RELATIONSHIP MANAGEMENT Corporate Finance-Based Part II Part I Summary Jack Strong is a 55-year-old chief executive and owner of a midwest-based steel supplies company, Midwest Steel Services Inc. (MSS). Strong has decided, with the help of Roseanne Morris the relationship manager from his principal commercial bank, Midwest National Bank Corporation (MNB) to relinquish control of his company. His primary motivation for doing so has been to create liquidity for himself as well as provide continuity both for management and the employees who have helped build 64 The RMA Journal April 2001 by Michael St. J. Pimley Many banks do not realize that some of the most important financial solutions that can be delivered in meeting their client s corporate finance needs already lie within their existing arsenal of corporate banking products and services. Part I of this article appeared in the February 2001 Journal. This second chapter in the cycle reviews the breadth of commercial banking products and how these can be delivered to a client to help meet such corporate finance needs. his $50 million revenue and $6 million EBITDA company. In helping Jack come to these conclusions, Roseanne has been instrumental in highlighting the various ways by which Jack could sell his company to his managers or, alternatively, to his managers in conjunction with a financial partner. The thought process that Roseanne, as the MNB relationship manager, introduced to this decision-making discipline demanded the following: a sense of Jack s agenda; the ability to discuss various strategic solutions; and, once Jack had decided to sell the company, an examination of the different alternatives by which his decision to sell all or part of the shares could be implemented (see Figure 1). Jack Strong s Strategy: The Bank s Product Response Much is made of the expression cross-sell. It is, however, in business opportunities such as these that commercial banks can truly leverage both the client relationship on the one hand and their product delivery capability on the other, thus garnering a larger share of the 2001 by RMA. Pimley is founder and principal of Pimley & Pimley Inc., Princeton, New Jersey. He has served as a Council member and director for RMA and has taught and written extensively for the association.
banking business being offered by Jack. Figure 1 The sale of Jack s shareholding: The Private Banking or Wealth Management product. Whether this response falls under the title of private banking or wealth management, the fact remains that he sells the company, Jack will be the beneficiary of a seven or eight-figure cash receipt in consideration for his shares. As an entrepreneur, the management of this new-found wealth will demand the expertise of a private banker not just to address the alternatives that inevitably flow from managing a diversified investment portfolio but also in counseling on effective tax structures to minimize tax liabilities that could flow from such a divestiture. Positioning the private banker or wealth manager to discuss these alternatives demands adroitness of timing by Roseanne, as the MNB relationship manager, not to mention careful planning and synchronization with the timing of the deal itself. Jack s decision to sell: The role of corporate finance advisory services. Many commercial banks today have acquired corporate finance advisory capabilities either through the acquisition of regional brokerage houses or their own in-house M & A or corporate finance advisory skills. These skills range from assisting in determining the valuation of the firm, through to helping structure the transaction. The challenge in such circumstances is to ensure that the enthusiasm of the more product sales - driven culture of a corporate finance department or a capital markets group does not trespass on the carefully nurtured relationship with the client. These sensitivities are heightened, and often exacerbated, by the untimely use of that dreaded three letter word beloved of investment bankers fee! Entrepreneurs like Jack typically have not created value for themselves by spending money on advice needlessly, and typically the best way to introduce this subject is by maintaining the constant involvement of the relationship manager throughout the process. As a result, the clients feel that real value is being delivered by the specialist group within the bank. Without such careful handling and a well-orchestrated demonstration of value paid for value given, too many commercial banks end up undermining well-established relationships through poorly coordinated involvement of product specialists. The decision to sell to management: The role of bank credit products. As has been already shown in Figure 1, there were a variety of ways by which Jack could sell the shares to the managers, all of which demand the close involvement of Midwest By Pimley & Pimley Inc. 65
National Bank. These approaches, together with the bank loan product required, include: Selling to the managers personally: The Personal Loan. While this may be administratively the most straight forward, it presents its unique set of challenges, most notably, the personal liquidity of the managers themselves. Nevertheless, in the event that the managers can provide sufficient external collateral, MNB could provide the loan directly to the managers. Proceed with care here. The managers might lack the necessary liquidity or collateral to justify borrowing the funds. Also, the principal source of repayment for their loans will be salaries or dividends paid by the company, which will, of course, be taxed in their hands and. As a result, this may not represent the most efficient structure. Selling Jack s shares back to Treasury: The Corporate Bank Loan. As a 100% owner of the company, such a strategy is simply unable to achieve the objectives that Jack has stated since, by definition, there would be no shareholders left. However, this may be a very attractive strategy if Jack had already started to sell a meaningful minority interest in his company to his managers over the last four or five years. This strategy has the advantage of retiring his shares and leaving the balance in the hands of the remaining managers. Further, this strategy demands a whole series of commercial banking products to retire the equity most significant of which, a senior bank term loan. Also, depending on the debt capacity of the firm and the underlying level or shares being repurchased, mezzanine debt may be used as well. Mezzanine debt is a hybrid of senior debt and equity, paying an attractive interest rate to the mezzanine lender while at the same time offering the mezzanine lender an equity-like return through the grant of warrants containing options that compensate them for their subordinated position on the balance sheet. Finally, from a credit perspective, while clearly there will be credit issues attributed to replacing equity with debt, it is now the company MSS that has become the borrower and, therefore, the direct source of repayment in terms of cash flows and, if necessary, assets. Selling the company to the employees: ESOP Advisory Services and the ESOP Loan. The Employee Stock Ownership Plan (ESOP) alternative presents a whole series of product opportunities for the bank. First, the ESOP will require an advisor, and that advisor will require valuation analyses done periodically on the value of the shares a role that could be carried out by the bank s Corporate Finance Department. Second, if Jack is required to reinvest the proceeds of the sale to the ESOP in required replacement securities, these replacement securities again could be managed by the bank s Corporate Trust or Asset Management Departments. This approach has two advantages, subject to the appropriate tax conditions. First, it gives Jack a deferral on his gain. Also, such securities could be used to help collateralize a bank loan to the ESOP to buy the shares in the first place. Third, the bank itself could provide the ESOP loan or, alternatively, could place the ESOP loan with third-party investors, such as other banks or, possibly, insurance companies. Selling to management and a financial partner: Bank Credit and Equity products. This approach is often very popular and, again, gives the commercial bank a tremendous positioning advantage in helping structure the deal. In such circumstances, Midwest National Bank could underwrite or, possibly, place the senior loan, just as it did under the Treasury Stock buyback strategy mentioned above. MNB could also underwrite or place the mezzanine financing. Finally, it could help identify and arrange the private equity sponsorship either by finding a local financial services firm committed to such investments or, as is becoming increasingly the case, refer the investment to the bank s own Private Equity Group. 66 The RMA Journal April 2001
A word to the wise. Such a structure is beginning to resemble the one-stop-shopping structures that were common in the 1980s and early 1990s. Not all of these worked out; in some cases, there were serious legal consequences to lenders who were perceived to have conflicts of interest between their lending position and their equity shareholding. A more responsible and less vigorous approach could still leave the bank helping to arrange some of the layers of financing without having to underwrite them. This, again, is where a wellschooled corporate finance department can earn its returns, with the commercial side of the bank underwriting the senior loan and the Corporate Finance Department arranging and advising on the placement on the mezzanine or the equity. Indeed, properly handled and with well-balanced marketing strategies, the bank could leverage the relationship with MSS in general and with Jack in particular. The bank could say that its position as the senior lender in the capital structure uniquely equips it to be the most wellinformed and best-qualified advisor on, and arranger of, the mezzanine and equity financing. Capital structuring solutions: Interest Rate Protection. All of these suggested alternatives, by which commercial bank debt is used as the vehicle for Jack to achieve his objectives, give rise to other related products to help S ELLING TO MANAGEMENT AND A FINANCIAL PARTNER IS BEGINNING TO RESEMBLE THE ONE-STOP-SHOPPING STRUCTURES THAT WERE COMMON IN THE 1980S AND EARLY 1990S. N OT ALL OF THESE WORKED OUT; IN SOME CASES, THERE WERE SERIOUS LEGAL CONSEQUENCES manage the risk of leveraging this company. Foremost among these alternatives is the criticality of interestrate risk management. A company s debt capacity in a leveraged transaction can be easily impaired and its cash flows diluted, by the effect of rising interest rates. As the senior lender in the transaction, the bank may require the company to hedge, say, up to 50% of its floating rate debt with some form of acceptable interest-rate protection, such as swaps, caps, and collars. MNB, as a potential senior lender, is uniquely positioned to be the risk protection provider of choice. Jack s Other Alternatives: Taking the company public or leveraged recapitalization. Jack s initial stated objective is that he would like to pass ownership to his management group. Suppose, however, he has decided he would like to stay involved in the business but would nevertheless like to enjoy some new-found liquidity. As Figure I already has illustrated, he could achieve this either by taking his company public or recapitalizing the company and paying himself a large dividend. Taking the company public: The Bank as Corporate Finance Advisor. Many commercial banks think that once this happens, their role will be diminished. This is not so. Not only will a fairness opinion have to be delivered something that MNB s Corporate Finance Department could provide but increasing numbers of commercial banks now have securities subsidiaries of their own who would be well positioned to carry out this exercise. Taking the company public: The bank as Stock Transfer Agent or Registrar. More interestingly, when a company first goes public, it requires a number of ongoing commercial banking support products most notably Stock Transfer Agency and Corporate Registrar capabilities. While some banks have discarded these corporate trust functions, others have retained them or, at a very minimum, entered into referral arrangements with institutions that have chosen to specialize in them. Leveraged recapitalization: Bank Credit Products. This might not be the most taxeffective way of achieving Jack s objectives of liquidity. 67
However, some owners see this as a way of cashing out and staying in. It would enable Jack to receive liquidity in the form of a dividend while still maintaining his shareholding in the company. Again, the bank can play the same type of role as it would have done in an acquisition financing senior lender or arranger of senior debt on the one hand and, perhaps, arranger of mezzanine on the other. As with the leveraged-buyout alternatives discussed above, these have the advantages of also requiring interest-rate risk management protection, something that Midwest National Bank would be well equipped to do. The Importance of Commercial Banking Products in Meeting a Client s Corporate Finance Needs As Figure 2 summarizes, the skills demanded of the relationship manager in meeting the corporate finance objectives of the client lead to commercial banking products and services as many times as they do to investment banking products and services. As Figure II illustrates, it is the senior bank loan, either underwritten or placed or syndicated, that primarily serves as the most critical element in enabling the client to achieve their corporate finance objectives. This is doubly so in the middle market and upper middle market, where many of RMA s banking customers operate. These banks and their clients typically operate in markets thatfall off the radar screen of the more widely heralded public equity and debt capital markets. For many, therefore, it is the bank loan that is the capital of Figure 2 68 The RMA Journal April 2001
choice and, in many cases, of necessity, enabling entrepreneurs like Jack to achieve their goals. This in no way detracts from the criticality of marrying credit product knowledge to investment banking and corporate finance skills. Walking Jack through the mine field of his alternatives requires genuine corporate finance professional skill and, in a number of cases, these skills will lead to investment-banking products IPOs, private placements, asset securitization, and interest-rate risk management through the derivatives market. Assuming they are able to properly structured and orchestrate the deals, there is no reason why the Roseanne Morrises of this world should not be equally adept at being a wellinformed orchestrator of these products as well as providing the more conventional bank credit products, such as loans. It is vital, however, that the skills Roseanne needs to round out her ability to deliver Midwest National Bank build on her existing experience. By expanding her capabilities in cash flow analysis and lending, she can become well versed in such disciplines as debt capacity, capital structure and valuation. As such, with the application of such skills, she is uniquely position to provide Jack with not only the advice on, but also the means to, achieve his goals It is these skills, and some of the techniques practiced in the market today, that will be reviewed in subsequent articles. 69