million in second lien and subordinated debt.
A New Era
While hybrid loans aren’t new, they are increasingly tailored to borrowers’ specific needs. In fact, they’re becoming an essential tool for the new breed of mid-market companies that exist outside traditional industries.
It’s important for borrowers to work with lenders that understand not only the unique needs of the middle market, but to look for those that understand their industry and their business model. In the search for the right lender, borrowers might decide that the best option isn’t a standard loan. Working with an innovative lender is essential for businesses to get access to the flexibility they need to grow and succeed.
Ten Tips for Smart Borrowers
Drawing on its experience with thousands of borrowers across industries nationwide, GE Capital set out to answer a central question: What do the smartest borrowers do to make their quest for capital more successful?
While every situation is unique, one clear differentiator did emerge: The way a company presents itself to a lender is critical. It may surprise business leaders to learn that there are factors beyond a company’s cash flow and credit history that can have a big impact on the outcome of a credit application.
The following top ten tips are aimed at helping borrowers of all sizes when applying for credit. Particularly for companies that may be seeking traditional financing — or those that are approaching a financial institution for the first time — these suggestions can increase the likelihood of success.
1. Reach out early: Approach a lender before you need capital
2. Find a lender that understands your industry
3. Think like a lender: Understand the application and review process
4. Sweat the small stuff: Get your documents in order
5. Truth trumps all: Be transparent
6. Optimize your cash flow: Show how you’re maximizing efficiencies
7. Tell a compelling story: Acknowledge challenges but highlight successes
8. Do your homework: Know competitors’ financing structures
9. Relationships matter: Treat the lender as a strategic supplier
10 Communicate, communicate, communicate: From day-to-day details to big changes, keep the lender informed
Steve Battreall is the chief commercial officer of GE Capital, Corporate Finance, one of the largest providers of corporate loans and equipment finance to mid-size and large U.S. companies. Battreall can be reached by e-mail at firstname.lastname@example.org. For more information, visit www.gecapital.com/americas.