Need capital to grow your small-to-medium business? To buy out the founder? To take out a well-deserved dividend? Banks probably won’t help. Look at Business Development Companies.
By Christian L. Oberbeck
Why not go to a bank for a loan?
Answer: A bank probably will not lend you enough. Banks are leaving your market, particularly companies with less than $10 million in EBITDA. Banks still will make asset-based loans for those companies that have collateralized, the size of those loans are limited by the value of the assets. What these companies usually really need is to borrow against the cash flow of their business. But banks increasingly will not write cash-flow loans to these smaller businesses because they are what bankers call “story credits,” meaning riskier, unsecured loans. The lender has to trust that a borrower’s cash flow will be enough to repay the debt. Increased scrutiny on banks from federal and state regulators has created an environment where the path of least resistance for bankers is to abandon story credits and other loans perceived to have higher risks. Regulators have reawakened to risk to depositor-funded institutions with an explicit government guarantee to their depositors. Regulators want to make sure that bankers aren’t taking depositors’ money and lending it in risky ways. As banks have stepped back from lending to smaller businesses, business development companies have stepped up.
What is a Business Development Company?
Answer: A perceived crises in capital markets led Congress in 1980 to amend the Investment Company Act of 1940. This added a new category of closed-end investment companies known as business development companies. BDCs use their investors’ capital to make long-term, cash-flow loans to private or thinly traded small to mid-sized companies. There are now about 60 BDCs in the US.
Why should a small to middle-market company work with a BDC?
Answer: A BDC is more likely to provide the amount of capital a business needs, and for a longer period of time. Banks amortize their loans on strict repayment schedules while BDCs want to keep their capital working. A BDC will be a value-added partner, not just a deal-maker. Yes, it lends money. But, it also offers extensive experience in how to get a deal done the right way on the front end, as well as help in managing a business along the way. Executives in smaller businesses often don’t have experience in capital markets. They started a business, built from the ground up, and they have become successful. They don’t have the experience necessary to have a breadth of understanding about capital markets, business valuation and financial engineering.
What should a CEO expect when financing with a BDC?
Answer: CEOs should expect a very knowledgeable credit partner who understands how businesses work generally and understands their businesses in particular, and understands the ebbs and flows, and cycles and the like. CEOs should expect a BDC to be a business partner — not necessarily an equity partner, but a debt partner in the growth of their business.
What should the relationship between a BDC and portfolio company be?
Answer: A BDC is a financial partner and corporate finance expert. It has invested in what a company is doing because the BDC believes in its vision and future.
Will a BDC take an equity stake in a small to mid-sized company?
Answer: Generally speaking, if a BDC makes a loan to a company of X dollars, it will invest in equity along the order of 10% of X. So it is not a controlling equity investor. But, it is looking for equity upside. It invests in a company where it thinks the equity is going to be worth more. A bank generally looks at assets, a borrowing base of accounts receivable, inventory, equipment. A BDC is a totally different way of thinking.
What kind of information do BDCs need to make a cash flow loan?
Answer: BDCs need 10 types of information to evaluate a company’s creditworthiness. This intense due diligence is necessary because a BDC judges a company as an ongoing enterprise. The information required includes:
- An executive summary of key information.
- Acceptable financial statements.
- Reasons why a BDC should invest in the company. The assumption is a BDC will remain with a company for five years or more. It wants to be confident the company will continue to be profitable and grow, while able to service its debt.
- A thorough business overview to help the BDC understand the company.
- Management bios and background. Management is important in driving lenders’ final investment decisions.
- Capitalization, and statement of equity ownership. This breakout provides the principal owners of the company and their percentage investment in it, both pre- and post-investment.
- Explanation of the risks of investing.
- A discussion of the industry in which the company operates and the competition it faces. This narrative discusses the marketplace in which the company does business and its position in it.
- A detailed discussion of sales and marketing. The BDC will need to know the breakout of sales production by representative segments; key customers by sales revenue and volume; customer concentrations; customer cancellations per year and reasons for doing so; suppliers and supply arrangements; production facilities and employees.
- Financial summary and projections. In addition to income and balance sheets, the BDC investment committee will want a cashflow analysis, a worst-case scenario and product and service margins.
This sounds like relationship banking, minus the bank.
It is relationship financing.
Christian L. Oberbeck is the Chairman of the Board and CEO Saratoga Investment Corp.