Let’s talk about Debt….

Why? With the current political and economic backdrop here in the UK…

• Many of our clients are searching for funding as an enabler for investment, growth, acquisition, management buy-out/buy-in, capex, or restructuring;
• Sourcing structured debt remains the cheapest and easiest form of finance to raise, even with current interest rates;
• And the emergence of the private credit funds is offering an excellent alternative to equity investment, allowing founders to retain value whilst scaling up.

But finding the right structure and funding partner that fits the business is more important than ever to get right. Preparation and presentation to the right lenders is absolutely critical to (a) make a positive impact statement, and (b) secure their early engagement in the process.

Typically, the more mainstream lenders will want to see a two year look back of profitable trading, and a minimum three year forecast of sensible growth enabling them to (a) calculate their structuring EBITDA (i.e. proven cash generation), and (b) model the cashflow available for debt service (more commonly known as “CFADS”).

Whilst many of our UK SMEs are able to report such trends, some are still open to ‘post-Covid normalisation’ meaning a two year look back might not hit the metrics. On the contrary, a business might be forecasting strong growth in line with their clients budgetary spend, but the level of funding required cannot be met due to the lenders leverage multiple (i.e. the amount of debt required versus the current EBITDA falls outside the lenders credit policy).

But fear not, this is where the increasing participation from the private credit funds (also known as private debt funds) is not only plugging the gap, but is fuelling the entrepreneurial spirit that drives UK SME Plc. Let’s take an example where a private credit fund can add rocket fuel for investment, growth, or acquisition. A business has had a tough trading period over the past two years. However, there is a strong pipeline of confirmed orders, resulting in what could be construed as aggressive forecast growth over the next 12 months.

Many traditional lenders might adopt a blended view across both the historical and forecast financial performance, often resulting in insufficient funding, and leaving what they perceive as an equity gap requiring shareholder or investment intervention.

Enter the ring, the new challenger on the block, the private credit fund. With capital already raised and committed, these funds are super keen to deploy their funds into businesses with a clear growth strategy. Whether asset heavy or service based, the credit funds seek to look forward, rather than look back. Naturally the usual rules around credit risk apply, but these operators are geared up to stretch the leverage multiple to generate the funds required to deliver on the strategy. The private credit funds also focus heavily on the structuring of such facilities, with a mix of revolving, amortising, and rolled up repayments to ensure a suitable balance between ongoing debt service, and cash headroom.

One other common factor to mention is their inclusion of ‘upside instruments’ commonly referred to as warrants, equity warrants, or equity kickers. This is agreed between the lender and the company based on a strike price at completion (typically 10% of the initial funding facility amount), exercisable within a set timeline (usually the facility term) based on a future event (funding round, refinance, sale/exit). Effectively, this represents the ‘equity risk element’ of their stretched funding facility, but doesn’t require the owners to significantly dilute their shareholdings, or relinquish control.

So these types of debt funds sit somewhere between raising equity and traditional debt. They can offer more funding than banks, albeit with a higher rate, but owners don’t suffer the dilution to the shareholding that raising equity entails. In many cases this can be the perfect sweet spot.

In summary, the debt finance market remains open to positive challenge when it comes to the structuring of solutions for our clients. With an array of choices through our extensive network, Forward pulls on all our internal and external expertise, to ensure our clients secure the right funding package.