Entrepreneurial companies continue to encounter challenges in financing growth as private capital markets remain volatile. However, both equity and credit remain available for high-quality, well-managed companies. By raising capital now, businesses can enhance their long-term strategic prospects by funding innovation, investing in human capital, expanding market share and pursuing strategic acquisitions. Summit’s Peter Chung joins Todd Hearle—a senior member of the firm’s credit team—in discussing the equity and credit financing options available to growing companies.
Choosing Equity or Credit
Even in a challenging market, deciding whether to seek equity or credit depends on a company’s needs and overall strategy, rather than on external market factors.
Equity differs fundamentally from credit—it involves the exchange of permanent equity capital for ownership. For a private equity transaction, investors will purchase either a minority or majority stake of the company. In either case, private equity investors typically require that the company grant them board representation and a voice in strategic decisions.
With growth equity—a subset of private equity—the investor typically takes a minority position, often uses little or no leverage, and works collaboratively with the current management team in overseeing operations. Growth equity differs from venture capital by targeting established companies that are growing and already profitable, and it differs from leveraged buyout financing by employing little or no debt capital.
Growth equity investors may assist in developing long-term strategy, recruiting executives, establishing a seasoned independent board, evaluating potential acquisitions, developing stronger financial systems and controls, or preparing for an eventual initial public offering or sale.
Credit—an alternative to equity—is generally less costly on an absolute basis than is equity capital. In addition, while the company takes on the fixed costs of interest and principal payments, stockholders do not give up significant equity ownership. However, credit is not “permanent capital” and must be repaid over time.
There are several different forms of credit. Bank debt—either term or revolving—is typically senior in right of payment and secured by company assets. While this is generally the least expensive form of credit, it typically requires hard asset collateral and principal amortization during the loan term with a final maturity within five years. Although more costly, subordinated or mezzanine debt is usually structured so that borrowers pay only interest for the first few years and then repay all of the principal at maturity—five to seven years or longer from the original loan date.
A third form of credit is a hybrid commonly known as “unitranche debt,” which can replace both bank and mezzanine debt with one tranche of debt at a blended price. Unitranche debt can be particularly useful in providing a tailored financing solution while maintaining the flexibility needed to complete an acquisition or a recapitalization, or to provide liquidity.
Adapting to Tough Conditions
While a well-managed middle-market company can obtain both equity and credit in today’s market, credit is not as plentiful or as inexpensive as it was just a few years ago. During the credit boom of the mid 2000s, for example, a company might have obtained 4.0 times its EBITDA (earnings before interest, taxes, depreciation and amortization) in senior debt and another 1.5 times or more in subordinated debt. Today, the multiples are approximately 3.0 times for senior debt and 1.0 times for subordinated debt—a 30 percent reduction overall. Spreads on senior debt are wider, too, up from a typical 350 basis points over LIBOR in mid 2007 to 500–600 basis points over LIBOR today.
Though debt financing is less available and more expensive than in years past, it may be the least costly form of financing available. Even with wider spreads, the all-in cost of debt can be far lower than the cost of equity capital.
For financial executives concerned about taking on too much debt, growth equity may be the right solution. This form of financing—in which investors purchase a percentage of the company and help the management team grow the business—is still available for profitable, well-managed companies. Although the multiples that growth equity investors are willing to pay may not be as high as a year ago, most likely you will be selling only a portion of the company—while gaining personal liquidity, strategic guidance and resources to grow your remaining stake.
Regardless of current market uncertainty and volatility, entrepreneurs of leading growth companies have access to capital from a variety of sources that support an organization’s overall growth strategy. When evaluating the appropriate capital structure for their businesses, these managers should consider the potential role and contribution of the financing source. If the company seeks an experienced partner to assist with the task of company building, growth equity may represent the best alternative. If the company has steady and predictable free cash flow, debt financing may represent the lowest cost means of funding its growth plan.