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Debt financing for the middle-market.

Whether you are looking to fund growth, make acquisitions, refinance current debt or take money off the table, now is a great time to access the capital markets. The market is at a capital-activity peak, with the availability of debt greater now than it has been in more than seven years. The competitive financing environment has driven capital providers not only to become more aggressive in the amount of capital they provide, but also in the pricing they require and the covenants they set.

This has created a good environment for business owners to obtain debt financing, but for the best result, you must understand the costs and benefits of each alternative. When aligned with the right business strategy, the correct capital structure is a critical component to your financial and operational success.

Capital Structure Hierarchy

Senior debt, subordinated debt and equity are three of the key types of capital available to middle-market companies. Middle market refers to well-established and mostly private companies in traditional sectors, such as metalcasting, with annual revenues between $20 and $500 million. The capital structure hierarchy starts with equity, the most expensive and riskiest form of capital, and builds up to senior debt, the lowest risk and least expensive form of capital (Fig. 1). Subordinated debt (commonly referred to as "mezzanine" debt) falls in between equity and senior debt in both risk and cost.

[FIGURE 1 OMITTED]

Within each of these categories, a variety of financing options and structures exist. The type and amount of financing available depends on the owner's personal objectives regarding the level of ownership he/she is willing to forego, as well as the company's industry focus, customer base, collateral position, cash flow, strength of management team and a host of other factors.

Senior Debt

Senior debt is the most common form of financing used by businesses. It is generally the least expensive form of capital and has first priority in the event of liquidation. Two general types of senior debt are cash flow' loans and asset-based loans. With cash flow lending, the key driver of the loan is the company's operating cash flow, which is generally measured as a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization). Total senior debt available to middle market companies averaged 4.1 times EBITDA in the first quarter of 2007 but may range from 2.5 to 4.5 times EBITDA based on the specific attributes of an individual company (Fig. 2).

Conversely, asset-based lending primarily depends on the quality and quantity of assets owned by the company, with the amount of the loan driven by advance rates against certain asset classes (e.g. accounts receivable, inventory, equipment and real estate). Traditional asset-based lending focuses on the underlying collateral in a liquidation scenario and therefore is concerned with assets first and cash flow second.

Another form of senior debt is the over-advance loan. Many senior lenders will provide a combination of asset-based and cash flow loans. This type of loan considers the amount of debt that is available based on asset advance rates but also will provide an additional over-advance loan based on the cash flow of the company (sometimes referred to as an "airball"). Generally, over-advance loans have a higher interest rote and require accelerated amortization with full recapture in one to three years.

Overall, the senior debt markets remain a strong source of attractively priced capital, as interest rates remain low, credit spreads are attractive and lenders continue to have significant capital available to invest.

Subordinated/Mezzanine Debt

Subordinated debt is debt financing that represents a bridge between senior debt instruments and equity. Total subordinated debt available to a middle-market company generally ranges between 0.5 and 1.5 times EBITDA.

The structure of mezzanine debt varies and offers flexibility with numerous amortization and interest payment scenarios. Additionally, subordinated debt providers often incorporate equity-based options, such as warrants, to enhance the overall return (Table 1).

Matthew Jamison and Gene Bitoni, P&M Corporate Finance LLC, Southfield, Michigan

Matthew Jamison is director and Gene Bitoni is vice president of P&M Corporate Finance LLC, Southfield, Mich.
Table 1. General Parameters for Subordinated Debt,
Middle Market Transactions

 Minimum Maximum Average

Current Coupon 9% 19% 12%
PIK Interest -- 9% 2%
Warrants % -- 24.4% 3-5%
Closing Fee 1.5% 3% 1.75%
Target IRR 15% 44.7% 18%

Source: PMCF Estimates as of June 2007

Table 2. Senior Debt vs. Subordinated/Mezzanine Debt

 Advantages Disadvantages

Senior Debt Cheapest form of financing May not cover entire
 No loss of ownership financing need
 Interest is tax deductible Least amount of
 Most readily available operational flexibility
 source of capital Must be secured,
 potentially with
 a personal guarantee

Subordinated/ Less (or zero) loss of More expensive than
Mezzanine Debt ownership than equity senior debt
 Takes the form of equity Will restrict cash
 but is less expensive positions and may
 Involvement of mezzanine result in warrant
 financiers as objective positions
 counsel Financial disciplines
 Typically does not and controls imposed
 amortize, providing
 incremental cash flow.

Fig. 2. Total senior debt available to middle market companies may
range between 2.5 and 4.5 time EBITDA.

2000 3.1
2201 2.7
2002 2.8
2003 3.0
2004 3.5
2005 3.9
2006 4.3
2007 4.1

Source: LCD Comps, Thompson Financial Group, Company Reports

Note: Table made from bar graph.
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Title Annotation:CAPITAL GAINS
Author:Bitoni, Gene
Publication:Modern Casting
Date:Jul 1, 2007
Words:893
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