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Part 1 – The benefits of bank debt and mezzanine funding when raising strategic capital

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Making money in a business does not only depend on profit margins, growth in turnover and growing market share.  The manner in which the business is financed can also have a substantial impact on the shareholder returns generated by the business.

It will serve any business to have a strategic look at its balance sheet and the various options through which capital can be raised and allocated.  Robert Peché, Corporate Finance Associate at Bravura, an independent investment banking firm specialising in corporate finance and structured solutions services, outlines the various funding options that companies may consider when seeking to raise capital.

Capital can be raised for various reasons, ranging from a requirement for capital expenditure, a strategy of acquisitive growth in new markets or even buying out one of the existing shareholders.  The purpose of the capital raise, combined with the underlying business fundamentals, will typically drive the decisions regarding which type of capital to raise and from which sources.

Bank funding or senior debt is typically the cheapest form of funding.  Capital structure theory would recommend raising as much senior debt as possible in the business, especially when the benefits of a strategic equity shareholder are not taken into account.

However, banks will not provide senior debt unless there is a low risk of default. Banks apply strict criteria to obtain a source of comfort in terms of debt serviceability. The business will likely need an established track record, cash flow forecasts underpinned by solid fundamentals and a sufficiently robust corporate infrastructure for the purposes of a bank due diligence. The balance sheet of the business may also need to offer sufficient fixed assets of a liquid nature for the bank to recover some of the debt in the unlikely event of liquidation.

Although cheapest in terms of outright funding costs, senior debt carries operational costs in the form of restrictive covenants designed to protect the bank, usually at the expense of flexibility for equity investors. These may not be palatable for the business if, for example, the growth strategy requires a short-term drop in earnings to achieve increased longer-term growth. A requirement from the bank for shareholder guarantees (suretyships) in private companies may also reduce the attractiveness of such funding.

Traditional bank debt is often not available for businesses with limited track records, non-linear cash flows or very lean balance sheets. In a world of tech start-ups, platform-driven businesses and capex-light operating models, there are many otherwise highly attractive businesses which cannot raise senior debt.

If senior debt is not suitable, then more expensive debt with a sculpted cash flow profile (e.g. higher interest payments in later years) may be of interest. Banks typically provide such structured funding at a premium over the usual cost of senior debt. There will still be restrictive covenants and security requirements.

The next cheapest source of finance is mezzanine-type finance. This category of funding allows for more creative structuring than senior debt, with various types of financial instruments and cash flow profiles utilised. The cost of such funding is usually significantly higher than the cost of senior debt, but still lower than the cost of pure equity funding.

These instruments could take the form of preference shares or convertible debt. Various triggers may be built into the funding agreements which make provision for changes in coupon / interest rates or conversion into ordinary equity.

Mezzanine finance is complicated to understand, structure and model accurately. The tax and accounting implications are also not straightforward. Providers of such instruments usually have minimum deal sizes which must be met for funding to be provided. Mezzanine finance, if not carefully structured, can easily end up being more expensive than straight equity funding if onerous conversions to pure equity are triggered.

For many companies, selecting the optimal debt structure to meet strategic requirements can be a daunting undertaking.  In these instances, it is worth obtaining independent strategic advice, not only to ensure that the funding vehicle complements strategic imperatives, but also that the most favourable funding terms are obtained.

Source: www.bravura.net