“The Constitution guarantees you the pursuit of happiness… but doesn’t guarantee to finance the chase.”
With the senior lending markets tightening over the past few years, Sub Debt is becoming an attractive alternative for capital. It is an excellent capital source for businesses with strong cash flow, limited asset base, and a positive growth trend.
What is Subordinated Debt? Those who deal in mergers and acquisitions or with larger private companies may have used “Sub Debt” or “Mezzanine” funding as a layer of structured financing. The moniker comes from the geographic location on a company’s balance sheet…subordinate to senior bank debt, yet above equity in payment and liquidation. Therefore, Sub Debt has characteristics of both debt and equity to protect and reward the lender for the investment risk.
The purpose of mezzanine financing is to provide long-term capital to support growth or acquisitions. Typically, companies need Sub Debt when:
- Senior lenders will not extend additional credit due to a shortfall in the collateral base, and
- Businesses have good cash flow with positive growth trends, but retained earnings are insufficient to finance working capital growth or capital expenditures.
Sub Debt is an alternative to equity. The terms and conditions that come with outside equity investments can seem onerous to an owner. Equity investors require board positions and special voting rights on key issues. Sub Debt lenders usually ask for board visitation rights and typically do not have voting privileges. Most owners prefer the capital without the loss of control.
The cost of Sub Debt is less expensive than equity. This reduced cost does come with increased risk to the owner in that the company has increased leverage and debt service. The pricing comes in two parts: (1) a current pay interest cost of between 10% and 14% (debt cost); (2) the remainder is paid in the form of warrants to purchase common stock of the company (equity cost) to provide the overall desired return to the investor. Sub Debt lenders are targeting a 18% to 22% investment return.
Underwriting of Sub Debt is focused on three primary areas. First, does the company’s historical performance demonstrate sufficient cash flow to cover the Sub Debt interest costs? Second, does projected cash flow meet future working capital and capital expenditure needs? Third, do the projections provide the investors the expected equity return?
The initial underwriting of Sub debt is straightforward. The complexity appears when the discussion focuses on the amount and pricing of the warrants. Therefore, Sub Debt can be challenging for companies to understand and structure.
“Sub Debt has characteristics of both debt and equity…and is becoming an attractive alternative for capital.”