One of the major side effects of economic instability is limited access to affordable capital. Businesses, especially those in the lower middle market, are having a difficult time finding capital partners to finance working capital requirements and growth initiatives, due to the macroeconomic risks currently at play. While traditional sources of capital may be scarce, there are other alternative solutions and innovative structures that create alignment through shared risk and incentives on both sides of the table. Middle Market Review sat down with Jeffrey Stevenson, Managing Partner of private investment firm VSS, for a Q&A on Structured Capital – hybrid debt and equity solutions that have proven to be beneficial for businesses, especially in times of crisis.
MMR: In today’s tight lending and economic environment, and as revenues across many industries have declined, how should owners of lower middle market businesses think about sources of capital both to cover obligations and finance growth plans?
JS: There’s no doubt about the impact the Coronavirus has had on the current market environment. In March, valuations of businesses across many industries precipitously declined, and while some sectors were better positioned than others, the ability for businesses to forecast future earnings and revenues remains challenged. Fortunately, there are plenty of sources of capital available, including presently during the pandemic when the U.S. government has stepped in to support smaller businesses. But overall, the ability to access this capital, including from Wall Street’s capital markets, isn’t always equitable. Nowhere is this truer than in the lower middle market, where companies that generate up to $15 million in EBITDA don’t have the same access to more established capital markets that larger businesses do. That’s why we think business owners of these sized businesses could benefit from learning more about how Structured Capital can serve as a flexible capital solution, especially in economically-challenging business environments. During the Global Financial Crisis (2007-2009), Structured Capital proved to be a viable financing option to meet LMM businesses’ growth needs while providing founders and entrepreneurs with some much needed financial flexibility. In today’s lending environment, traditional bank financing has become more constrained as a result of the lack of visibility of businesses’ future financial performance. That is especially the case for smaller and mid-market sized companies. That means it has become more difficult for owners of these companies to obtain financing that would enable them to focus on important initiatives that help drive growth while meeting their working capital requirements and existing debt obligations.
MMR: Why is Structured Capital an attractive financing solution for entrepreneurs and founder-owned businesses as an alternative to traditional M&A/private equity?
JS: Considering that many companies have put their growth plans on hold over the past few months, it’s not surprising that Structured Capital has been gaining popularity. It has become particularly important to the LMM. That’s because as the pandemic unfolded, many smaller businesses’ revenues literally contracted overnight. Without a sufficient capital cushion to offset declines, LMM businesses needed capital very quickly to continue operations and pursue growth. Many entrepreneurs have invested years building their businesses, so handing over the keys to new owners when valuations are depressed is generally not an attractive option. This situation is exacerbated for many LMM companies that will not qualify for bank loans in the current market environment.
MMR: So, how does Structured Capital help?
JS: Structured investments that combine equity- and debt-like components offer significantly lower dilution versus traditional private equity investments. In Structured Capital investments, owners typically maintain the majority of their company’s equity. Structured Capital helps businesses with their current liquidity and growth needs, while preserving upside for future liquidity events.
MMR: How does the leverage profile of a Structured Capital investment compare to traditional bank loans?
JS: Structured Capital investments often have lower total leverage than traditional bank loans due to the flexibility of including both equity and debt. In addition, when compared with conventional bank debt, Structured Capital investments can come with a number of attractive features, such as payment-in-kind (PIK) interest and non-amortization of principal, which enables more cash flow to be used for working capital and growth versus debt service.
MMR: What types of strategic growth activities are best suited to Structured Capital investment?
JS: Structured Capital is a viable financing option for a broad range of growth initiatives, from research and development to acquisitions, new product launches, sales, or even investment in manufacturing infrastructure and supply chain improvement. Structured Capital is suitable for all types of companies.
MMR: Can Structured Capital be paired with traditional bank financing or private equity investment?
JS: Yes, Structured Capital can be paired with private equity or traditional bank financing. As a result, there are opportunities to support private equity sponsors that may be seeking to make an investment where a flexible capital solution rounds out the capital structure.
MMR: What makes the Risk/Return profile of Structured Capital different from traditional growth equity?
JS: Structured Capital generally trades some of the upside of traditional growth equity investments for downside protection and current income. The debt or debt-like portion of a Structured Capital investment is higher in the capital stack than equity, and hence has higher priority in the event of a liquidation. This piece also typically has a fixed return component that pays investors a quarterly coupon, whereas generally all of the return in a growth equity investment comes at a liquidity event in 3-5 years. Structured Capital also benefits from growth in the business through the equity or equity-like piece of the investment.