Andrew Wiechkoske has never had the unfortunate experience of having a deal fall apart at or near the finish line, even though he’s worked at PNC since 2008 and completed more than $1 billion acquisitions.
“We don’t get focused on driving to the very best economic outcome,” says the managing director of PNC Riverarch Capital, the private equity affiliate of The PNC Financial Services Group. “We focus on working with people that we know and that we trust and that will deliver on what they tell us.”
Despite its deal structure preferences, the PE group knows relationships are critical. For example, PNC Riverarch works almost exclusively with five or six lenders that it trusts.
Wiechkoske discussed how to set up the right capital structure at the 2019 ASPIRE conference. Here are some of his insights:
From an equity sponsor’s view, what’s your process for forming a capital structure in a typical acquisition?
We start with a fair amount of internal modeling at our firm. We focus not only on what we think will be the most likely scenario, but also what we think is a reasonable worst case.
When we finance a business, we want that financial structure, that capital structure to work in good times, but also to work in times that aren’t so good. We start with our own internal models and run three to five cases of varying levels of performance to see what a business will support.
While we’re doing that, we look to collect market feedback — primarily to understand what the market will support in terms of leverage and capital structure, but also to collect some market intelligence on a transaction. You can often learn a lot from talking to lenders that are in the market. Maybe they’ve financed a similar company. Maybe they have a history with the company that you’re interested in acquiring and can provide some historical perspective.
What are your goals when formulating the structure?
We primarily utilize leverage to amplify and improve our returns. We, as a firm, and most private equity firms, emphasize investments that have cash flow. So, we’re utilizing that cash flow to pay down debt and service the debt over the course of the investment.
Our cost of capital is typically 17, 18, 20 percent and the senior debt cost of capital can be as low as 3 or 4 percent. So, substituting some of our expensive money with cheaper money allows us to generate a much stronger return among our equity. That’s the overarching goal for us.
As we think about making that work with some other goals for the business, primarily financial flexibility, we want a capital structure that allows management to have operating flexibility. We don’t want our teams focused on financial covenant compliance or anything related around the debt — to the extent that that diverts their attention away from growing the business and making the enterprise more valuable.
How do you work with the executive team?
The one thing that’s important to us in setting up a capital structure is to have good alignment with the senior executive team of our companies.
Ideally, they’re invested in the same securities and on the same terms as you are, and they’ve invested an amount of money that would be meaningful to them, whatever their personal or professional circumstance. We want everyone to have the same skin in the game and for us to all be pushing in the same direction.
Do you prefer seller debt or rollover equity?
We have a decided preference to incentive alignment with our companies and the executives at those companies. We, overall, prefer rollover equity.
When we do well, we want the former business owners and the management team to do well, and if we don’t do as well, frankly they shouldn’t do as well either.
So, we prefer equity. There are some situations, however, where that’s maybe a little less practical.
What are examples of tailoring financing structures to each situation?
Midway Dental Supply is a fast-growing distributor of dental products and supplies in the Midwest, effectively from Detroit to Chicago, run by a very impressive, growth-oriented entrepreneur. The business has consistently grown at 50 percent-plus per year. That business, though, is capital intensive. So, it’s hard to grow the business and pay down debt at the same time because you’re investing in inventory and receivables, you’re investing in salesforce.
We wanted to set up the business, first, with a modest level of debt to reflect the fact that there wasn’t a tremendous amount of cash flow being generated, but also something that would grow with the business as we needed to finance acquisitions and working capital over time. So, we looked to an asset-based financing model with modest debt.
A contrasting transaction would be a business called Sola Salon Studios, which we closed last fall. In that business, because it’s a franchise model, cash flow is very strong. Growth doesn’t require any capital investment because franchisees are making that investment on your behalf and the primary cash flow is royalties, which are highly recurring, contractually obligated and there’s a tremendous amount of visibility.
There, we capitalized the business with more than seven turns EBITDA external debt. Most of our businesses couldn’t support that, but that was one that could. That level of debt was probably required for us to ultimately win the deal and generate a good return.
With debt repayment, how do you deal with interest and amortization?
In order to get flexibility about things like covenants, amortization or to establish an acquisition line — and to work with lenders that will facilitate those things that are important to us — we might give up a little bit on interest. It’s not that it’s entirely unimportant. It’s just not No. 1 on the list.
On amortization, we want to be able to pay back debt, but we want to be able to do that at our pace and when it makes sense for the business. One year, you [might] have a large capital project or an acquisition that makes it more difficult to have a few million dollars of excess cash flow to pay down debt. We don’t want to be precluded from engaging in those growth-oriented activities because we have to pay back the bank. It’s important to have that type of flexibility.
Every economic term is important, but we don’t focus on any one, and instead emphasize the totality of the financing package.