Mezzanine capital serves a purpose for those who know how to use it

Mezzanine capital is the portion of a company’s capital that sits between the senior debt and common equity and typically is in the form of subordinated debt. Mezzanine debt can provide flexible, longer term capital, which is less expensive and dilutive than equity.

Smart Business spoke with Jim Altman, Middle Market Pennsylvania Regional Executive at Huntington Bank, about mezzanine capital, the situations in which it can be leveraged as well as what criteria those who borrow mezzanine capital must meet in order to qualify for it.

Mezzanine capital is referred to as subordinated debt. What does this mean, and how does it affect when it is used and who uses it?

The senior debt has priority to all payments and collateral. The subordinated debt has priority before the common equity stakeholders. Mezzanine capital/subordinated debt can be used in order to fund acquisitions and as growth capital, and it also has applications in situations such as management buyouts, debt restructuring and succession planning, and can be used to leverage recapitalization.

Mezzanine capital providers are looking for certain criteria when providing this type of debt. For instance, lenders want companies with a solid, proven track record, good cash flow and solid management. Mezzanine capital is not, however, available for startups, companies that have a high exposure risk to commodities, or companies that have narrow customer concentration.

In what ways can mezzanine capital be used to as a tool to help finance an acquisition?

In an acquisition, mezzanine capital can certainly provide a portion of the capital stack. The utilization of mezzanine debt along with senior debt can provide a cost-effective solution for expansion-minded companies and provide the ability to raise less outside equity for the acquisition.

What are the potential risks or the downsides of acquiring mezzanine capital?

Borrowers may see covenants that restrict the ability for additional borrowings and refinancing, and may require quarterly or annual measurements of financial performance. In addition, spending including compensation and dividend payouts may be restricted. The cost of mezzanine capital is higher than that of senior debt.

What misconceptions are there around mezzanine capital that might mean it’s a product that goes unexplored?

The misconception certainly could be that mezzanine capital is not really a well-known product, but is certainly a viable source for companies to access capital for a variety of reasons:

  • Mezzanine capital can support a company’s long-term growth and increase the value of current shareholders, and in some cases allow the owner/shareholder to receive liquidity.
  • Mezzanine capital providers have the ability to continue to invest in a company to support future growth needs or assist in ownership transitions.
  • Mezzanine providers are making a five-year plus investment and certainly have the ability to provide advice and support in the operation of the business over a longer time period.

Mezzanine financing can be particularly advantageous for companies that are going through ownership transition, recapitalization, internal aggressive growth or an acquisition growth strategy

This type of financing is just another arrow in a borrower’s finance quiver. For those who haven’t heard of mezzanine capital or who aren’t aware of the ways in which it can be used, it’s certainly a product that is worth exploring.

Insights Banking & Finance is brought to you by Huntington Bank

Take steps to find a bank that can help your company grow

The banking industry is ever changing. In 2016 alone, banks saw more integrative technology, a changing physical landscape and an increase in mergers and acquisitions.

“As these changes cause customers to re-evaluate their banking relationship, many institutions are also being proactive about customer retention,” says Donna Dolezal, Vice President of Commercial Lending at Northwest Bank.

“As we look into 2017, innovation, product and service improvement and exemplary customer service will continue to be a critical piece for banks and their efforts to retain current customers and remain competitive in their respective markets.”

As your business assesses its own future, it’s important to find a bank that can provide a level of service that meets your own unique needs.

Smart Business spoke with Dolezal about what to consider when assessing the compatibility of potential banking partners.

What signs might indicate it’s time for your business to look for a new bank?
Many issues stem from poor communication. This can be an issue if you’re planning on growth that will require funding to make it work. It’s also a problem if your trusted banker leaves for a new opportunity. No matter the problem, if you’re committed to invest time, money and resources in your growth plan and you’re uncertain as to whether you have the right partnership to meet those needs, it might be time to look for a new bank.

What’s the best approach to take as you explore your banking options?
Take time to think about your trusted advisers. Who are they? Hopefully your accountant and attorney come to mind. Also consider business advisers you work with. You can even speak with employees who deal with banks to provide suggestions for better solutions. They can also make introductions to other banks and bankers.

Don’t forget to consider the banker who calls on you regularly and has expressed interest in your business or introduced you to solutions before your own bank did. You may want to list the products and services you currently use on a spreadsheet.

Add information like rates, fees and terms. When you meet with other banks, add in details for comparison. You may also want to add other suggested services and their cost into the conversation.

What if you have concerns about the transition and process involved in switching banks?
The transition process is a little more complicated than opening a new account. Most clients have multiple services, including deposits, treasury and credit facilities. These services need to be set up and people need to be properly trained. This often requires other bank employees to be involved and committed to the transition.

As you think about the change, refer to your spreadsheet and create a new column of concerns. Have a conversation with your new bank before you transition to share your thoughts. Have employees involved with banking matters at your company identify and share their perspective with you.

Share this feedback with your new bank and work together to create a transition plan. Everything should be addressed so the changeover is as smooth as possible. To that end, consider the personnel involved and the timeline for completion, along with who to contact if something goes wrong. It’s also important to communicate with your existing bank and provide notice that you’re leaving.

What can a company do internally to create a stronger partnership going forward, whether it’s your current bank or an existing bank?
Involve your CFO/controller and employees who interact with the bank regularly. Invite these key individuals to attend meetings as you interview other banks or meet with your current bank. They can aid in the internal due diligence to determine the best fit in a banking relationship.

There are many great banks and bankers out there. But there is always the potential for change. It’s never an easy process to change, especially when it concerns such an important partner in your business as your bank. The long-term goal is to gain a trusted banking adviser who adds value to your company by providing the right solutions.

Insights Banking & Finance is brought to you by Northwest Bank

Strategies companies can use to mitigate the effects of interest rate risks

With interest rates just off record lows, now may be an opportune time to lock in rates on variable long-term debt, especially given the backdrop of potential rate increases by the Federal Reserve.

“Right now the market is predicting that the Federal Reserve will increase short-term interest rates at least a twice this year,” says Jim Altman, Middle Market Pennsylvania Regional Executive at Huntington Bank. “The truth, however, is that no one knows what will happen, not even the Federal Reserve.”

Traditionally, companies would mitigate interest rate risk by choosing a fixed rate loan. In today’s market, a company can employ a more customized strategy using interest rate swaps that can actively manage potentially rising interest rate costs.

Given the inherent uncertainty and volatility with the interest rates going forward, managing interest rate risk by using an interest swap or securing a traditional fixed rate are examples of commonly used risk mitigation tools. But companies should form their own risk management strategy that is developed based on their view of the market and their unique risk tolerance level.

“It should be a strategy that says, ‘This is our view of what may happen to interest rates and these are the risks we’re willing to take.’ And companies should adhere to it regardless of what rates do.”

Smart Business spoke with Altman about strategies businesses can use to mitigate the risk of interest rate increases.

What should companies consider as they create a plan to mitigate the effects of an interest rate increase?

Risk mitigation strategy is based on a company’s risk tolerance, the amount of debt it holds and its perspective of the market. Interest rate predictions offered by market analysts shouldn’t be the only consideration because no one really knows what will happen next. The economy is global and issues outside the U.S. impact the domestic market. So companies must operate within their set risk strategy, which is based in part on what their business can handle if rates were to change.

With the company’s expected debt levels and associated finance terms in mind, determine what risks can be absorbed. The questions to ask are:

  • What is the risk to the business if rates increase?
  • What is the effect at each stage of an escalating increase?
  • How high could interest rates rise before it becomes a problem?
  • Is the company willing or able to risk that its costs will increase to that level?

Most customers do not delve this deep into the impact of interest rates, and it’s a simpler question: Do I prefer a level of certainty of interest cash flows or am I comfortable with the uncertainty of the future?

Once those questions are answered, then determine how to keep risk within manageable levels. Once a strategy is formed, execute on it.

How do businesses benefit from using interest rate swaps to hedge against interest rate increases?

It’s really about managing interest rate exposure. An interest rate swap is an alternative way to manage variable rate exposures and gives the borrower an opportunity to customize that exposure and risk tolerance to fit the borrower’s strategy. Whereas in a traditional fixed rate loan, the company would fix the rate on the entire loan amount, the interest rate swap allows a company to set how much floating rate exposure it wants, determine when the hedge will start, and how long it will be in place. For example, if a company is building a new facility and will take 12 months to do so, the company has the ability to set a fixed rate at closing to begin when the construction loan matures and the permanent loan begins 12 months from now, eliminating the interest rate risk between the start and end of the project.

There’s a benefit to having interest rate protection, whether that is through an interest rate swap or traditional fixed rate loan. It provides a level of certainty and allows businesses to focus on their day-to-day operations. Businesses need to think about their risks and have a strategy to protect themselves. Develop that strategy, implement it and stay true to it irrespective of what’s happening in the market.

Insights Banking & Finance is brought to you by Huntington Bank

How working with your bank can bring you closer to your goals

Banks can play an integral role in the long-term success of your business, says Michael Benson, Vice President/Akron Metro Manager at Consumers National Bank.

“While banks are always interested in lending to businesses, they are required to do so to healthy companies that have a high probability of repaying their loans,” Benson says. “So, the banker has a vested interest in the success of your company and doing what it can to put you in a better position to achieve your goals.”

When you take the time to review quarterly financial statements and talk about what’s happening in your business or to ensure that your banker and CPA know each other, it can help you in good times and when times turn tough.

Smart Business spoke with Benson about how to build a stronger partnership with your bank.

What are some key points to consider when choosing a method to fund your business?

When you’re ready to look at the various options to fund your business, it’s helpful to focus on three key areas:

  • Purpose of funds — This will drive the type of borrowing that is needed. For example, if you need to fund operations as part of your normal cash flow cycle, then a line of credit is the most appropriate tool. Banks expect that you will use a line of credit to fund short-term working capital needs such as payroll, materials and other short-term expenses, and then pay down the line as you get paid for finished goods. If you need equipment, vehicles or other fixed assets, a term loan should be used. Generally, term loans will have a three- to five-year payback period for most equipment and vehicles. However, very large pieces of equipment are sometimes financed up to seven years.
  • Availability of cash — Even if your business is flush with cash, you should always make sure you have sufficient reserves, as it is possible for sudden growth to eat away at those funds. If arrangements aren’t made for a backup (line of credit), it is possible to grow the business out of existence. When you seek financing, the bank is always interested in your cash reserves to provide reassurance that your business could survive a downturn. There are also times that a business may present the idea of a significant down payment on a fixed asset, but the bank recommends a lower cash investment. This happens in cases where the bank does not want to see the business deplete all of its reserves.
  • Expected return — Finally, you must consider whether it is likely that your business will get a big enough return from the investment. Not only should you do financial projections on expected revenue and expense changes, but you should also work to make sure these projections are as realistic as possible. Thinking in terms of ‘worst-case scenario’ helps you to anticipate difficulties and plan ahead for them.

How do factors such as the size and status of your business affect this decision?

Exercise restraint when taking on new clients in high-growth conditions. If you add equipment and labor costs, these expenses will have to be confronted in a slowdown.

Conversely, if your company’s growth is stagnant, you should work to keep costs down, be as efficient as possible and be disciplined about your line of credit usage.

There is sometimes a temptation to use the line instead of dealing with cost cutting. This results in an embedded line, with no availability of cash for future working capital needs.

Regardless of the growth opportunity, a smart business takes on growth in a slow and careful manner. Otherwise, you increase your cost structure and put yourself at risk in the event that the growth is not sustained. You need a vision that is rooted in a path for success. When you take the time to forge a good working relationship with your bank, you’ll typically gain a partner that can help you plan for success, as well as take a vested interest in your success.

Insights Banking & Finance is brought to you by Consumers National Bank

Are you overlooking your foreign currency risks?

Nearly all S&P 500 companies discuss foreign currency risk and hedging activities. However, any business that is competing, buying or selling services and/or products internationally, regardless of its size, faces some form of economic risk attributed to currency movements. Even if companies are transacting internationally in U.S. dollars only, they are still subject to foreign exchange risk.

“One of the biggest challenges companies face is the ability to identify and quantify their foreign exchange risk exposures,” says Jim Altman, middle market Pennsylvania Regional Executive at Huntington Bank. “This is particularly true of economic risk — the competitive advantage or disadvantage resulting from exchange rate fluctuations that impact the value of a firm. Even those that can identify their exposures face the issues of optimizing their hedging strategies or forecasting their future exposures.”

Smart Business spoke with Altman about foreign exchange risk and strategies to hedge against it.

What are the first steps to hedging the impact of foreign currency fluctuations?

An effective strategy is to lock into a forward contract or enter into an option contract. These strategies allow companies to lock in exchange rates today to settle contracts in the future and can mitigate currency exposures currently on the books or expected future exposure. Hedge accounting rules may also play into companies’ hedging policies, if applicable.

What are the more common hedging strategies?

Most companies implement a foreign exchange risk hedging program to reduce earnings or cash-flow volatility. Given this objective, it’s wise to create and implement a formal hedging program, which includes establishing a foreign exchange policy.

For example, the program may seek to hedge 100 percent of foreign currency receivables/payables currently listed on the balance sheet. Additionally, the company may also forecast foreign exchange risk exposure out one year. However, if the company does not wish to hedge all exposure, as many do, the plan may include hedging 75 percent of anticipated exposures less than six months out and 50 percent of anticipated exposures six to 12 months out. This is called a tiered hedging approach.

Often companies ask if it is best to hedge all known exposure at one point in time, called a static approach, or if they should layer on hedges — a dynamic approach — throughout a defined time period while blending the varied rates. It is important to consider the level of confidence in forecasted payables and receivables to decide which strategy is best. When considering an approach, it is important to define what percentage of ‘core’ hedges should be locked-in vs. the percentage that should be ‘tactical’ or market driven hedges.

What should companies know and understand before hedging their foreign currency risk?

Throughout the risk management process, the most challenging step can be exposure identification. Foreign income translation can be challenging to hedge, but it may be the cause for unwanted cash-flow fluctuations. Meanwhile, other foreign exchange risk exposures may go completely unnoticed. For example, a company that sells internationally in USD would be extremely vulnerable on a competitive scale if the U.S. dollar rallies broadly. Conversely, if a U.S. company is sourcing overseas in U.S. dollars, it may be over-paying, prompting price concessions.

It is also important for a company to know and understand their tolerance for foreign exchange risk. It is not always advantageous for a company to hedge all of its exposures. Comfort with a specific earnings-at-risk or cash-flow-at-risk will help prevent over-hedging.

Developments in technology and globalization mean the world is increasingly becoming a single market. Often, companies grow faster than their comfort level in managing associated foreign currency risks. Fortunately, the foreign exchange risk market is extremely accessible to businesses of any size, and banks’ foreign exchange risk advisory teams can help tailor risk management solutions that best fit companies’ ever-changing needs.

Insights Banking & Finance is brought to you by Huntington Bank

How to identify the right banking partner for your technology company

Since 2009, there has been significant growth in the number of new technology companies as a result of an increased amount of capital available to entrepreneurs through venture capital, growth equity and corporate investment.

Technological advances have made it easier for companies to create and scale their businesses, and has contributed to the amount of new tech companies present today.

But what about the actual business of creating these innovative products? Most startup companies face a plethora of administrative challenges. Investor-backed technology companies typically have a finite amount of time and capital to create value and attract subsequent equity investment. As a result, they are forced to be thoughtful when selecting service providers.

Smart Business spoke with Peter Haman, Vice President and Relationship Manager for the Technology Banking Division at Bridge Bank, about what technology companies can do to identify a suitable banking partner.

Where should technology companies begin their search for a bank?
With over 6,000 banks in the U.S., there are only a handful of banks that provide complete banking services to technology companies and even fewer that do it consistently.

Within the small group of banks that do provide treasury and credit services to technology companies, many dedicate more time to providing services to investors or the investors’ funds. Technology companies need to consider a bank that has a primary focus on what it does rather than those banks that support the broader technology industry.

Second, once the companies move beyond the limited scope of banking options, there are a number of operational challenges that are unique to technology companies. For most seed to early-stage companies, the primary goal is validating the product or business model through an initial product launch or through early sales traction.

Given these goals, combined with the traditionally limited resources these businesses have to employ a full-time finance professional, banking becomes a low priority for early technology companies. Having a banking partner that has the experience to recognize these priorities and can help guide the founding leadership team is important.

Equally important is selecting a business bank that has an intuitive platform and a responsive relationship team that acts as a trusted counselor to the leadership team.

What happens as the process to grow the business moves ahead?
As technology companies validate their business models, the priorities for the business often shift to boosting sales as a way to attract further investment.

Scaling rapidly can create several operational challenges. So the third piece of the puzzle should be to find a bank that can identify the business’s growth trajectory and proactively recommend treasury solutions to help address and automate part of these operational burdens.

During this same time, business banks are able to begin extending credit given a company’s sales traction or capital investment by institutional investors. The type of credit most often provided solves two main challenges with scaling companies: working capital and runway extension to the next equity event.

Technology companies should seek out a banking partner that can tailor credit solutions to the business objectives and anticipate future capital needs.

Finally, when technology companies begin to reach scale and they can dedicate more time to long-term objectives, their banking partner should be strategizing and collaborating with the leadership team to ensure the appropriate products and services have been implemented to meet these long-term goals.

A bank specializing in technology businesses should be able to asses an organization and recommend account structures and services to best meet the client’s needs. The type and amount of credit a bank can extend impacts a later stage technology company’s ability to execute on strategies or implement cost-effective capital solutions.

Most technology companies are challenged with universal issues whether it’s fundraising or solving growing pains. An experienced business bank should be able to identify these challenges and deliver the appropriate solutions no matter the life stage or market segment that applies.

Insights Banking & Finance is brought to you by Bridge Bank

How to ensure a smooth transition as your company automates its processes

Automation affords companies the opportunity to provide more efficient service to customers, but caution must be taken with the manner in which this efficiency is achieved, says Matthew Berthold, Executive Vice President and Chief Administrative Officer at Westfield Bank.

“A lot of the larger banks follow a mass banking strategy with banks located everywhere, which is the traditional way of banking,” Berthold says.

“There are some customers who like that connection and like to be able to go to the office to do their banking. Others appreciate the growing movement toward self-service banking that utilizes automation. Every bank, and every business, needs to figure out how to deliver its own products and services most efficiently in a way that satisfies its customers.”

Berthold has been working on an in-depth project this year to automate processes at Westfield Bank. One of the most valuable lessons he has learned is the importance of always keeping the end customer in mind as decisions are being made.

“It’s important for us to look at all the processes that aren’t a value-add to the customer,” Berthold says. “It’s really trying to eliminate those non-value-added parts of the process.”

Smart Business spoke with Berthold about how to make automation work in your business without upsetting customers who value a more personal touch.

What are some helpful tips for companies looking to automate their processes?
One critical component to any change management strategy is an upfront dedication of resources to the task at hand. You need to completely commit to the investment to create buy-in throughout the process to ensure that you’re adequately addressing all the key concerns that may be out there.

If you’re not allocating the necessary resources and engaging the right people who have a stake in the change you’re considering and if you’re not using that input to guide your decision-making process, it becomes much more difficult to achieve your goals.

As part of that soliciting of feedback, you also need to examine the end-to-end processes you are targeting to automate. Be clear about what you have and compare it to what you’d like to achieve. In other words, you need to know where you are before you can determine where you want to go.

There are typically a number of steps to any process. You need to take a methodical approach to ensure that the new and improved process you formulate really is just that, a better way of completing the job. Metrics can play a key role in this step by giving everyone specific targets to aim for and goals to measure the success of the new system.

For example, there are certain steps that are part of extending a loan to a customer and there is a certain order in which those steps need to be completed. If you’re a bank and you don’t take a comprehensive look at the process and study how to make the transition, you may not gain the efficiencies you had hoped to achieve.

Finally, you need to alleviate fears that may be out there about what automation could mean to an employee’s future in the company.

It’s easy for non-management personnel who aren’t privy to all the details to view automation as an effort to reduce costs by eliminating positions in the organization when the end goal is actually to reduce costs by creating efficiencies.

Focus on what is being gained. Explain that automation will enable team members to focus on other tasks and in the process, make the company stronger.

How do you know if you’re maximizing the potential of automation?
When you’re dealing with new systems, there is often a learning curve to understanding their functionality and capability.

The dedication of resources is again important in this area to ensure that you’re making every effort to get the full benefit of the system you’re implementing.

You want to get what you paid for, so work with your vendors and make certain that they have delivered a product that meets your expectations.

Take advantage of their expertise to help you and your team understand how to use all of the processes that are now available through the new system. ●

Insights Banking & Finance is brought to you by Westfield Bank.

There’s no risk in hedging, but much risk for companies that don’t

Hedging for companies that buy or sell commodities helps protect a company’s cost of goods sold or top line revenue. It allows a company to lock-in the price of a particular commodity for a certain period of time to limit exposure to unexpected price swings that could negatively impact budgets and bottom lines.

“Good candidates for hedging are midsize companies, especially those buying a lot of fuel, metals or agricultural products, for instance,” says Jim Altman, Middle Market Pennsylvania Regional Executive at Huntington Bank. “It also applies to businesses that bring in specific commodities, value-add such base-metals like aluminum or copper and move them out, which means they’ve got to inventory their price risk. Anyone directly purchasing commodities should have a hedging strategy. If commodities are a big cost component, companies should use every tool or strategy available to de-risk their purchases by stabilizing pricing.”

Smart Business spoke with Altman about commodities hedging, how it works and what companies that purchase commodities should consider to mitigate their price risk.

Hedging can help protect gross margins from wild or inconsistent swings in prices. How does this work?

Financial hedging to reduce price risk means decoupling the physical commodity from the price component, which tends to fluctuate. How a company buys the physical materials doesn’t change. It’s about the financial hedge reaching a settlement that gets them back to a price that’s stable and reliable.

When hedging, companies buy a commodity at a locked-in rate over a defined period of time. At the end of each month, there’s a gain or loss versus where commodity index settled. If the company is a buyer of a commodity and the price goes higher than the set rate, a settlement comes back to the company. If there’s a loss on the hedge the company can still realize a gain in the physical buy — there’s a settlement in the market that’s offset by the lower prices.

Midsize companies are typically worried about a spike in diesel prices that they can’t pass on to clients. Some of these companies may burn 100,000 gallons per month, so they don’t want to risk a spike of 50 cents. Putting a financial hedge on that commodity offsets any price change on the diesel index.

What do those interested in commodities hedging need to understand or consider before they participate?

Companies must understand their price risk. In transportation, companies buy diesel but may or may not be able to pass on or surcharge their customers for any swing in prices. What’s important is defining the price risk the company will bear — that which it cannot pass on to customers — then setting up a strategy to hedge that risk.

It’s a gut-check question. Companies should recall the last time gas went up to $4 per gallon and how that affected them. Those costs likely couldn’t be passed along to customers.

Be honest about how much of an increase the company could absorb. Define what part of that increase the company might be able to pass along. Are margins being protected? Taking price variability off the table will help set the strategy for the hedge price and how long it should be hedged for.

What are the factors that determine a company’s hedging strategy?

Many companies don’t understand they have exposure until it’s too late — for instance, after a price run up. That’s why it’s important for companies to understand their exposure.

Those that are worried about their budget in 2017 should set a budget for their commodity purchases in the third quarter and then hedge the cost. It’s a best practice to have a hedging strategy that reaches out 24 to 36 months, which allows the company to average out the dollar cost and mitigate the volatility in commodity pricing. A company could decide to be 75 percent hedged at first then taper down as time moves on. But don’t quit hedging.

Do an annual review. Check to make sure nothing has changed in the exposure. Check to see if contracts and risks are the same, if line items have changed and that the strategy is in line with exposure.

Hedging is good insurance. It also helps companies be more thoughtful about their exposure, and determine a strategy to reduce that risk.

Insights Banking & Finance is brought to you by Huntington Bank