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 disadvantages of the proposed financing mix are:
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:
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 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:
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
