During 2019, Phoenix Management Services was engaged as financial advisor by a middle market importer and distributor of construction related products to develop a turnaround plan and financial projections to help it address several important issues. Because the company was in default, the relationship with the incumbent lender had become strained and a hard deadline to close a refinancing had been issued. There was no lack of clarity on the requirement of getting a new deal done, setting into motion a rapid transaction process. Phoenix Capital Resources was engaged in 2020 to locate suitable financing, and the process began in earnest in late February. At the time, no one had any sense what COVID-19 would mean to businesses and capital markets around the world.
The borrower, with revenue approaching $50 million, had posted several years of losses. Over the course of the prior year, the company had implemented many elements of the turnaround plan, all designed to improve margins and cash flow by reducing costs, eliminating unprofitable products, diversifying sales channels, improving financial reporting and bolstering the senior management team. To make matters more difficult, the company was confronting repetitive and challenging demands from its large retail customers that were also adapting to a highly competitive and rapidly evolving market environment.
It appeared that most of the borrower’s challenges were behind it — or at least clearly identified and understood — and the future looked bright. However, not much time had passed since the turnaround began and losses still colored the company’s financial history and could be expected to impact a new lender’s appetite for the loan.
The COVID-19 pandemic wave crashed onto U.S. shores in mid-March 2020, just as offering materials were being finalized to raise almost $10 million of debt capital to refinance the company’s debt facilities. The pandemic added significant complexity and uncertainty to the situation. Suddenly there was no clear way to determine which institutions were lending money at all, and if they were lending, how the pandemic had impacted and would continue to impact appetites for providing a loan to a company still experiencing corporate renewal. Probability of closure was critical and extremely difficult to ascertain as COVID-19 threatened that most sought after aspect of a capital raise — understanding uncertainty.
In order to become better informed as to who was “in business” and who wasn’t, as well as who could provide a loan package that adequately addressed the borrower’s needs, it was necessary to pursue a larger solicitation than originally planned. Instead of approaching 10 to 12 lenders, it became necessary to approach more than twice that number, representing several tiers of the market for secured debt in order to ensure the borrower retained at least modest optionality at the end of the process.
In addition, the pandemic had both positive and negative impacts on the borrower. Revenue had historically been concentrated in the home center channel, and the company’s strategic plan called for expanding revenue across other channels as well. But instead of diversification, COVID-19 caused reduced demand in other channels and forced revenue to become even more concentrated. This was a welcome but mixed blessing that had to be clearly explained to interested lenders.
The company also was forced to close its headquarters location and segment the warehouse team, with half working three days per week and the other half working alternate days. This resulted in increased cost and lower efficiency, another reality that required clear explanation. Interruptions within the largely overseas supply chain in February and March resulted in substantial challenges in executing on the company’s financial projections. Thus, the issue became supply, not demand. COVID-19 had a destructive effect on overseas manufacturing output as well as availability of freight transport capacity. The future impact on the borrower’s operations was difficult to assess, and the company missed its revenue projection in April just as potential lenders conducted pre-screening. Revenue then recovered well in May and June, preserving credibility with lenders considering the deal. But this volatility took its toll and many lenders took the exit ramp at this stage, underscoring the necessity of approaching a broader group.
Certain segments of the market for storied credits are “closed for business,” particularly for loans to new customers that have experienced recent challenges. The environment is new and exhibits significant gaps in reliability. A borrower should not waste time chasing “good relationships” amid opportunities to optimize the situation by approaching better qualified capital sources that are eager to lend. In this case, there was little interest from the company’s existing contacts and relationships. Many of these lenders were distracted by the tidal wave of government funding flushing through the financial sector. Many were forced to divert most of their staff to address requests from existing clients and the resulting response to the borrower’s approach was, in a word, crickets.
Similarly, bank-based ABL groups, while expressing initial interest, were unsuccessful in achieving any real traction on the deal given the borrower’s historical performance and current volatility. Ultimately, with a few notable exceptions, the size of the deal, the timing of the recent turnaround process and the uncertainty caused by the pandemic took them out of the game.
One could logically expect higher coupon ABL lenders (typically above 10% to 12%) to have a keen interest in the deal. We thought this was a good safety net if things didn’t go as planned. However, a torrent of opportunity in this market segment as COVID-19 rolled over the country narrowed these lenders’ appetites and allowed them to “cherry-pick” opportunities exhibiting a well-defined blend of characteristics they desired. The deal we proposed had elements that placed it outside of “straight down the fairway” parameters, and there was surprisingly only limited interest in this tier of lenders. One such lender related that, “Normally, we would be all over this deal. But right now, we have more than we can handle, and this one gets disqualified because…” We were ultimately gratified, however, that one such lender expressed a desire to move forward, verifying our theory of broader solicitation. But by then there was a good indication we could close a more cost effective, flexible solution. Rather than consume this lender’s time unnecessarily, we asked it to stand down pending the outcome.
In this situation, the company had a story to tell. In such situations, you should spend the time and effort to prepare quality offering materials so the story is clear, understandable and detailed. We were told repeatedly by lenders that the offering materials impacted the process in a very positive way. The Confidential Information Memorandum (CIM) told the story clearly so we didn’t spend needless hours covering the same ground. Calls with interested parties were therefore efficient and value-added, which was a benefit given the short time frame and the increased number of lenders in the process. Borrowers often want to keep the cost of the process very low and end up doing themselves a disservice by making decisions driven solely by perceived upfront cost instead of ultimate value. Even though the requested package was below $10 million, the borrower wisely chose to invest in preparing a high-quality range of offering documents, including an attractive and informative teaser, a detailed CIM, and comprehensive financial projections. Doing so showed that management was serious and professional in its approach to the process. The CIM articulated the challenges the company had faced as well as how it had responded or intended to respond. This speaks volumes to underwriters and credit officers. The feedback received reinforced that more information and attention to detail is required, and this is even more true in the lower middle market.
Lenders with an appetite for providing funding to recovering companies will conduct enhanced underwriting due diligence. During the push for final credit approval, questions were numerous, incisive and detailed, far more so than the company was used to seeing. Navigating this full-contact part of the process was a challenge for all parties involved but especially for the borrower’s finance team. With some guidance and support, the team delivered, thus enabling a very fast-paced closing. The lesson here is that a borrower’s finance and accounting team should be proactively prepared at the inception of the process to expect numerous late nights to fulfill information requests they may perceive as spurious and unnecessary. In this situation, as well as many others in which we have been involved, the nature and amount of information required by the new lender far surpassed the company’s previous experience. Developing an understanding that the lender is driving the due diligence process is critical, especially in an uncertain market with a turnaround process still very visible in the financial statements.
Appraisals and legal documentation should be started as early as possible. We had heard stories of appraisers being stopped at state borders with zero ability to conduct onsite inventory counts and facility inspections. No one really knew how this aspect of the process would play out simply because this deal was one of the first attempted during COVID-19’s onset. However, the appraisers we worked with adapted ably and efficiently. In addition, several proposals did not include a requirement for an updated real estate appraisal. Had this been a requirement, it’s unlikely such a tight timeline could have been met. The fact that the company was well-prepared supported a truncated legal documentation process.
Geography didn’t appear to matter. It’s true that four of the five proposals the borrower received were from lenders far outside its geography, but the winning proposal was provided by a lender with a regional presence. However, the margin of success for the winning lender was slim enough that the borrower could have easily selected another option and still obtained an attractive financing package that met the majority of its needs. In fact, the competition was a “toss up” until the day a decision was made. This argues against approaching the exercise from a purely region-centric point of view.
This transaction demonstrated the resilience and adaptability of the market for secured debt and what it takes to be successful when approaching it. The market’s ability to deliver attractive capital solutions at a reasonable cost was evident, even for a borrower with meaningful and recent challenges. But to be successful in this COVID-19-driven market, a company seeking to refinance its credit facilities must be willing to venture outside the well-established, comfortable norms of “the way things used to be.” Many of these comforts are, at least for now, fond memories. Companies should expect to invest time, effort and money to efficiently tell the entire story in a transparent and detailed fashion. Finance teams must be prepared to work through a challenging and invasive credit approval and due diligence process. But the results of doing so speak for themselves. Ultimately, from a pool of more than 30 potential lenders that received the CIM, five proposals were issued, two of which were set aside early based on uncompetitive pricing or structural challenges. Approximately 10 weeks had passed from the time the first teasers were distributed to the day the deal was funded — the last day of the forbearance period.