Previously the capital options available to CFO’s were limited to a domestic bank charging 2 to 4% above a base rate and raising equity. The entrance of non-bank lenders, primarily Asian and US based funds, is providing borrowers with further options which could result in a considerably lower expected cost of capital.
There is understandably a large focus on the interest rate when considering debt options, but this is not necessarily the most important variable particularly when you look at the relative cost of equity. If you are a rapidly growing company or for whatever reason the value at which you can raise equity at today is far below the expected future value of your company, then the implied cost of equity can be significant (>50% IRR).
In this scenario a bank debt package, however cheap, that leaves you with a significant equity funding requirement will result in a very large weighted average cost of capital (WACC).
Non-bank lenders have identified this gap and can structure debt arrangements that go to a far higher loan to value ratio (LVR) or multiple of earnings than a traditional lender. The interest costs of these financiers are generally > 10% but when looking at the total costs of the capital requirement they can turn out to be significantly cheaper than a bank debt option if you can eliminate or reduce the requirement for further equity.
These lenders can also structure their facilities to work alongside existing senior debt. In these circumstances an inter-creditor agreement is needed that governs what occurs under a default scenario. All domestic banks can accommodate this now and whilst their first preference is for equity to be raised, a well-structured mezzanine finance position.
The introduction of high yield corporate debt does add to the risk profile and it is therefore only appropriate in circumstances where there is relatively low operational leverage and the return on investment is well above the cost of capital. However, if appropriate, it can be a far more attractive solution to be presented to the existing shareholders of the company then an equity capital raise which can be both very expensive as well as complicated in terms of relinquishing controls.
Case Study: E-Commerce
The client is a privately held e-commerce company that was generating A$13m EBITDA. The Company was on a very steep growth trajectory and needed a further A$25m of funding to further expand their distribution capabilities and increase their inventory. The return on this investment was expected to be north of 30% with a payback period within 3 years. They could validate this based on data they held on cart drop rate for out of stock SKU’s.
There were broader market reservations about the impact of a Amazon entering the Australian and New Zealand markets resulting in indicative equity valuations being heavily discounted. The shareholders felt this discounting was grossly mis-founded. Moreover, they felt that with the visibility they had on earnings growth, that they were on track to list on the ASX within 18 months at a valuation that was at least double the indicative valuations they had received. This put the expected cost of equity somewhere between 50% and 100% IRR.
Their domestic bank was only willing to offer a facility around the A$15m mark as they struggled to place any value on the inventory and the fixtures/ fittings in their leased warehouse in Queensland. The shareholders had limited access to further internal funds and would therefore need to raise third party equity meaning the WACC of the A$25m would be somewhere around the 30% mark.
The alternative solution proposed was an Asian based credit fund who could lend as high as 4x EBITDA due to the Company’s stable and growing cashflow. The credit fund put forward a term sheet that had an all-in cost of funds of 12% that covered the full A$25m and also flagged further headroom to go above that if there were further growth opportunities. The net outcome is that the shareholders achieved a far lower WACC than the equity alternative and they did not need to relinquish any control over the company.
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