With Attractive Equity Raises for small-caps and private entities poised to remain challenging, debt structures will continue to evolve to help fill the financing needs
Although equity for major transactions ($500 million and up in enterprise value) has clearly become more abundant in recent months…resulting in materially higher multiples for acquisitions in this space…equity raises with attractive terms for smaller transactions and for Micro-caps and private entities in general has remained challenging. There is a strong likelihood this trend will continue, at least in general, for a number of years ahead, with exceptions for specific sectors and specialized deals, for example raising equity for cloud computing firms in the first six months of 2011 has been less problematic than with other sectors.
The Challenges in Equity Markets
At the forefront of ongoing challenges for fair and attractive equity raises in the Micro-cap and private entity markets is the demise of the traditional Micro-cap IPO market. Since this article is limited to a discussion concerning U.S. markets and is focused on debt alternatives, a detailed analysis of the Micro-cap IPO market and post-IPO support in general for Micro-cap firms is not possible. Suffice it to say that this market has been in a period of continuous and substantive decline since 1997 for a whole host of reasons. The virtual elimination of small IPO’s as an exit strategy severely limits liquidation options for equity investments in private firms that historically would have viewed a traditional IPO as a likely exit mechanism. From a practical standpoint, a sale of the company to a strategic or financial buyer becomes the only likely scenario for returning funds to investors. For existing Micro-cap companies, the inability of firms to be reasonably compensated for research and executing trades makes after-market support very challenging. I have the privilege of hosting the annual meeting of the International Stock Exchanges Executives Emeriti and for those readers interested in this subject, we have created a “Small Business Task Force” headed by David Weild, former Vice-Chairman of NASDAQ, to address these issues.
The substantively more complex and burdensome regulations that equity raises face compared to debt financing result in the need for a material premium on overall yield. Although regulatory issues and concerns are probably overstated in terms of what percentage of the total problem they actually cause (and issues such as the proliferation of electronic trading, decimalization, etc. are understated or not even mentioned), there is no question that the attractiveness of debt structures is greatly enhanced by the less burdensome regulatory environment for these types of financings. The trend has been for the “spread” in the scope of difference in regulatory burdens between these alternative funding structures to increase, not lessen. We currently see no likelihood that this “spread” will materially decrease, at least in the near term, thus continuing to favor lending oriented raises.
A variety of other factors will favor the rise of debt financing as an alternative to equity in the days ahead. The concern over dilution with raising equity at prices deemed by company principals to not be in the long term best interest of shareholders will remain a constant issue. In many cases companies will elect a debt option with the plan to defer an equity raise until more attractive terms can be negotiated. The recent noteworthy financial reporting irregularities of select Chinese domiciled firms subsequent to reverse merging onto U.S. exchanges resulted in the typical reaction of taking macro level steps to ensure such events cease to occur…with the result that the market for Chinese reverse mergers was immediately decimated. We believe that many worthy Chinese domiciled firms (and other foreign domiciled firms wishing to trade on U.S. exchanges) will find funding solutions via listings in other countries, or thru debt structures.
These types of “macro reactions” to issues have pronounced long term consequences that can fundamentally change entire dynamics. Approximately 30 years ago, while I was working at Caterpillar, Inc., an embargo was put in place on the exporting of earthmoving/construction equipment to the Soviet Union. Though the dollar loss of that particular transaction was significant, it was not catastrophic to the company…but the underlying message that the United States would use an embargo to impose its social agenda had far reaching effects on the firm.
Another issue that will challenge equity investments into Micro-caps and private equity will be a growing need for current cash yields. With a dramatic decline in the risk free rate of return as evidenced by the concurrence of the academians and consultants around the country, interest rates and dividends are compressed to levels that make current yields on debt structures seem especially attractive. Although a number of major pension funds by policy limit investments into the traditional Bulletin Board stocks, these types of institutional investors face tremendous pressure to generate overall current portfolio yields in the 8% annual return range in order to meet actuarial contribution requirements. In recent months I have met with and spoken to a number of major U.S. pension funds that are venturing into the high yield bridge loan space or focusing more on preferred stock structures with meaningful current distributions. Likewise, in meeting with sovereign foreign wealth funds on my recent trip to Asia, it is quite clear that a number of these entities believe equity type yields can be attained through innovative debt transactions in the U.S. markets…with much simpler due diligence, less challenging negotiations, and materially lower risk levels.
Debt Will Provide at Least a Partial Solution
Given all the regulatory pressures, the issues with current yield, and the changing nuances of marketplace requirements involving equity, debt financing structures will continue to evolve to fill at least part of the missing funding gap that will not be able to be fulfilled by traditional equity raises. The fact that debt transactions are almost always much simpler and faster than equity financings will be a major influencer in the months and years ahead. We continue to see new variations in debt financing terms and structures being implemented to serve as a surrogate for equity.
For established companies generating revenues from financially viable customers, we believe purchase order financing will continue to grow in significance as a replacement for equity raises. The purchase order financing business was in a state of despair with the easy credit markets in the middle of the last decade. Now many of these firms are able to charge a significant fee per month (for example 2%) plus a percentage of profits on orders…and sometimes with a guaranteed floor yield regardless of how short the borrowing period is. Though on the surface this may not appear to be an attractive alternative, it is materially less costly in the long run than a highly dilutive equity offering…and much, much faster to consummate. As an example, we have arranged multiple tranches of purchase order financing for a firm exporting products to South America where the speed in closing the funding was paramount, or a major customer would have been lost. The alternative would have been for the client to take an equity partner and give up a major stake in his company…forever. Since the length of time the debt was outstanding was short, the absolute cost of the financing was very modest, though on a daily basis the cost would have been deemed to be unattractive.
Debt structures that incorporate underlying collateral as security, coupled with some form of upside yield potential, are poised to grow in popularity. Though not necessarily the traditional “mezzanine” type financing structure, the end result will be similar…a base yield coupled with the potential for meaningful return enhancements. We believe many of these structures will be a senior debt base (as opposed to subordinated debt), coupled with yield upside. With the challenges smaller firms will have in raising equity, debt providers are concluding that they can “have their cake and eat it too”. The return enhancers will certainly include options and warrants for the lenders, but will also include more non-traditional type terms, for example “revenue participation certificates” or guaranteed floor yields via “puts” upon the sale of the company or some other type of liquidation or financing event.
Convertible debt structures in the Micro-cap space have a less than stellar reputation due to the utilization of classic “toxic spiral” type structures in past years. In most of these situations, the lender would short the stock being held as collateral, with notorious ratchet features allowing the lender to further prosper as the borrower’s market cap declined…requiring the continued delivery of additional shares. We envision a more benevolent debt structure where stock is not the primary collateral utilized, and if used as supplemental collateral the parties would agree to a “no short” clause in the loan agreement, subject to very specific exceptions. The return enhancers incorporated into the agreement serve to add value to both the borrower and lender if the borrowing entity prospers, thus eliminating the incentive for the lender to take actions to cause the demise of the borrower.
Jim Schnorf, CPA, CMA, MBA is the Founder and President of Wall Street Strategic Capital, Inc. and a number of other entities that arrange non-traditional debt financing including bridge loans, facilitate revenue opportunities with government agencies and large entities, and arrange strategic partners and high profile board members/endorsers for client firms in the U.S. and approximately 20 foreign countries. He is a frequent guest speaker at conferences and symposiums involving debt funders, major pension funds, and private equity firms and most recently presented at the SuperReturn Conference in Boston.
Syndicated with permission from Stock News Now and the Micro-Cap Review.
