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Capital Insights: How lenders can handle quirky deals in a frothy market

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Heading into 2015, it’s safe to say that Canadian banks are open for business. According to the Bank of Canada’s Q3 2014 business lenders’ survey, bankers have once again confirmed that credit markets are robust and demand for credit among Canadian companies is high.

This is good news for commercial bankers who now have a wide range of lending tools at their disposal and the strong support of their credit rooms. Intense competition has lead to the return of high leverage and covenant light structures, but there is no substitute for good advice and sound structuring when it comes to winning business. This is particularly true in the case of quirky deals. Although required less often in this type of market, sub-debt and mezzanine financing remain useful tools in deals that feature unusual elements.

Growth

Rapidly growing companies often make significant investments in their people, equipment or facilities in order to keep up with customer demand. We have seen this recently in several manufacturing and oilfield services transactions. The deposits required on equipment purchases, down time associated with re-tooling, and cost-overruns on expansion initiatives can lead to pressures on working capital.
In other cases we have observed growth situations that are complex and require time and consideration, such as a family business looking to diversify by entering a new industry and a business seeking to grow through new product development. We also have clients who have rapidly growing seasonal businesses that require working capital support during the slow season.
Even when the growth strategy makes sense and financial results to date have been solid, these situations can be challenging for bankers given the reliance on projections. Sub or mezzanine debt provides a layer of comfort behind the senior lender that fills the gap between the company’s historic results and its future needs, smoothing the growth path for bank and borrower alike.

Unusual security

Sometimes it’s tough to finance all, or even part, of a transaction if the collateral available is unusual or unique. Certain kinds of security, such as highly mobile, very high value and/or compact assets, can be particularly problematic. Lenders are ultimately worried about the enforceability of their security and this can be further exacerbated if the location of the security is outside of Canada.
By ascribing lending value to unique or foreign security, sub-debt can supply additional capital to your clients without diluting ownership. We can assign higher lending value to assets that wouldn’t normally be considered by senior lenders – such as helicopters and diamonds – giving additional buffer or reassurance to the bank.
Similar challenges can present themselves on high-ratio real estate financings. Banks are typically comfortable lending 65-75% of appraised value so as to leave lots of residual value in the land as an insurance policy against ups and downs in the real estate market. However, many companies prefer to finance the down payment on real estate purchases in order to conserve working capital. Working closely with the banks, we have assisted several companies across Western Canada to buy their premises in this way.

Earnings history

Other quirks can include hiccups in a company’s earnings history that make it difficult for banks to easily understand debt service coverage. These include one-time inventory write-downs, currency adjustments, the transition from R&D stage to full product commercialization and other extraordinary circumstances. As long as we genuinely believe these items to be non-recurring, we can find a way to support such businesses.

Fit

There are instances where a borrower has simply outgrown one of their funding partners. This can happen for several reasons; policy or mandate constraints, and misaligned management styles are most common. Although many banks have in-house cash flow lending products, most are restricted to certain client profiles or industries. For example, deals in the retail and hospitality industries may be difficult to finance using only senior debt due to the nature of their assets.
Sometimes the misfit between a borrower and a funding partner is as basic as management style, approach or rapport. When fit becomes an issue, there may be an opportunity to refinance the existing lender with one who represents a better partner for the bank and borrower alike.
Frothy credit conditions will likely continue for the foreseeable future. Expertise, sound credit structuring, and the effective use of creative partnerships are the keys to winning business in this environment. Sub-debt can be used to address gaps and help bankers get comfortable with the twists and turns of quirky deals.

Capital Insights is a regular series on financial industry trends and challenges written by Kristi Miller, vice-president and co-founder of First West Capital. First West Capital specializes in financing small and medium-sized businesses, in amounts of up to $10 million, across all industries in Western Canada through customized subordinated loans and mezzanine financing.