Since the 1980s, leveraged financing
has become more widespread in the
middle market. By increasing the amount of debt relative to equity, companies can enhance the return on equity. Of
course, there are significant risks, and not
every business is well suited for this type of
financing.
“Leverage can increase returns to equity,
but it can also cut the other way if things
don’t work as planned. The art is determining how much is too much and how much
is just right,” says Edmund Ozorio, senior
vice president of Comerica Bank’s Western
Market.
Smart Business spoke with Ozorio about
financial leverage, the risks involved and
current market terms and conditions.
What is leveraged financing?
The generic term ‘leverage’ refers to the
amount of debt relative to either the value
of a company’s assets or its cash flow.
Today, the term ‘leveraged financing’ is
generally understood as debt financing in
excess of the value of a company’s assets.
This means that debt is replacing part of
what is traditionally funded with equity.
Because debt is cheaper than equity, the
average cost of capital is lowered and the
return on equity goes up. Since nothing is
free, this increased return comes with
increased risk. The trick is to use the
‘Goldilocks’ amount: just enough to get the
increased return on equity, but not so much
that a minor downturn causes payment
problems.
How can a company determine if it is a good
candidate for leveraged financing?
The best candidates are businesses with
reliable cash flow over a fairly broad spectrum of scenarios. While nobody can predict the future, banks look at likely projection scenarios and past performance under
various economic conditions.
The best candidates have a strong market
position and barriers to entry, meaning
their products will continue to sell even in
a moderate downturn and are difficult to
displace by competitors. Branded products are common examples of this type of business. Other good candidates include businesses with low fixed operating costs.
Less attractive are businesses that are
highly cyclical with high fixed costs, or
those that consume large amounts of capital due to growth.
When is leveraged financing used?
Common uses center around changes in
equity structure. The most frequent example is an acquisition, when a new owner
borrows against the cash flow of the company in order to buy out the former owner.
Leveraged financing is also used to fund
distributions to owners and equity holders
for other outside investments. Over the
past several years, banks have seen many
business owners increase the leverage on
their operating businesses to provide the
equity for commercial real estate investments or to finance unrelated businesses
that might not qualify for financing on their
own.
What are some common mistakes, and how
can they be avoided?
The most common mistake is taking on
too much leverage relative to the level of reliable cash flow. In today’s fast-paced and
highly competitive marketplace, businesses can be affected much easier and faster
than ever before. The debt structure has to
leave some buffer for drops in revenue and
cash flow. This means one of two things:
either less leverage or debt structured in
such a way that there is some flexibility in
repayment terms.
One of the best ways of achieving a fairly
high level of leverage is a combination of
bank debt and mezzanine, or subordinated,
debt. The bank debt generally amortizes
early and the subordinated debt later.
What terms and structures are commonly
used?
Commercial banks will usually want
keep the company’s bank debt at three
times cash flow or less. Subordinated debt
lenders might provide an additional one to
two times cash flow. There are extraordinary circumstances that might increase or
decrease these levels by as much as 50 percent. Banks may also require that the
amount of financing in excess of asset values amortizes more quickly than other
debt.
On rare occasions when the business has
a very strong model and cash flow but
extremely limited hard assets, the analysis
is based on the value of the intangibles and
amortization is set accordingly.
The terms are a function of the risk
involved. While premiums for leveraged
financing have come down over the past
few years, it remains more expensive than
traditional financing. The spread over comparable rates for debt fully covered by
assets will generally range from 1 percent
to 4 percent. Fees might increase by a quarter to one-half. Some lenders will also take
warrants instead of part of their fees, lessening the cash drain on the business.
EDMUND OZORIO is senior vice president of Comerica Bank’s
Western Market. Reach him at [email protected] or (619)
338-1512.
