Dave Enright finds capital markets for middle-market buyers to be bifurcated into two separate worlds, with $5 million EBIDTA as the dividing line.
“Below $5 million EBIDTA, it’s kind of the wild, wild west — very inefficient, and the sources can come from a plethora of different sources,” says the senior vice president and commercial banker at S&T Bank. “Above $5 million, it tends to be a little bit more efficient of a market, and things like getting mezzanine and equity checks are more defined and specific.”
Enright’s experience has been mostly in that lower middle market, where the rules aren’t as set. He typically does $5 million to $50 million senior debt deals that are a combination of senior, mezzanine and equity debt.
Enright shared his thoughts at the Smart Business Dealmakers Conference in September on raising capital to buy companies.
When you talk about $5 million EBIDTA as the dividing line, is that pro forma?
It’s a frothy market today. The deals we see, companies very rarely come in at $5 million every year. It’s usually a little bit up and down, and in this market, people are buying off the highwater mark. So, when I say $5 million, I’m talking about recent trailing 12-month EBIDTA, versus pro forma.
Beyond EBIDTA, what else is considered when setting up the capital stack?
You’re solving for a few other variables. Things like, what are you buying the company for, what’s the equity check capacity from the person buying, what’s the collateral base and how much of it is blue sky or air ball lending?
Who’s buying the business — a fund-less sponsor, a private equity group, a family office —drives the deal structure. That can determine the equity check capacity and the optimal structure.
Once you’ve started to fill those variables in, you can start to decide who are the best sources for capital.
How does mezzanine funding usually work?
Mezzanine funders usually want to be one or two turns of EBITDA. Their pricing is somewhere between, low end, 8 to 10 percent to as much as 20 percent, but it is interest-only debt. They want to put a certain amount of money to work, a minimum check is $2 million to $3 million. So, mezzanine debt plays better in that $5 million and above space.
In the $5 million and below space, mezzanine debt is used from time to time, but it’s usually coming from private sources or seller debt.
Mezzanine senior providers also want to see skin in the game from equity, which ranges from 10 percent, usually using U.S. Small Business Administration scenarios, to as much as 50 percent.
What are a few examples of capital stacks you’ve seen recently?
A business had about $10 million in revenue, and $2 million in EBIDTA. We came in with a $5 million senior piece, the equity was around $1 million, and the seller debt and some other debt was about $3 million.
So, it was being purchased for about $9 million, $9.5 million. The all-in purchase price was four and a half times, and there was no institutional mezzanine debt in this deal. As I said, below $5 million, you usually don’t see that; it’s seller debt. It’s really an equity and senior play.
Another example was a deal that was $7 million in EBIDTA, which had mezzanine debt. The company had $40 million in revenue. It was purchased for about $56 million, which is a little bit over eight times. This was normal in this market for that size business in its niche.
We did $18 million senior debt. The mezzanine and co-equity debt were $15 million. It was a family office deal with $25 million in equity.
Switching gears, when a bank is determining whether to go forward with a loan, what helps the process?
I find deals go much smoother with banks when you put together a CIM, a confidential information memorandum, that goes into the intricacies and details of the deal. Buyers that are able to do that successfully allow the banker or the financer to really get familiar and understand the business in a succinct format.
There’s a lot that goes into those. The better ones are ones that really understand the industry, the company’s competitive landscape and the customer base. Usually in the space I play in, below $5 million, there’s customer concentration — it’s understanding how important those customers are and what are the sensitive points to that customer base.
What else can help smooth the deal process?
Another thing that I think is important is making sure the transition goes smoothly. It tends to work better when you have the seller on the hook for a seller note, where they work with you over the next couple of years through some type of consulting and/or seller debt. Those owners know the business well, and, depending on your investment thesis, you definitely want to keep your customer base throughout that process. Having the seller on usually helps with that transition.
You also really need to understand the cyclicality of the business and how recession-proof it is. Have a contingency plan in place in case it doesn’t hit the numbers that you expect. Banks like to hear that a company and the management have thought that through.