No assets, no problem Featured

9:41am EDT February 26, 2004
Strong market trends indicate that M&A activity is finally on the rise, especially in the middle market (companies with $25 million to $250 million of total enterprise value, i.e., net debt plus equity value).

The amount that financial buyers can borrow from banks to finance their purchases of middle-market companies is also rising, meaning many buyers will be able to borrow more and, in theory, pay more for acquisitions.

However, for companies with less than $10 million of annual EBITDA, these trends may not necessarily hold true.

Unless a small company has substantial assets to collateralize acquisition financing, the number of lenders willing to lend to such a company, solely on the strength of its cash flows, is relatively low. Fortunately, there are hopeful signs that cash flow lending for companies with less than $10 million of EBITDA is becoming more available for particularly solid businesses.

Historical middle-market lending activity

Significant consolidation in the financial services industry in recent years has substantially reduced the number of banks and financial services companies lending to small and medium-sized businesses. From 1987 to the beginning of 2004, the number of FDIC-insured financial institutions declined from 17,325 to 9,228.

This consolidation trend has led to more large financial institutions de-emphasizing their product offerings to small and middle-market companies in favor of larger corporate clients with more sophisticated capital markets needs.

Tighter lending standards in recent years have also contributed to less middle-market activity. According to an October 2003 study by the Federal Reserve System Board of Governors, the number of banks tightening their corporate lending standards exceeded the number of banks easing their standards in each quarter from the fourth quarter 1998 through the third quarter 2003.

S&P/Portfolio Management Data reveals that for companies with borrowings of less than $100 million, the average ratio of senior debt to annual EBITDA decreased from 3.1 times in 1998 to 2.5 times in 2003. For companies with few tangible assets and less than $10 million of annual EBITDA, these leverage ratios have been lower still.

We are at a point in our economic cycle similar to that of the early 1990s, with the United States emerging from a recession. Middle-market loans made to companies during the recovery years of the last decade turned out to be very strong investments for the lenders, including the handful of banks and other financial institutions lending on conservative terms to strong middle-market companies on the basis of their cash flows.

Based on the current stage of the economic recovery now in progress, middle-market lenders are again becoming comfortable lending on the basis of cash flows (rather than assets) to middle-market companies with strong macroeconomic attributes and sound management.

How does a middle-market company find a cash flow lender?

There are many banking veterans experienced at cash flow lending. Unfortunately, many of these bankers are currently at institutions that are not interested in providing relatively small cash flow loans.

The most likely group to provide such loans is new lending institutions, several of which have sprouted over the last few years, and many of them are headquartered in Chicago. However, most of these lenders focus almost exclusively on lending to private equity fund sponsored transactions and not to companies without such backing.

The market, therefore, needs more middle market cash flow lending groups, and recent signals suggest that such lenders are emerging. Further, continued banking industry consolidation, such as the announced mergers of Fleet Bank into Bank of America and Bank One into J.P. Morgan, could increase the need for -- and spur the formation of -- additional new lenders focusing on the middle market.

Although it may be challenging, there is almost always a reasonable financing solution. With the help of an experienced financial adviser, and as the economy continues to recover and new cash flow lenders emerge, financing options for strong middle-market companies should become increasingly available and attractive. Andrew Chidester is a vice president at Brown Gibbons Lang & Co. His main focus is the development of the firm's private placements and corporate restructurings business services. Reach him at (312) 658-1600 or