One thing to keep in mind when considering funding a purchase or planning for corporate growth…if you borrow it…you’re obligated to pay it back…whereas if you seek out investors, repayment need not be part of the game plan.  Please comment on your recent experiences obtaining funding.

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Posted by Peter Heydenrych.

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Posted by Patrick Powell.

Akin to the underlying transformation in corporate objectives, the challenge with the project finance strategy is that the investment is made upfront while the anticipated benefits of the initiative are realized in the much longer term.  It is imperative to identify and prequalify sources of funds that can thoroughly understand the underlying changes being implemented by the prospective borrower(s) and project sponsor(s), and to achieve a comfort with the future cash flows arising from the collateral package of project investment or captive acquisition.

Originating and arranging long term financing in the current global credit environment is a daunting task when trying to get lenders comfortable with such a complex and flexible project financing strategy.  It is critical to create financing structures that include a collateral package of assets and contractual arrangements that capture a bankable flow of cash to service the debt, operating and capital expenses of project, while providing robust returns to the sponsors/company.  It is equally important that companies or project sponsors meet their objectives of keeping such capital intensive assets off their balance sheets and that the financing structure and terms limit or preclude recourse to their corporate balance sheets.

In sum, project finance is usually based on non-recourse or limited in recourse structures to the balance sheet(s) of corporate sponsors, whereby project debt and equity (and potentially leases) used to finance the project are paid back from the cash flow generated by the project, with the project’s assets, rights and interests held as collateral. In other words, it’s an incredibly flexible and comprehensive financing solution that demands a long-term lending approach not typical in today’s credit strapped marketplace.

Many project financings require credit enhancement due to the overwhelming asset class size and capital expenditure, the heightened political or credit risk in certain emerging market countries, and/or local or regional financial institution capacity to provide debt service on such projects. This entails working closely with established local and foreign relationships in government agencies and multilateral organizations to fortify the creditworthiness of a project and related asset classes. It is critical to be closely advised on the required political risk insurance, bank guarantees, public debt and equity participation, among other vehicles to provide credit enhancement for projects.

Advisors and project sponsors should work with local, state and federal government agencies as well as multilateral agencies and development organizations to support their projects. For more information, please refer to my article on Project & Public Finance Strategies (PDF) or leave a comment here.

His point was that professional buyers are in the market everyday and need very little assistance in evaluating opportunities.  The individual buyer, no matter how sophisticated they think they are, is not in the market on an ongoing basis and therefore, will be less proficient and therefore a more risky prospect.

With that introduction, since joining CFA I no longer deal with individual buyers.  My concentration tends to focus on recapitalizations (recaps) where I represent a business owner that is looking to sell part of their business to gain some liquidity and continue growing their company aggressively with a financial partner over the next several years before ultimately selling. This financial partner is almost always a Private Equity Group.

There are several things I like about the Private Equity Groups.  First and foremost they have money (although there are a few exceptions).  Secondly, they are compensated primarily through equity stakes in transactions completed. Therefore they have a tendency to not waste their time or mine. While they may not always be able to specify what they are looking for, they are very competent at deciding quickly if they like an opportunity or not.

My approach to targeting prospective buyers starts with my knowing the Private Equity “players” that tend to concentrate on energy transactions. I like to keep my targeted group to a relatively low number (25) so that I can interact with them one-on-one to determine their interest — including who will be in the final five or so that gets to meet my client.  I can tell a lot by the questions they ask (are they knowledgeable) and by the obstacles they raise (are they positive) in discussing my client.

The last and certainly most important of the criteria is the chemistry between my client and the prospective buyer. Certainly their price has to be competitive, but the chemistry, normally solves this issue.

In summary, my screening process includes:  money, knowledge, interest, and chemistry.

While these guidelines will certainly apply to an individual buyer in a “brokerage” transaction; individual buyers are far more difficult to screen. Eliminating unqualified buyers is a key skill that an intermediary brings to his client. This skill ultimately saves the client valuable time.  At the end of the day, when a business owner thinks about selling his business it is critical that they keep their eye on the ball (i.e. continuing to run their business profitably) and minimize any distractions.  This time saving skill that an intermediary provides in only allowing qualified buyers to meet with business owners is “priceless”.

“A share of any profits that the general partners of private equity and hedge funds receive as compensation, despite not contributing any initial funds.  This method of compensation seeks to motivate the general partner (fund manager) to work toward improving the fund’s performance.”

Given the recent election results and ongoing debate about executive compensation in the midst of the current financial crisis, it should not be a surprise that the tax treatment of income associated with carried interests could be changed as early as 2009.

Under current federal tax law, the character of the income to the carried interest is the same as the income earned by the fund.  Therefore, if most of the profits of the fund consist of long-term capital gains, then the carried interest receives, in direct proportion to its allocated share of profit, the same tax treatment.  So with the substantial income earned by some of the managers of large private equity groups over the past few years, there has been a heated debate over this favorable tax treatment.  At the moment, with a few exceptions, the maximum federal tax rate on long-term capital gains is 15% while the federal tax rate on ordinary income is as high as 35%.

Without any amendments to the federal tax code, the 15% federal long-term capital gains rate is scheduled to expire on December 31, 2010 and, thereafter, move up to 20%.  Some members of the private equity community may believe that the substantial change in the capital markets and a higher capital gains rate in a few years will move this political issue to the sidelines.  With the promise for change by President-elect, Barack Obama, and a democratically controlled Congress, just about anything is possible with regard to changes in the federal tax code.

Let us also keep in mind that the current federal budget deficit problem does not appear to be going away anytime soon.  With Congress looking for new ways to increase tax revenue, it seems logical that ordinary income treatment will soon apply to a carried interest, just as it does for executive compensation reported on Form W-2.

Think recapitalization. While not for everyone, a recapitalization or “recap” as often referred to, can provide an attractive option for sellers. A recap enables a seller to sell a portion of a business now, while keeping an ongoing equity stake, maintaining an active management role, sharing in the growth of the company, and retaining the opportunity to participate in better markets which may be ahead.

A partial sale now could yield considerable wealth with which to diversify into retirement appropriate investments. It could also avoid possible higher capital gains taxes that may apply to future sales. Once diversified, a seller may feel reinvigorated and more eager to expand a business with a partner’s help and co-investment. A recap is also appealing to most private equity groups because it demonstrates that the seller believes in the company’s future. It can mean the difference in doing a deal or not and can positively influence the amount of an offer.

The object of the recap is to grow the value of the company generally over a 3 to 5 year period at which time there is a subsequent sale. Often this growth is accomplished organically as well as through add-on acquisitions. While there are no guarantees, many private equity firms have successful track records of exiting their investments with lucrative returns for themselves and their recap partners.

It’s a smart idea to explore a recap with an experienced M&A advisor. A good M&A advisor knows the private equity firms that have successful track records with recaps and knows the critical areas that must be negotiated. Your advisor can show you how a surprisingly small reinvestment can enable a business owner to retain a significant stake in a company post transaction. He or she can also brief you on the importance and feasibility of pari passu treatment of reinvestments, abolishment of all personal guarantees and a host of other important aspects of a recap.