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Financing Mix.

Managers of the proposed Agrando plc would invest £35m to buyout the regional airport from Aston plc. The initial investment of £35m would comprise of equity participation by the managers and Aston, loan of £20m by Forgage bank and an additional £15m mezzanine debt facility by Glenfield plc.  Glenfield would acquire warrants also.

A)
Management invests £4m and gets 80% stake in Argando plc. Aston plc would then need to invest £1m to obtain 20% stake in Argando plc. Forgage Bank would loan £20m and Glenfield would then lend £10m to reach the buyout figure of £35m. Appendix I shows the interest and principal repayments to Forgage Bank and Glenfield. Appendix II shows the profit and loss accounts of Argando over the next 7 years. The retained profit is then used to calculate the shareholders funds and total debt to total equity ratio as shown in appendix III. This scenario assumes no warrant exercise by Glenfield.

The advantages of the proposed financing mix are:

• The management gets hold of 80% equity of Argando just by investing £4m. This is due to the high leveraged financial mix where Forgage and Glenfield provide 86% (£30m / £35m) of total investment.
• By using high leverage, management’s equity return would increase substantially. Once management reduces loan and interest payments, the price to earning multiple would give significantly high return on management’s equity.
• Aston would also not increase central costs abruptly and significantly because they have a 20% in the venture and would be more interested in higher exit value rather than earning more through costs and jeopardising the success of Argando.

The disadvantages of the proposed financing mix are:

• Because of the higher financial leverage, the profit projections are very sensitive to interest rate movements. A 1% increase in LIBOR would reduce profits by £200,000 as the £20m Forgage Bank loan is linked to LIBOR. If LIBOR rises over 11% in the first year, Argando wouldn’t be left with enough money to repay first principal instalment of Glenfield’s loan. This sensitivity can be mitigated by buying an interest rate cap for £800,000. This would significantly reduce the chances of failure of interest rates increase rapidly but would entail an additional £800,000 increase in loan.
• Under current projections of 5% increase in revenue and costs, the total debt to total equity ratio would be 330% at the end of 4th year and would fail the condition set by Forgage Bank. Forgage Bank could withdraw the loan by giving one month’s notice. If management fails to secure new loan within one month’s period, they would lose totally lose their equity investment or might be forced to sell it at deep discount.

On the total debt to total equity ratio risk mitigation side, the proposed financing arrangement has an in built mechanism in terms of warrants to Glenfield. As Glenfield’s mezzanine debt is junior to Forgage Bank lending, Glenfield would be more interested in keeping the venture alive. If the business is meeting or exceeding revenue and profit projections, it would exercise warrants. The extra cash received could then be used to retire Glenfield’s loan or to increase shareholder funds. 

Let’s assume the scenario where Glenfield has initially lent £10m. Since Glenfield can exercise warrants any time between after 2 and before 5 years, it will probably exercise it just at the close of 4th year to meet Forgage Bank’s loan covenant condition. Appendix IV shows the revised shareholders funds if Glenfield exercises warrants. For every £100 of initial loan by Glenfield, it will get £10 of equity (10 shares of 100 pence each). So for £10m of initial loan, the shareholders fund would increase by £1m. As can be seen from the appendix IV, even under this scenario, the total debt to total equity is way above 100% level.

There are two possible ways to overcome Forgage Bank’s covenant issue:

• To sell the business before year 4. The current independent debt free value of the business is £35m. The profit before interest and tax (PBIT) in the last year was £6.1m (£3.6m of taxable profit + £2.5m of interest). The implied price to PBIT multiple is 5.7.

The projected PBIT at the end of 3rd year is £8.4m (£4.7m of taxable profit + £3.7m of interest – appendix II). Assuming the economy and industry characteristics remain same in the next three years, the business would then be able to get a similar price to PBIT multiple of 5.7 and would be valued at £48m.

The total loan outstanding at the end of 3rd year is £24.0m. So the equity would be worth £24.0m. If Glenfield exercises the warrants, it would receive 9% of equity by paying £1.0m. 9% of £24m is £2.2m. So Glenfield would definitely exercise its warrants before the sale in the 4th year. Management would then receive 73% of £24m, which is £17.5m. So if the revenue and profit projections are met in the next three years and the management sells the business in 4th year, it would receive more than four times its initial investment.

• Management may also like to have an option of running the business over a longer term. If during the first three years of operations, management notices that the profit would be much higher in 4th or later years, it would probably like to retain ownership to get much higher returns later.

Management can offer Forgage Bank and Glenfield more equity stake in lieu of reducing their debt at the end of 4th year. Appendix IV shows the total debt is £22.0m and shareholders funds are £7.67m at the end of 4th year. In order to meet Forgage Bank’s requirement, the total outstanding debt and equity should be 100%.

Management should offer Glenfield that its £2.0m loan outstanding at the end of 4th year would be converted into equity. It should also offer Forgage that upto £5.0m of its loan to be converted into equity at the end of 4th year. If Argando makes more profits than budgeted in the first 4 years, then only the part of £5.0m facility would be converted into equity to meet 100% covenant criteria.

The above would result in significant dilution of management’s equity but would keep the business running if the management fails to buy a business in the 4th year.

B)
The following additional information is required in order to make a decision on loan:

• Past performance of the business. The revenue and profit projections of the business are sensitive to projected growth rate of 5%. The past performance would show the actual growth rates achieved in revenues and annual cost inflations and whether they justify projected 5% increase in revenue and costs. If the past performance can’t justify the future projections, what is the management’s strategy to achieve the targets.
• Consistency of revenue and profits increase. Though the overall past performance may show annualised 5% growth, it is also important to note annual trends because of the high leverage structure of the deal. Any 1 or 2 years of lower growth could jeopardise loan repayments.
• Fixed assets. The book value of fixed assets in Argando plc. This is useful for calculating depreciation and find out how much tax can be saved through depreciation. The higher the depreciation, the more cash available to repay debts.
• Revaluation of assets. If any revaluation of the assets has been done recently and if so, what is the value. This will be useful in assessing the quality and strength of assets behind the business and likely recovery scenarios if business goes into administration.
• Other expenses. Other expenses are a substantial component of total costs. It would be useful to analyse a more detailer version of other costs and its components.
• Exit strategy. It is very important what are management’s plans on exiting. That will decide the length of loan and likely return rates.
• Management skills. A good and knowledgeable management is very important to successfully run a business.
• Role in management. Venture capital firms like to play a more active role in management than banks. What kind of role and participation is the current management of Argando going to offer to the venture capitalist firm.
• Competition. Management’s knowledge about competition not only will demonstrate the probability of meeting the budget but also the quality of the management. A better management would be aware of the practices being adopted by its competitors and their likely impact on profits.
  

Appendix I – Loan and interest payments of Argando plc

Appendix II – Profit and loss accounts of Argando plc

Appendix III – Total debt to equity ratios of Argando plc

Appendix IV – Debt to equity ratio after incorporating Glenfield’s warrants

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