Introduction to Debt Capital – Types of Borrowing

Capital Raising Process

At each stage of a company’s lifecycle, the need for capital changes. In particular, ESOP companies have unique capital requirements throughout the stages of their ESOP journey. At inception, the company, and selling shareholders, typically look for senior financing to help provide liquidity at the time of the transaction. Later, as the ESOP matures, transaction leverage declines and cash often accumulates, growth strategies and capital expenditures must be balanced with ongoing ESOP sustainability needs such as repurchase obligation or potential re-leveraging. How will  you fund this?

A capital raise process can typically take anywhere from 3-6 months depending on the complexity, project type, and amount of debt required. The process will start by analyzing the capital requirements for your company under various performance scenarios, understanding its debt capacity, developing a proposed capital structure and reaching out to potential capital providers. There are numerous loan products that provide costs and benefits to a company. Similarly, there are numerous providers with their own likes and dis-likes.  Having a financial advisor with a thorough understanding of the risks and rewards for each product and matching your company with the right capital type and provider are imperative.

Types of Borrowing – Senior Loan Products

Lenders offer various loan products that fit a variety of company structures, liquidity needs, and risk profiles. Understanding the purpose for each loan product is imperative when creating a company’s optimal capital structure. While the form of a loan is typically customized to each organization, the three main types that most borrowers will see are Senior Unsecured Cash-Flow loans, Senior Secured loans and Asset Based loans.

Senior Unsecured Loans

Unsecured loans are ultimately supported by the stable, predictable cash flow characteristics of the company and multiple independent alternative exits. Leverage is typically at the more conservative end for the cash flow borrower with full repayment ability often demonstrated in the 3-5 year horizon.  Given strong cash flows, low leverage and multiple alternative exits, the blue chip borrower typically sees the lowest rates available. Borrowers can anticipate the unsecured loan to be a floating rate note with a spread determined by the borrower’s strength, a term of 5-7 years and may see an annual sweep of excess cash flow to fund the pre-payment of the loan.

Primary uses for cash flow loans:

Senior Secured Loans

Secured loans typically hold a blanket security interest across all assets of the company, or a specific operating asset such as a building or fixed asset. Secured loans, often prevalent in moderate- to high-leverage situations, may support working capital and general corporate needs on a revolving basis, or may be in the form of a term loan providing a single use of principal – where any repaid principal cannot be reborrowed. In some instances, the loan can be funded in a lump sum, whereas in other instances, typically when tied to the construction of a new asset, may be funded in installments throughout a specified timeline. Secured loans are accompanied by standard lender covenants, such as fixed charge coverage ratio (FCCR), sometimes referred to as the debt service coverage ratio (DSCR), and senior funded debt to EBITDA. Borrowers can anticipate the loan to be priced as a floating rate note with a credit risk spread over an underlying benchmark rate and a term of 3-5 years (or longer for a real estate loan). An annual sweep of excess cash flow to the pre-payment of the term loan can be anticipated.

Primary uses for secured loans:

Asset-Based Loans

Asset-based loans (ABL) are tied directly to high quality assets, such as inventory and accounts receivable, that create a formula-driven borrowing base with tight bank oversight. Given their well-secured position, asset-based loans are generally covenant-lite.  These loans typically take the form of a revolving line of credit, where the borrower can reborrow funds once they are paid back so long as they stay within the collateral coverage determined by borrowing base formulas. Borrowers can anticipate the asset-based loan priced as a floating rate note, where the base rate is set to a benchmark rate and a company specific spread is applied. ABL rates may be lower than a borrower might find in the secured loan as the relative certainty of repayment in default, via very strong asset support, is higher. The term is typically less than 3 years, renewed and extended annually.

Primary uses for an asset-based loan include:

Each loan product has a place in a company’s debt strategy. Understanding the differences, the correct application, and the risk/reward characteristics of each is necessary when managing your company’s capital stack. If you are interested in raising debt capital to fund your unique business needs, start by talking to an experienced advisor. Prairie would be happy to work with you on understanding needs, determining debt capacity, exploring loan options, optimizing your company’s capital structure, providing access to capital providers, and executing a debt capital raise process.

Richard Shuma is a Managing Director and Joseph Labetti is a Senior Associate at Prairie Capital Advisors, Inc. Richard can be contacted at 630.413.5598 or by email, rshuma@prairiecap.com. Joseph can be contacted at 630.413.5586 or by email, jlabetti@prairiecap.com.

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