Capital Structure Analysis
In Private Transactions

Two weeks ago I started a series on an approach to evaluating private transactions. In the first part I set forth the idea that there are three pillars to effectively evaluating a transaction - capital structure, ownership and company. The evaluation of these three pillars helps frame two of the cornerstones of your transaction - the size of the commitment and the required return. 

In this second part of the series we'll look at the first of the three pillars - capital structure. Capital structure refers to how a business finances its operations and growth. At its simplest level capital structure consists of debt and equity.

The components of capital structure that I'll discuss below are: Leverage; Loan-to-Value; Liquidity; Inter-Creditor Relationships; and Bankruptcy Considerations.

 Leverage - Leverage in this context refers to debt to cash flow, with cash typically defined as EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). If you are evaluating a business that has significant capital expenditures, ("Capx"), you will want to consider using free cash flow ("FCF") in your leverage calculation. FCF is simply EBITDA less normalized Capx. If you find that the company's depreciation is a good proxy for Capx, then you can use EBIT or EBITA.

A company's Leverage is the back-of-the-envelope metric, or shorthand, used by corporate finance professionals to measure the debt load of a company. Additionally, it is a metric that speaks to the general mood of lenders; i.e. higher average leverage ratios mean that lenders are aggressively pursuing lending opportunities while lower average multiples reflect cautiousness on the part of lenders.

Leverage in a transaction will need to be assessed for both senior debt as well as any junior debt (also referred to as mezzanine or subordinated debt). The leverage multiple is expressed as a cumulative number, so that if senior debt is "3.0x cash flow" and there is half again as much debt from a junior facility, the total leverage would be expressed as 4.5x cash flow.

For example, if a company had $2.0 million of cash flow, $5.0 million of senior bank debt and $1.0 million of junior debt (which can either be "institutional" sub-debt or seller debt). The leverage ratios would be 2.5x senior and 3.0x total debt.

The "right" amount of leverage is more art than science. It needs to be weighed against credit statistics such as interest coverage and fixed charge coverage, the company's business model, and the loan-to-value, or LTV.

Loan-to-Value - The leverage ratio cannot be thought about in a vacuum; it needs to be considered against the enterprise value of the business. When I was a lender I would regularly receive queries about what multiple I would lend. The only valid response would be "what's the business" and "what's the deal". There were times someone would be looking for 3x senior financing on a business they were acquiring for 3x or 3.5x cash flow. So from a purely multiple standpoint, 3x cash flow sounded reasonable, but when considered in the context of LTV, the request clearly consisted of some measure of equity risk.

The LTV analysis is easier when considering an acquisition transaction - where there is a money vote on the valuation. And even here, I'd submit that you'll want to validate the valuation by running your own return calculations and looking at comps (to the extent available). In the case of a refinance or recap, it's a combination of judgment, experience, available comps and some math. All you're looking for is some reasonable range on the enterprise value to put the transaction into proper context.

Liquidity - Liquidity refers to the short-term capital a business requires to finance its daily operations. A company's liquidity is generated from 1) profitability; 2) working capital; and 3) lines of credit. Reviewing a company's statement of cash flows is a great place to start when assessing cash flow and liquidity. If you're not familiar with how to think about the statement of cash flows (and, you're not alone), think of it as what ties the income statement and balance sheet together.

Working capital analysis involves looking at the business's cash cycle and whether cash is being generated or consumed by the company's working capital. One of the simplest fixes I've seen from buyout professionals has been fixing a company's working capital. In more instances than I can recount, significant buyout debt had been repaid from cash generated from better working capital management.

Finally, with respect to any line of credit, make sure that it is sufficient to meet cash flow demands. Look at advance rates as well as excess availability.

Inter-creditor relationships - Inter-creditor relationships refers to the agreement(s) between different classes of debt holders. The most common would be the inter-creditor agreement between a senior lender and a subordinated lender. These agreements spell out the rights and remedies of each class of lender and typically only comes into play when there is a default or an event of default. The inter-creditor agreement will spell out what kind of blockage rights one class of lender will have over another. And while this topic may be of more interest to the providers of debt capital to a business, it is also important to understand for the business owner or transaction sponsor.

Bankruptcy Considerations - Bankruptcy considerations address the question of what happens in the event the company files for bankruptcy protection. From the perspective of a junior lender - which can either be a third party lender or a seller note - the junior lender will want to be secured. In the event of a bankruptcy, if the junior lender is unsecured, he will fall into the same class as all other unsecured claims. If however the junior lender is secured, he will have a priority claim over the unsecured debtors to any proceeds from a liquidation. The other implication here is that the topic above - Inter-creditor Relationship - comes into play. If the junior lender has a second lien on the company's assets, the senior lender will want to make sure that they can control the security so that they protect their priority claims on the secured assets.

This covers the first pillar for effectively evaluating a transaction. While each of the areas discussed can be taken deeper, the purpose here is to give you a framework with which to think about a transaction. The next article in this series will address the second pillar of evaluating a transaction - Ownership.