Comment

London: 08 September 2010

My name is Business, and I’m a recovering debtaholic

The capital structure of deals has changed beyond recognition

Debt is a little like alcohol – very powerful stuff, but deadly if used to excess.

During the first few years of this century business gorged itself on debt, and became heavily intoxicated with the stuff. Some companies suffered from acute debt poisoning and went bankrupt, or were sold or broken up. For many others, the past couple of years have been a drawn-out hangover, gradually recovering from an over-indulgence of borrowings. And now a great many businesses of all descriptions have to live a reformed, debt-free life – teetotallers from the demon credit.

In the new world of debt abstinence, where funding is scarce, the capital structure of deals being carried out has changed beyond recognition. I have found that while many major banks are pretending to be open to new customers, in truth they are shrinking their books and effectively extending no new lines. Hence, acquisitions my firm is considering are being financed with 50 per cent or even 100 per cent equity – transactions that three years ago would have needed just 25 per cent equity.

Moreover, banks have dramatically compressed loan amortisation – so, recently, instead of lenders offering a seven-year facility with a bullet repayment at termination, we were grateful for a four-year facility with a quarter of principal repaid each year of the term. Meanwhile, arrangement fees and margins charged by banks have soared. Lenders have gone from reckless, profitless lending to over-cautious usury, at least in some cases.

Entrepreneurs can no longer rely on financial engineering using debt of some description, be it factoring, leasing, revolving credit, term loans or what have you – to fund their projects. If they want to grow, be it buying a plant, carrying out mergers or financing working capital, often they must now embrace shareholding partners. For the vast majority, a flotation on any form of stock exchange is an impossibility – the IPO market remains moribund save for a tiny selection of companies. So they are forced to seek private capital. Yet taking on angel investors or venture capitalists can be a positive move. Such partners can bring experience, contacts and credibility as well as cash. Of course, there are situations that turn sour, but on average private equity relationships generally work – otherwise the industry would not have grown so successfully.

One alternative for founders having to dilute their ownership stake is to persuade suppliers to provide credit, and cajole customers to pay cash up front. Playing games with working capital like this is not for those who like a quiet life, and is a precarious method of financing an enterprise. And anyway it can’t function in industrial sectors where customers demand credit.

This era of more sober balance sheets should mean plenty of development capital opportunities for private equity. A bigger, more liquid balance sheet means a company can invest in research, in stock, in people, in equipment, and can take advantage of new orders promptly. As confidence returns, ambitious entrepreneurs will doubtless look to seize share and satisfy pent-up demand. The wise ones will adopt a more prudent approach for their funding structure, in keeping with the times.

I anticipate this autumn will be lively in the M&A world. August was surprisingly busy, and many expansion plans or acquisitions that have been deferred may have to be put in to action because management are no longer willing to wait. Eventually boards will push the button marked “advance”, thus confirming their belief in a positive future. There might be a double-dip recession, or perhaps not, but in the meantime the sands of time are running out; after all, entrepreneurs as a breed are not renowned for their patience. So I suspect the merry-go-round will pick up pace in the coming months, but on a rather different basis than in the past – more share-for-share mergers, more equity, much less debt, and greater pragmatism generally. All of this should foster increased stability, and generate more sustainable returns over the long run than a mania for leverage. Long live equity: RIP too much debt.