The following article is excerpted from a recent GE Lending Views Newsletter.
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The national economy is improving, mergers and acquisitions (M&As) and other activity are picking up steam, and corporate demand for funding is rising. In this market, cashflow-based debt financing can offer significant advantages over equity-based funding, say experts from Wharton and from GE's Corporate Lending team. But Federal Reserve data indicate that banks are retreating from the corporate lending market. In the wake of their pullback, nonbank financial institutions like GE Corporate Lending appear ready to fill the void. Following this discussion, see a Case Study involving Evercom on a real life example of filling the M&A financing void.
The Good News
"The good news is that after a rocky economic period, businesses are getting healthier," says Dan Karas, a Senior Vice President with GE Corporate Lending. "One indication of this is the volume of Chapter 11 bankruptcies, which are trending down. According to the American Bankruptcy Institute, corporate bankruptcies fell from 9,331 in the second quarter of 2003 to 8,446 in the third quarter." As companies regain their footing, M&A activity-like window manufacturer Atrium Companies, Inc.'s recent acquisition of Superior Engineered Products Corporation - is trending up.
"The recovery is spurring demand among large middle market companies, those with financing needs between $100 and $500 million, and more of them are expressing interest in cashflow-based loan structures," reports Karas . In the Atrium Co. transaction, for example, published reports noted that cash accounted for $42.5 million of the $47.5 million deal. "A few years ago, businesses might have looked to fund these deals with pumped-up stock, but a series of accounting scandals and market corrections have made companies a bit more wary of stock-based strategies."
The M&A Financing Void
Karas cautions that even as corporate demand swings up, there could be a crimp in the supply of funds. "In the last economic downturn many banks took significant hits to their corporate loan portfolios," notes Karas . "Because they operate in a highly regulated environment and must carefully manage their loan portfolio loss ratios, an increasing number of banks have limited their exposure by reducing their activity in that segment."
His observation is supported by a December 2003 Federal Reserve bulletin, which points out that following rapid growth during much of the 1990s, "the inflation-adjusted value of commercial and industrial (C&I) loans at domestic commercial banks and at U.S. branches and agencies of foreign banks has fallen 19 percent since the beginning of 2001."
Filling the Void
The share of total syndicated loan commitments held by nonbanks, "has increased from eight percent in 2001 to 11 percent in 2003," according to the Federal Reserve report, titled Recent Developments in Business Lending by Commercial Banks.
Considering the apparent swing away from equity-based financing, the nonbanks may be placing themselves in a good position.
"The question of debt vs. equity is one of the big issues in corporate finance," says Wharton Professor Franklin Allen. "The traditional theory is that firms should trade off the tax advantage of debt against the expected costs of financial distress. There is a tax advantage to debt because interest is tax deductible but dividends are not. And issuing equity can be expensive, since the transactions costs are high."
Market conditions can also play a role in the demand, he adds. "It's best to issue equity when you think it is overvalued, and to issue debt if equity is undervalued," explains Allen. "But if buyers think the issuing firm views the equity as overvalued, they may be reluctant to take it on." Instead, he says, more financing is now done through debt issues and equity is built the traditional way, "by retaining earnings rather than issuing equity."
But despite his overall endorsement of debt financing, Allen still has a concern.
"Companies need to carefully monitor their debt levels," he warns. "If the firm has a lot of debt it is more likely to go bankrupt and this is costly." Karas agrees, and says that as the overall economy continues to recover, companies need to strike a balance between seizing appropriate opportunities and pacing their growth.
Trends
The steady, yet measured pace of the economic comeback is also driving some other lending trends. "As businesses continue to move to cashflow-based loan structures, we've noted that 'Term A' loan volume has faded and 'Term B' activity appears to be replacing it," says Karas. Term A loans generally carry a similar interest rate to a Revolving Credit Facility and amortize on a straight-line basis over the life of the term.
Term Bs, on the other hand, carry a higher interest rate, and generally have a nominal principal amortization schedule, with a balloon payment at maturity. Often, nonbank lenders like GE Corporate Lending partner with Term B buyers like investment banks and institutional investors to spread the risk of big-dollar loan activity. "As lending activity in this category expands, we're likely to see a rise in the volume of transactions with Term B components that require an institutional placement, " comments Karas.
"In GE Corporate Lending's case, the combination of an improving economy, our collaborative efforts with other nonbank lenders, and the growing Term B appetite will drive deal activity and structure.
Meanwhile, the combination of our revolver hold-which eclipses that of traditional banks-and our willingness to collaborate with investment banks and institutional investors makes us an attractive partner in the debt finance market."
According to Wharton professor, John R. Percival, there's a good chance that the market will continue to expand. "Companies seem to be aware that debt may be cheaper than equity because of the tax deduction, but they say that they manage their capital structure to maintain flexibility," he says. "That seems to mean keeping some unused debt capacity just in case something happens that they did not foresee. Debt financing also seems to be a matter of investment opportunities-companies will use internally generated cashflow (equity) if it is available, but will borrow if the equity is insufficient for their needs."
A Case Study:
Evercom Systems - one of the country's largest independent suppliers of detainee telecommunications and information management solutions for correctional facilities - delivers high quality solutions and builds longterm client relationships. But a growth spurt fueled by a dozen strategic acquisitions between 1996 and 1998 left the company saddled with high-interest debt, and Evercom turned to GE Corporate Lending for a financial solution.
"Our business plan-entering new geographic markets through a targeted M&A strategy-was validated by our success in the field," says Evercom CFO Keith Kelson. "The only drawback was that we had to fund the growth with high-yield senior bank debt and publicly traded bonds that carried interest rates of up to 18 percent. The plan was to retire the debt with an IPO, but the capital markets put this plan out of reach. Subsequently, a recession gripped the economy which hampered our ability to maintain a highly leveraged balance sheet."
Initially, the company was frustrated in attempts to restructure its debt. "We had healthy EBITDA (earnings before interest, taxes, depreciation and amortization), but found that banks and other potential lenders had a tough time understanding our industry, and hesitated to lend to us," explains Kelson. "Fortunately, we were pleasantly surprised when we spoke with GE's Corporate Lending team."
The company's relationship with the lender actually extended back some years, to the time that GE acquired Heller Financial, Inc., which was already doing business with Evercom.
"GE helped to restructure our balance sheet with a $57.5 million cashflow-based loan that carried competitive interest rates," reports Kelson. "The GE team was very patient, took the time to learn about the fundamentals of our industry, and worked very closely with our management to learn about our company."
Dan Karas, a Senior Vice President with GE Corporate Lending, says it was a matter of looking beyond the company's short-term issues. "As we engaged in the due diligence that's part of our ACFC ( At The Customer, For The Customer ) approach, it became apparent that Evercom was-and continues to be-a well-run company that got caught up in factors beyond its control," he comments. "We were confident enough to take a $30 million hold position, which sent positive signals to the financial community."
He adds that a variety of observations gave GE confidence in Evercom's long-term health.
"To begin with, the company's contracts typically run for three to five years, which means it's likely to recoup its investment and achieve a good ROI," says Karas. "Further, an average contract renewal rate of 95 percent means Evercom has a dependable revenue stream."
GE's strategy worked out, and today Evercom has a solid balance sheet as well as an expanding customer base. "We continue to examine M&A opportunities, but with GE's guidance we're now more focused on financial issues that can have an impact on our operations," says Kelson. "Meanwhile, as we continue to grow we'll look to GE first when it comes to debt."
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