As leveraged buy-out professionals, debt (i.e. leverage) is fundamental to what we do. When used properly, it enables us to generate higher returns on invested equity. It also instills valuable disciplines and practices in the companies we have invested in or acquired.
Although often feared – particularly by entrepreneurs – properly used debt can provide business owners the same benefits. Some things to consider about debt are: How much is desired? How much can be supported? What type? What is the lending environment?
How much debt is desired? This depends on how the debt will be used. Most often, debt is used to fund growth or to bridge working-capital cycles. Debt also can be used to buy new facilities, fund acquisitions or provide partial realizations to business owners. Potentially, any capital needs of a business can be funded with some form of debt.
How much debt can be supported? This is the key question. For the answer, look at your company’s trailing 12-month cash flow – or earnings before interest, taxes, depreciation and amortization (EBITDA). The appropriate amount of debt typically is talked about as a multiple of EBITDA. For example, if your company is not expected to grow much but has a very high certainty of stable EBITDA, the right amount of total debt likely will range from 1.5 to 2.5 EBITDA. If your company is on a high-growth trajectory, then the right amount of debt might be as high as 4 or 4.5 times EBITDA.
However, when doing this calculation, BE CONSERVATIVE! The reason debt is feared by many business owners is that, if things go badly, the lender(s) can become very intrusive and expensive and potentially take your company. In our investing, we are far more conservative than most other professionals. It is very rare for our leverage to exceed 2.5 times EBITDA, regardless of the company’s projections. Things can go very differently than planned.
What type of debt? Essentially, there are three types of debt: senior term, senior revolver and sub.
Senior term is typically partially or completely unsecured, will have scheduled principal reduction payments, and often requires additional principal reduction based on cash flow. Because it is not wholly secured, lenders charge more for this debt (
usually at least a point or two) and want it paid off as quickly as possible.
Senior revolver, known as asset based lending (ABL) is the most commonly available debt. It is wholly secured – typically by receivables, inventory and other more liquid assets. Virtually all senior lenders offer and compete for this type of debt, and it is the most competitively priced.
Sub debt (or mezzanine debt) generally is not asset secured and is far more expensive than senior debt. Sub debt should be viewed as the middle ground between senior debt and equity.
What is the current lending environment? For the most part, lenders are cyclical “pack” actors. The availability of debt ranges from too much (like we experienced from 2004 to 2007, where debt was often more than five times EBITDA), to very little (like now, when most lenders struggle to lend over 2.5 times EBITDA). Regardless of where we are in the cycle, it will change. Because a number of lenders have done very well over the past year or so because of their low cost of funds, we are again starting to see more aggressive, competitively priced proposals.
The amount and type of debt you seek will dictate which lenders to approach.
Regardless, you probably should use some debt – but use it wisely!
Dan Lubeck is founder and managing director of Solis Capital Partners (www.soliscapital.com), a private equity firm headquartered in Newport Beach, Ca. Solis focuses on disciplined investment in lower-middle market companies. Lubeck was a transactional attorney, and has lectured at prominent universities and business schools around the world. Reach him at firstname.lastname@example.org.