Bringing in investment partners using a private investment fund structure as an
equity investor in the specialty lender is one way to address this. Recently, for example,
US Capital Partners helped a specialty finance company transition to a preferred equity
fund structure. This finance company was obtaining bank leverage on a deal-by-deal
basis. It had approximately 40 private investors, many holding high-interest demand
notes with various interest rates and terms. With such demand notes, a lending partner
can often request repayment by giving as little as three to four months notice. The capital
supply of this specialty finance company was therefore quite volatile.
The finance company was able to shift almost all its investors over into a new preferred
equity fund structure. These investors became limited partners (LPs). Typically, investment funds have a hurdle rate of between 7% and 10% per annum in favor of their LPs.
This means that the general partner (GP) of the fund cannot take a share of profits from
the fund’s activities until the LPs first received their preferred return for that year. After
this, any profits are divided between the GP and the LPs. The initial dividend rate can
appear lower, but the profit share component can lead to equivalent or higher returns for
investors to encourage this transition.
One immediate benefit of such an equity-like fund structure is that any leverage
from the bank now becomes fund-level leverage, which is less expensive than portfolio
leverage. If a specialty finance company has an SEC-registered investment advisor as
well as a broker dealer placement agent, the new structure immediately gives comfort
to wealth managers, making it easier to raise capital. It also transforms the company’s
profile as a borrower for a commercial bank, making it easier for the bank to reduce its
leverage interest rates and increase its advance rates.
Tapping New Sources of Private Capital
Small investment funds, if properly designed in a compliant manner and supported
by a registered broker dealer with this credit specialty, can fundraise through “general
solicitation.” In other words, an SEC-registered private placement offering can be
advertised to a wide variety of potential investors through either social media or
Such offerings can also be made widely available to registered investment advisors
(RIAs) acting on behalf of their clients through popular investment custodial platforms,
provided the offerings have an assigned CUSIP number and have gone through the
onboarding process for those platforms. Offerings, compliantly built, can be listed on
popular public brokerage platforms such as TD Ameritrade, E*TRADE and State Street.
TD Ameritrade, for example, is one of the biggest discount brokerages in the U. S., with
more than 10 million client accounts.
The supply of capital for specialty retail companies is restricted, so the cost of capital
is high. Specialty finance companies may find it helpful to evaluate new, optimized fund
structures to reshape their own balance sheet capital structures. Making use of a private
investment fund structure allows specialty finance companies to give a greater number
of investors access to their asset class, potentially driving down the costs of capital. abfj
JEFFRE Y SWEENE Y is chairman and CEO at US Capital Partners and founder of US Capital
Investment Management, a private financial group and fund manager headquartered in San
Francisco. US Capital Partners specializes in making traditional middle-market banking products and services available to the lower middle market.
These costs are, of course, proportionally higher for
smaller credits. For larger companies, these costs are
amortized over greater financing amounts.
High Costs of Capital for ABL Lenders
The cost of capital for an ABL lender is the cost of bank
leverage, which is relatively low, plus the cost of private
sources of capital (or equity-like debt), which is very
high. Size also affects this cost structure substantially.
Smaller companies’ capital stacks cost significantly
more than larger facilities, leading to a higher lender
cost of capital.
A commercial bank lending to a specialty finance
firm will carefully assess the finance firm’s underlying
portfolio and its quality and structure as well as any
legal claims on these rights. The bank will provide
different levels of availability depending upon underlying asset type and industry and will typically request
an interest rate from 2% to 7%.
Additionally, banks will not allow any other debt on
the portfolio or finance company, but will require equity.
In the past, subordinated debt was usually considered
equity, but due to changes in the banking regulatory
climate, banks that finance lending lines of credit increasingly cannot consider subordinated debt to be equity, but
will require true equity in the finance company.
The traditional way to launch or scale an ABL
finance company is by bringing in investors as partners
under promissory, demand or subordinate notes. These
investors may be family funds, private investors, private
equity firms and the like — essentially most of the equity
of the business. These partners usually represent a 10%
to 12% cost of capital for the specialty lender and sometimes also require a further profit share. Some specialty
finance companies may have as many as 30 to 40 investors, which creates a complicated debt schedule.
Bank leverage has gradually been reduced for
finance companies, because of pressure from regulators and new underwriting guidelines for underlying
assets in portfolios. Consequently, private capital for
specialty finance companies is in demand, and, due
to the subordinate equity-like risk involved, the cost
of private capital is higher. To attract private capital,
specialty finance companies are under additional pressure to have a sufficient volume of deal flow and assets
under management to create a return on investment
appropriate to meet mounting costs.
How to Deliver the Greatest Reduction in Costs
Operational costs, origination costs and costs related to
the smaller size of transactions are relatively intractable.
Although significant, they are not easily addressed. High
costs of capital due to decreasing leverage, high cost of
subordinated debt and even the withdrawal or reduction
of leverage lines due to changes in bank requirements for
equity are probably the most important issues to address
to reduce ultimate borrowing costs. Reshaping the debt
and equity ratios on the balance sheet is the best way to
The supply of capital for specialty retail companies is restricted, so the
cost of capital is high. Specialty finance companies may find it helpful to
evaluate new, optimized fund structures to reshape their own balance
sheet capital structures. Making use of a private investment fund structure
allows specialty finance companies to give a greater number of investors
access to their asset class, potentially driving down the costs of capital.