(This article appeared in SBIC Weekly as part of its Weekly Expert Author Series)
by Brad Whitman, Founding Partner, Renovus Capital
Last month’s column looked at the key challenges to using the SBIC program to do leveraged buyouts. Now let’s look at the key advantages.
From a transaction process perspective, SBIC funds do have a clear-cut advantage relative to traditional funds because they do not have to secure third-party debt on a deal-by-deal basis. An SBIC fund effectively has a credit facility priced at about 4% which it can draw on as it makes investments without having to deal with any third parties. In contrast,
a traditional fund must not only find a lender for every deal but also manage that lender’s due diligence and internal approval process while negotiating a credit agreement. These requirements translate into greater time and expense to close a transaction while also introducing financing risk that must either be assumed by the fund or transferred to the seller. As a result, an SBIC fund can not only close a transaction faster and less expensively than a traditional fund but can also provide greater certainty to a seller, a key source of differentiation in a competitive process.
Putting process aside, SBIC leverage offers a buyout fund a truly fundamental advantage by significantly reducing the cost of capital. For a traditional buyout fund in the small cap market, an attractive capital structure for a transaction might be a 1:1 ratio of debt to equity with the former priced at about 6%. Assuming a 30% cost of equity and a 40% tax shield on interest expense, you end up with a blended cost of capital of 16.8%. The table below summarizes how this cost changes across a range of debt levels and interest rates.
In contrast, on any deal, an SBIC fund is assured of a 2:1 debt to equity ratio and an interest cost of about 4%. Again assuming a 30% cost of equity and a 40% tax shield on the interest expense, you end up with a blended cost of capital of only 11.6%, more than 5 percentage points lower than a traditional private equity fund. This lower cost of capital significantly expands the universe of attractive buyouts by lowering the EBITDA growth rate needed to generate an acceptable return to investors.
The table below summarizes this differential. For the sake of simplicity, let’s assume an LBO at 6x EBITDA of a business with no capital expenditures and a 40% effective tax rate. Using a 1:1 debt to equity ratio and a 6% interest cost for the traditional fund yields the returns shown assuming a 5-yr hold and a 6x exit multiple. As can be seen, the same assumptions but under an SBIC Fund capital structure (2:1 debt to equity and a 4% interest rate), produces IRRs that are 6-9 percentage points higher.
This IRR spread means that to achieve a 30% IRR, a traditional fund must grow its portfolio at nearly 12% per year while an SBIC fund can achieve the same outcome at 6% growth. In today’s economic environment where growth is challenged, there is a world of difference between 6% and 12% growth. We’ve seen many deals in the last year with growth in the 5-10% range but hardly any above that level, and our ability to put capital to work has been meaningfully enhanced by the SBIC structure.
Admittedly, one could argue that the SBIC capital structure entails more risk because it involves a higher level of leverage. But this is true really only in a liquidation scenario. Because of the lower interest rate on SBIC debt, the actual interest expense burden imposed on the company is slightly lower in the SBIC fund scenario than with a traditional fund. In neither scenario is the EBITDA / Interest coverage ratio concerning (6.3x in the SBIC scenario and 5.6x in the traditional fund scenario). Moreover, since the SBIC debt has no company-specific covenants, the risk of a default is also significantly less than in the traditional fund scenario.
Having worked at traditional private equity funds where the EBITDA growth rate needed for a successful investment was typically in the 12-15% range, the SBIC fund structure has proven liberating. Instead of having to pursue aggressively the handful of high-growth businesses we see in today’s environment, we have a much broader range of investment opportunities to choose from. As a result, we’ve been able to invest at attractive valuations in solid, stable businesses that can consistently deliver 7-10% growth rather than paying a premium to buy a high-growth business whose financial projections require a lot of things to go right. This ability to invest profitability behind lower growth trumps all other considerations when it comes to the SBIC program and why Renovus Capital is likely to stick with the program for the long haul.
About the Author
Brad Whitman is a founding partner of Renovus Capital. Prior to this, Mr. Whitman was a Managing Director at Leeds Equity Partners, and was previously a Vice President with The Carlyle Group. Mr. Whitman began his career as an investment banker with Merrill Lynch Mergers & Acquisitions. Mr. Whitman is a summa cum laude graduate of Harvard University where he earned his B.A. in economics.
He can be reached by email at email@example.com, or by phone at (646) 660-4040.
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