The New Quiet Money
They don't have a branch on every street corner, but that doesn't mean private investors won't be happy to see you
Most people remember the 1987 stock-market crash for the fear and panic it triggered. Chief financial officer Kevin McMahon remembers it because that's when he had to raise $12 million for his company, Aim Telephones Inc., in Parsippany, N.J. Finding capital in those days "was just about impossible," recalls Roger Winston, the Ladenburg, Thalmann & Co. investment banker to whom McMahon turned for help.
The fount of cash that flowed to Aim during that grim period wasn't from the paralyzed stock market, which Aim, as a public company, had probably counted on to be a permanently open spigot. Nor did the public bond market pony up. The money came from a quiet place called the private-placement market.
This isn't the clubby, do-we-know-you kind of spot that it sounds like. In fact, the private-placement market is much more liberal than the stock market as to whom it will give money, particularly for private companies looking for equity. It's called private because the loans and equity infusions that take place aren't registered with the Securities and Exchange Commission and aren't sold to the public. Instead, the debt and stock are sold to -- or privately "placed" with -- large institutions, mostly insurance companies and pension funds.
Lately these monied firms have been funneling more of their cash into such private investments. The market is now so rich that many large public companies can borrow privately at interest rates that are at similar levels or not much higher than those in the public market. Smaller, private companies obviously won't enjoy the same rates, unless they are sterling credit risks, but they will find the market extremely accommodating. "There isn't much that can't access this market," confirms Neil Powell, head of Bankers Trust Co.'s private-placement group.
The Aim Telephones transaction with Teachers Insurance & Annuity Association shows just how deep the private-placement market has become. Though many insurance companies were temporarily immobilized after the crash, McMahon nevertheless got to choose among several very different financing packages. Had he been looking for money six months later, after everyone had digested the crash, he might have had even more offers to sort through, according to Winston. But is that because Aim is big, public, and a paragon of stability? Not exactly. Revenues, primarily from the sale of telephone systems, were growing fast enough to give your local banker ulcers. Sales had zoomed from $8 million for the fiscal year ending in February 1985 to $30 million in February 1988, when Aim's private placement was completed. Moreover, the company wanted to borrow $12 million. That's on the small side for the private-placement market ($5 million is probably the minimum), yet it was a big number for a company of Aim's size.
You could have seen Aim's fast growth as risky -- or promising; its need for capital in order to make a $20-million acquisition as scary -- or exciting. That's how private investors react to financing opportunities; they're all over the place. Beyond some basics, including the all-important credit criteria, every institution sees a potential borrower differently. Accordingly, each tailors its offer to suit the capital seeker's needs as well as its own investment requirements.
Private debt has some special attractions. You can arrange to borrow long term and at a fixed interest rate. That's a big advantage if you want to nail down interest expenses or if you believe that interest rates are heading up. Private-placement debt is also often subordinated to bank debt, making it quasi-permanent capital. While you can get private capital in the form of debt or equity, a combination is increasingly common; an "equity kicker" may be the sweetener required for a loan that might otherwise be unattractive because the company is too small or its financial standing too weak. For stronger companies, throwing in an equity kicker may result in a lower interest rate.
In Aim's case, McMahon wanted to keep his interest rate low, and he didn't want to pass up the acquisition that was in the works. So he and Aim founder and president Bill Christopoulos were willing to give up equity. Thus Teachers's $12-million loan to Aim is convertible to stock at any time during its 10-year term. The exercise price of this option is $7 per share, a 26% premium over the $5.56 that Aim shares commanded when the deal was done. If Teachers were to exercise the option, it would own about 24% of the company. In exchange, Aim pays only 10% on the debt, just 1½ percentage points over the seven-year Treasuries rate then prevailing.
Interest rates and equity aren't the only negotiating points, though. Private investors are rigorous about installing safety nets in their deals. These typically are financial covenants that restrict a company from taking on excessive new debt.
Michael Hermsen, the Teachers senior portfolio analyst who worked on the Aim loan, considers management one of the most critical elements in a successful transaction. To protect Teachers against losing Aim's managers, Hermsen required that "key man" insurance be carried on Christopoulos. That's standard for many deals. But he also created a provision that allows Teachers to, in effect, call its loan if Christopoulos, McMahon, or one other manager leaves Aim.
A public company doesn't necessarily have more cachet in the private market than a private company when it comes to debt. In a "plain vanilla" debt deal, insurance companies treat private companies as they would public companies. Things get more complicated when a deal involves equity. Then the lender has to worry about how to cash out. In theory, the shares of a public company are a snap to sell. But there's an extra wrinkle when those shares are acquired through a private placement. In that case, the SEC requires investors to hold onto their shares for two years. Thus, to make sure it can turn its investment into cash easily, Teachers demanded registration rights from Aim. Those rights would require Aim to file a prospectus with the SEC. Once Aim got the SEC's blessing, Teachers would be able to sell its shares right away.
Teachers has another exit alternative as well. During an earlier financing, Aim sold 10% of its equity to NEC America Inc., its largest supplier. What's more, NEC has an option to buy up to 51% of Aim -- within a defined period. Teachers's Hermsen sees that option as a potential way to cash out of the insurance company's position.
Because private companies don't offer investors the handy exit that public companies do, the cash-out provision in their deals is much more sensitive. Hermsen says that in most cases Teachers makes money from an equity stake in a private company because the company is sold -- either to the public or another company. The alternative: a prenegotiated "put" to the company, which would require it to buy the investor's shares. The share price of such puts is based on a multiple of operating earnings, fair market value, or appraised value. If the insurance company owns a significant amount of equity, this exit essentially requires a company to find new financing to buy back its shares.
The custom work that goes into fashioning a private placement requires some expensive labor. The borrower usually pays for its own legal work as well as that of the institutional lender. For an ordinary debt deal, each set of legal fees might range from $20,000 to $30,000. The most complicated transactions could cost more than $100,000. The borrower may also have to bear the cost of an audit by an accounting firm. For the most part, insurance companies don't charge commitment fees, though Winston says they are becoming more common. They range from 1% to 2% of the principal amount.
By far the biggest expense for most private borrowers is the investment banker's fee. Aim paid Ladenburg close to 5% of the total amount to find the Teachers deal. Though it could have tried to place its own debt, McMahon didn't have the time or knowledge to scour the market. "We don't have a big staff of financial people and that's not our business," he explains. "We feel it was worth it."
So does Teachers. "I think smaller companies tend to rely on their banks," says Hermsen, "but they don't have to, because there are people like us who enjoy and look to lend to companies like Aim."
AN INVESTOR'S CHECKLIST
What the private capital market looks for in a company
There's no such thing as a cookie-cutter transaction in the private-placement market. But that doesn't mean anything goes. While every institutional buyer of debt and equity has a different set of standards, they all look for some of the same strengths in a business. Here are some examples:
* Credibility. A lender needs to be sure that you are what you and your financial statements say you are. Using a well-known accounting firm is probably to your advantage.
* Industry ranking. Most investment banks and insurance companies will compare your growth rate, profitability, market share, and other factors with those of your industry peers. Naturally, you want your company to look better than your competitors.
* Credit ranking. Teachers Insurance & Annuity Association runs the financial characteristics of a potential borrower through Standard & Poor's or Moody's formulas to see what kind of rating emerges. That unofficial grade becomes the benchmark for pricing the deal.
* Interest coverage. This is a measure of how well you will be able to pay the interest on the proposed debt. Teachers wants to see that a company could have covered the interest charges for the past year, at a minimum.
* Debt capacity. In general, the more debt you have, the less lenders want to give you. Unless you're structuring a leveraged buyout, private lenders probably won't want to see more than a 50% to 60% debt-to-capitalization ratio.