Privately-owned companies discover the advantages of mezzanine financing. (Special Advertising Profile: Key Principal Partners).

A Los Angeles leader of a local management-owned business who cannot borrow all the necessary capital for a desired acquisition has special needs. So does a family business owner seeking some liquidity for a long held equity position and wanting to arrange for "the younger generation" to step up to a higher ownership position. These business owners are discovering that "mezzanine" or "junior" capital may be the solution in achieving important strategic goals while maintaining free cash flow and a controlling interest in the company.

"Junior capital is often the best mix of flexibility and cost, offering business leaders the chance to accomplish their goals today and maintain the opportunity to make decisions later," says Andy Bacas, a principal at Key Principal Partners (KPP). KPP is a $1 billion family of junior capital funds targeted exclusively for investments in mid-size private companies. Typically, KPP can invest up to $20 million in any one company.

How it works

A mezzanine investment security usually occupies the middle part of the capital structure, below the interests and rights of senior lenders, but senior to shareholders' equity. Junior capital providers, are typically willing to provide financing to private companies to fill the void between the fair value of assets they plan to acquire and the limited borrowings they can make against those assets.

Junior capital can take the form of subordinated debt, preferred stock or common stock. In most circumstances the cost of junior capital is higher than secured bank debt, but is much less restrictive and has long maturities (seven to 10 years) before principal is due. Most forms of junior capital have an equity component, which means a portion of the investment is convertible into equity after a certain period of time. However, non-controlling junior capital is much less dilutive and significantly less expensive to existing ownership than new equity.

Bacas explains that strategic acquisitions, financing ownership structure changes, and recapitalization are among the most popular uses of junior capital among family-owned and management controlled businesses.

Helping with strategic acquisitions

According to Bacas, KPP recently helped a manufacturer that had learned its largest supplier was about to be put up for sale. "Controlling a supply source can be critical to the strategic development of a company, and there's, the risk that' a competitor might purchase a supplier and lock up a key source of supply," explains Bacas. "If the se ling price of a supplier is five times its cash flow and a company's bank can only provide' senior financing equal to three times cash flow, how does a company successfully acquire a critical supplier?"

The solution, says Bacas, is to find a junior capital firm to fund approximately 1.25 times cash flow with subordinated debt, leaving 0.75 times cash flow to be covered by the family owners with cash equity. The junior capital provider could be given warrants that could convert into equity in five years, but the equity given up is comparatively small, the family would retain majority control of the entity formed to hold the acquisition. The owners of the company would accomplish their strategic goal, limit their out-of-pocket cash outlay and maintain control of the asset they acquired.

Providing liquidity to a retiring partner without changing ownership structure

Junior capital can also be used by owners to finance out retiring partners. In such deals, for example, the agreed upon value of a business might be five times cash flow. The owner does not want to sell the business, but cannot borrow enough cash from the bank to buy-out the partner. Furthermore, the bank will require principal repayments over the next several years and the owner may not want to restrict the growth of the business during a critical strategic period.

The business owner could bring in a financing partner to provide subordinated debt equal to about 2.0 times cash flow, with no principal due for seven years. The company would give up a small portion of equity in the form of warrants to the subordinated debt provider, but provide a liquidity event for the retiring shareholder. As the company grows, it would be able to pay off the subordinated debt with lower-cost bank debt. The ownership structure of the company would not be disturbed.

When recapitalizing may make sense

These strategies can be extended to larger recapitalization transactions, whereby a family-owned or management-controlled business can engineer a substantial liquidity event without selling control of the business to a third party. Many business owners believe the only way to take substantial cash out of a private business is to sell the entire enterprise or to go public. However, depending on the amount of existing debt and other-factors, there are a wide variety of alternatives available to business owners as they ponder the strategic, wealth management and retirement issues before them. Leveraged recapitalizations of steadily performing industrial businesses can be an attractive way to accomplish a number of objectives in one transaction.

"For many businesses, now is not a good time to be selling control," says Bacas. "Results may be depressed, the bank lending market is not good, and buyers are not being aggressive. We think recapitalizations are the better way to go for many companies, especially in today's market, and it's a good time to have some personal liquidity. It is also a good time to be a buyer, both for business and personal reasons."

Good candidates for recapitalizations with subordinated debt, according to Bacas, are businesses that operate in established markets, generate substantial cash flow, but may not experience top line growth beyond a few percentage points a year.

"A private company that has done well, for a number of years and has little debt on its balance sheet, is likely to have a lot of value in the plant, equipment and inventory," Bacas explains. "A family ownership group may not want to sell its business, but may want to engineer a significant liquidity event for the senior generation, while providing the younger members of the family with a smaller amount of liquidity. If conditions improve and a good sale opportunity arises in the future, the family can always sell control of the business when the time is right."

How KPP works with owners

KPP has a strong reputation of working with families on a personal basis and with viewing its investments as partnerships and long-term commitments. Typically, KPP is the only outside equity investor with its partner companies, and the family usually maintains control and governance of the company, with KPP functioning primarily as an advisor.

"We prefer to work with family-owned businesses because they are typically careful, conservative and very dedicated to customers and employees," says Bacas. "We admire and respect those values."

KPP focuses on companies that do something important for their customers, or deliver a product or service that is hard to compete against or copy. Bacas adds, "We call it the 'reason for being' test. Growth is not that vital, so long as there's staying power. Growth will come to companies that do a good job."

Many advisors have a vested interest in championing the "sell the whole company" option to accomplish corporate financial objectives, advises Bacas, and few owners really appreciate how difficult that process can be. "Taking the middle course is often the best course; time usually works to people's advantage. We help private companies explore more options, do more things and take more time. In the long run, that usually works out best."

Key Principal Partners looks to partner with privately owned businesses with more than $25 million in revenues and $4 million in EBITDA. The firm has special expertise in manufacturing and value-added service companies. KPP has offices in San Francisco, St. Louis, Cleveland and Greenwich, CT. Please contact Andy Bacas, Creg Davis or Andy Bacas at 415-733-2494 or [e-mail] with any questions you may have about this article, KPP, or junior capital in general.