What a senior lender checks before it funds a private equity deal

• KeyBank asks for three years of financial statements prepared by an outside party, not necessarily audited, plus interim figures to calculate the trailing twelve months.
• Where statements are company prepared or only compiled, the bank requires a quality of earnings report to validate the add-backs, and relies on the buyer's diligence rather than repeating it.
• Lamirand describes KeyBank as a less than 3 by 4 shop: senior debt under three times EBITDA and total debt under four, with more headroom for businesses under $20 million of EBITDA.
• The bank underwrites the base case, discounts the buyer's plan by about 20% and sets covenants with at least 20% cushion.
• Fixed charge coverage is the covenant that matters most, typically set between 1.1 and 1.2 times, and a trip is meant to reopen the conversation.
• Cash flow recapture sends part of any outperformance to pay down the term loan, because these deals rest on enterprise value with little collateral behind them.

Tripping a covenant does not mean handing the bank your keys. Kelly Lamirand, a regional credit executive at KeyBank, says the covenant is there to give the lender a signal that there might be a problem and to bring everyone back to the table (around 19:08). Maybe you had a misstep, maybe a one-time purchase of a big piece of machinery paid out of cash. Either way, she says, the point is to re-engage the conversation. That framing runs through the whole interview.

“We generally piggyback off of your diligence. We're not trying to make this an onerous process where we're gonna require a bunch of separate people doing the same work.”

Kelly Lamirand, Regional credit executive, KeyBank

The host is Bobby Kingsbury, managing director at the private equity firm MCM Capital Partners, and the episode is aimed at business owners who are about to sell and take on acquisition debt. Lamirand has spent her whole career of almost 22 years at KeyBank, and now runs a team managing middle market credit across Ohio, Indiana and Michigan. KeyBank defines the middle market as roughly $10 million to half a billion dollars in revenue, she says, with most borrowers under $100 million.

“You can show me a bunch of projections that show a bunch of growth and I will discount those and say, okay, well, all I really need them to do is perform at the level that they have.”

Kelly Lamirand, Regional credit executive, KeyBank

The document request is short. Lamirand says the bank wants three years of historical financial statements, meaning the balance sheet, profit and loss and statement of cash flows, usually from an outside party. They do not need to be audited. Interim numbers plus the same period last year let the bank calculate the trailing twelve months. If the statements are company prepared or just a compilation from the accountant, KeyBank generally requires a quality of earnings report, because the sale process brings assumptions about add-backs that need validating.

“Cash is king, cash flow is king, and that is a number one most important.”

Kelly Lamirand, Regional credit executive, KeyBank

The bank does not commission that work itself. Lamirand says KeyBank piggybacks off the buyer's diligence, so the sponsor's quality of earnings serves both. What the bank is testing is whether the debt can be repaid, measured as funded debt to EBITDA. She calls KeyBank a less than 3 by 4 shop: senior debt under three times EBITDA and total debt under four (around 15:56). For businesses under $20 million of EBITDA she aims nearer 2.75 or 2.5. Her reason is arithmetic: on $2.5 million of EBITDA, a 10% dip is 250 grand, and you can drop 250 grand pretty quickly.

“It doesn't mean the end of the world and you're gonna throw us the keys and we're throwing you out of the bank. That's just definitely not what it's meant to do. It's meant to re-engage the conversation.”

Kelly Lamirand, Regional credit executive, KeyBank

Two terms tend to surprise owners. The first is revolver availability. Lamirand says the worst thing you can do is fund the deal from the line of credit and then find there is not enough money to meet payroll the next week,. She puts the cushion at about half a turn of EBITDA, depending on the size of the business and whether it carries inventory. The second is cash flow recapture: when a company beats the base case, the bank takes a percentage of the excess to pay down the term loan. She says these deals rest on enterprise value with little collateral behind them, an airball, and amortisation now stretches to ten years.

Lamirand walks through the five Cs of credit. Character comes first, and she says she has worn hard hats, goggles and lab coats on plant tours to meet management teams, because the team has to pass that test as well as the private equity firm. Capacity is whether the earnings are sustainable or a hockey stick, a one-time event. Condition covers the industry: regulation that drives demand, as in heavy trucking, or headwinds such as the Amazon effect. Collateral is the first lien on receivables and inventory, though she says these deals do not lean on it much. Capital is the owners' skin in the game.

Kingsbury notes that MCM's own screen looks much the same. Lamirand names the difference: the private equity firm underwrites the growth case, and she only needs the base case. She says banks look at history as an indication of future performance, because anybody can put a projection forward, and it only becomes real when you actually hit it. In practice she discounts the plan by about 20%, depending on how lofty it is, and sets covenants with at least 20% cushion. She is not looking for defaults (around 22:17).

Her most important covenant is fixed charge coverage: operating cash flow divided by principal, interest, distributions, capex and taxes, usually set between 1.10 and 1.20. Below one, she says, the bank has to reserve a lot more capital against the loan, which costs it money. That is why maintenance capex, what you spend year in and year out to keep earnings steady, sits in the ratio, while growth spending such as a new building is treated differently. Pricing is relationship pricing, she says: deposits, treasury services, interest rate swaps and the whole sponsor relationship all count.

If you are selling to a private equity buyer, the lender will read the same quality of earnings and statements the buyer collects. Get three years of outside-prepared financials and a defensible list of add-backs in order before the data room opens.

0:00 hello and welcome to another episode of well capitalized I'm your host Bobby Kingsbury managing director at MCM Capital Partners and today we're gonna be continuing our education on the due diligence process and today we have with us kelly lamb ran from Key Bank talking about Bank diligence so Kelly thank you very much for for joining me yeah if you wouldn't mind just give us a little bit of background on yourself and sandy key and then we can start sure so Kelly lamb Hren I'm the regional credit exec at a key Bank and I've been there for coming up on 22 years so I've been there my whole career I started at key right out of college I went to Miami University I started there in their credit training program and did did a bunch of training to all throughout the summer and then got into the middle market space as an analyst I took a sidestep into the corporate bank for a couple of years I hated that job and then I came back to the middle market as an associate for a couple of years and then got my credit Authority about 17 years ago and so I was a junior credit

1:03 officer and I just expanded my credit role throughout the years from the Cleveland Market in Cleveland and Akron in Columbus and now I have a team of folks that helped me manage middle-market credit for the Great Lakes which four key is all of Ohio Indiana and Michigan so it's a lot of windshield time yes yes so how does key just for the viewers at home how does key define the the middle market what size businesses are you typically underwriting key to finds the middle market from about 10 million in revenue to about a half a billion and the majority of our borrowers fall in that tend I would say less than a hundred million in revenue the outliers of the big companies there there are a handful of them but in terms of volume its it's definitely in that 10 - less than 100 million dollar revenue space great so let's get into the the M&A process and you know from from a legal or from a bank diligence standpoint what

2:08 information do you generally require upfront from the companies either from buyer or from the company itself what we're looking for are three years of historical financial statements balance sheet profit and loss statement of cash flows from an usually from an outside party sometimes that gets a little tricky because if a business hasn't had a lot of debt they haven't had a lot of financial statement requirements so do they need to be audited no of course not no not at all not at all but that's that's where and then we if there's an interim statement we look for you know as of a September and then the September of the prior year so we can calculate the trailing 12 months over the last 12 months of revenues EBIT etc and where we usually come up on statements that are either company prepared or maybe they're just a compilation from the accountant will generally require a quality of earnings and the reason for that is that you want to you want to validate what your assumptions are and sort of test the the financials a little bit in terms of accuracy so and there a lot of a lot

3:12 of times they're after the the sale process we're making some assumptions on add backs and so we need to validate those and quality of earnings will give that to us so are you is the bank doing additional work or does the bank generally rely on the quality of earnings performed by a outside accounting firm we generally piggyback off of your diligence we're not trying to make this an onerous process where we're gonna require a bunch of separate people doing the same work so we piggyback off of off of what your what what the what MCM in your case would require so so why does the bank require you know just for the business owners that listening why does the bank require this information for what purpose so what we're looking at when we do a transaction is we're putting a certain amount of debt on on the books and we need to make sure that there's the ability for that debt to get repaid we look at the leverage of the business defined really by the cash flows the debt to EBIT to us a total funded debt

4:15 to EBIT which means in our case and then senior funded debt so senior funded that would just be keys so senior lender to EBIT and then the total would be if there's any sub debt or jr. capitulate on top of that so as negotiations might might be going on entrepreneurs may hear some terms that they may not be familiar with like cash flow recapture or revolver availability can you describe or define some of those for them just a you know the most common terms that they might not be familiar sure working capital availability or revolver availability we just want to make sure that the business has enough liquidity to you know going forward to meet their needs so the worst thing you can do is use some of the revolver the line of credit to fund your deal and then all of a sudden the next week you have to meet payroll and there's not enough money there you need to you know you need to account for those absent flows and your taxes and then your payroll when is your insurance due maybe it's only an annual insurance payment or

5:18 quarterly or I I don't know exactly how some of that work works but it's not a monthly number but if that number is due right after closing you didn't leave enough revolver availability to help you pay for it and you haven't collected a bunch of receivables yet we just need to make sure there's enough cushion there so what in your definition then what would be enough cushion so draw down on revolver at close what would you like to see in terms of availability ten percent no more than twenty percent I would say it's about it it depends on the size and and the nature of the business you know it's less if there is an inventory component if it's just a service business that's not that's receivables based so that you know if there's no inventory it consumes less cash but I would say it's generally between I want to say a half a turn of events on maybe okay you know businesses are all different though we look to the owners and to who've been through the cycle before and you guys to help us through that conversation and making sure that there's enough liquidity there and what about cash flow recapture so cash flow

6:22 mur capture essentially means so if you we underwrite to a base case and we make sure there's room in the covenant however if you outperform we we take a percentage of that to pay down the term and the reason for that is that we've done a deal based on the enterprise value and there's not usually there's not a lot of collateral there as a secondary source of repayment to repay the debt so an airball yeah another term that you may hear collateral shortfall if you will and that so that the reason we want over capture is that if a downturn then does come the leverage is brought down a little bit a little bit in the years that the performance has been really good and amortization zong term loans have stretched market you know will go up to ten years on an amortization if you down that back a handful of years in my career we really weren't doing anything more than seven yeah just a handful of years ago so because of that stretching of that amortization is also why you want we

7:27 want some of that recapture in the years that you've that you that you've outperformed and also the deal is such - that it doesn't really benefit the company all that much to just sit on a bunch of cash you really can't do anything else with it something unless the bank says it's okay I mean it's not like you can take a distribution or you know you'd have to get banks consent for that because we really sort of lock that down until you know leverage is in good shape so there's really - in order to be sitting on a bunch of cash on the balance sheet really doesn't it's it's not all that beneficial no it doesn't do anybody know right because we're also we're paying for that money right - questions as a follow-on to that now what what if I'm a business owner and I'm hearing that I'm talking about cash flow recapture and I'm outperforming you're taking some of the the cash way but what if I want to invest in some growth growth capex so it's net of that number so it's it's really the operating cash flow so what the the cash flow of the business is generated - all the

8:29 fixed charges and the capex is part of that calculation and so you know if you wanted to do that we've already taken that into account so if if the performance really killed it but you you wanted to do investment that's our that whatever's leftover is already smaller so we've taken that into consideration already and so when when we were talking prior you had mentioned you know the five seats to lending and we're shocked ahead I guess three out of five or the five Cs of credit so can you that was harder training for the business owners and myself what are the the five season of credit what we're always looking for our threats to and to how we get repaid so we are looking at sources of repayment for the loans that we make and and some of the determining factors of that you sort of like you said go back to the five Cs of credit character is a big one that's why I really like keys process and that getting loans approved and whatnot we

9:33 like to meet management teams I've met a ton of management teams we've been on a bunch of plant tours together you know I I always tell people I've warned hard hats and goggles and lab coats and you know I really like getting out and seeing businesses and meeting people and so character is a big one for us and what we're trying to assess there too is the strength of the management team it's not just all about the owner but you guys have passed the character test but we need to know that the management team can as well so it's not just a private equity firm it's also the management team that you're taking like that too for sure for sure you know you try to figure out their ability to navigate tough situations how have they how has their business abdun flowed how has it grown and you know is there have been any turmoil in the industry and how do they how do they figure that out and how do they you know keep the EBIT study where it is in order to repay the debt so that's you're trying to assess their ability to navigate those waters I want to interrupt the five seas for another national question so as you look at oftentimes there's a lot of business

10:39 owners that haven't had to put any debt on their balance sheet so when you know a private equity firm is coming in obviously it's a leveraged recapitalization we are using leverage to help fund the transaction how do you look at a business owner management team that have never dealt with that on their balance sheet prior well you I mean that's that's really not that big of a deal you sort of want to make sure that through the diligence process they know what covenants are if there's any additional reporting that and and what's important to the bank but as long as I mean what they should really be focused on is their ebit on their performance I don't really want them to be sort of worried about the banking relationship if they perform everything else will fall into place because that's what we underwrite to we underwrite to their EBIT on their financial performance the rest of it should be which should be fine what they should take into consideration the only thing that that will sort of trip that up maybe a little bit is on the liquidity side and and if there's [11:41] there's absent flows in their working capital if it's a seasonal business you know making sure if they're when they're in and out of their line of credit and as appropriate and capital needs we know you're good so we talked about character we talked about capacity or cash flow and that's just sort of what we talked about is the capacity of the business to repay the debt and that is all about the financial performance and the EBIT ah so you know the business and we don't a lot of businesses they grow and then they've hit a level of performance in EBIT and they decide that that's a good time to sell because they've grown their business and the multiple of a bigger number say multiple of a bigger number obviously that's them more more cash but what we really try to get into is well what's the sustainability of that you know is it a hockey stick was it a one-time event and it can they repeat that performance on a consistent basis condition is another one and that's some

12:45 time that comes a lot from outside factors what's going on in the industry how do they fit within that industry are there you know laws and regulations that sometimes help businesses that laws and regs require businesses to you know buy whatever the product is that that company is selling you'll see that a lot in like heavy trucking and all the rules change and so that drives a lot of business to get ahead of those certain things like that but or conversely are they facing you know headwinds is there the Amazon effect and a lot of you know consumer discretionary right now is incredibly stressed so you try to look at outside factors as well collateral is another one in that those are the assets pledged against the loan so your receivables inventory your senior lender has a first first lien on those assets and so you look at that as a source of repayment generally speaking in newer kinds of transactions we're not looking to the

13:48 collateral for a ton of repayment because they're not asset heavy deals we focus on the value of the company is not just what's on the balance sheet there's an enterprise value which is why we sort of look at funded debt to EBIT and then lastly is I lost my train of thought so not lastly is is the equity you put in I know it's not - see - it's no it's not no my gosh I'm totally blank Capital it's the capital that is equity you put into the business so I'm seeing capital so you you know the ownership of the business what skin do they have in the game and you want to make sure that that the ownership team has has something at risk as well yeah so it's not too dissimilar from what we look at you know we put the other potential investment standard score and we look at the macro micro environment we look at the competitive advantage of a company we look at the depth and strength of their management team right we look at our ability to add value and then we

14:51 look at the financial profile so you know there's there's a lot of things in common from what we look for - sure you guys are the only I say the biggest difference is that you guys are under right into the growth case and I really am just looking at the base case that's all I need yeah you know you can show me a bunch of projections that show a bunch of growth and I will discount those and say okay well all I really need them to do is perform at the level right at the level that they have and you know banks generally look at history as an indication of forward-looking performance it doesn't always match up but that we generally because anybody can put something on but until you actually hit it that's what you know that's when it becomes real yeah so that's a good transition into debt levels so generally what are the total debt levels that Key Bank or senior lender might be comfortable with both from a total debt perspective and then from a senior lending perspective as it relates to EBIT da sure so generally speaking were less

15:56 than 3 by 4 shop and what that means is that we focus on putting we require really putting less than senior debt to eat itself less than 3 times in total less than 4 so 3 times would sort of be our benchmark and we generally an small some smaller businesses and size matters in that space on smaller businesses which is generally what you guys do and small I'd say and by our definition is less than 20 million dollars in EBIT and there is a reason for that we try to stay you know 275 250 so that we try to give ourselves some room under that 3 that 3 handle threshold and then you can put a layer generally of of sub debt on top of that and the reason that that $20,000,000 EBIT on number is significant because generally speaking bigger companies have access to the capital markets that smaller businesses just do not and so those structures just don't fit in that smaller space you know the percentage is you know 10% of a 20

17:01 million dollar business obviously is you know 2 million dollars that's a significant in terms of dollars if it's only two and a half million dollars that's 250 grand you can drop 250 grand pretty quickly and that's already 10% yeah so that's that's another reason that the the math sort of gets a little bit different when the numbers are smaller because the percentages are very small changes that businesses can see very often and it's a function of risk right they write from a rates standpoint you know where our race a what you've seen your lenders generally charge generally I mean it's really relationship pricing and so we basically look at yeah of course we we basically we basically look at the entire relationship and what products and services are going to be used there's a lot of factors that can that contribute to that are there any deposits that that are will remain on the balance sheet are there using treasury services which we would require

18:03 and any deal we would be the only lender so we would require all that are they going to do fix their rate using an interest rate swap you know we factor all of that in and honestly in our relationship we factor the whole MCN relationship into into the deal you know because we we've been we've had such a good long-standing relationship that we take into that we take into account that whole relationship that we have with your team into our pricing models great so what can you explain for the business owners what debt covenants are and which ones are the most important sure to you sure we generally try to keep it we keep trying to keep it simple so I always say to people you know what really matters you know what are we trying to solve for here and cash is king cash flow is king and that is a number one most important so you're operating cash flow or your fixed charge coverage ratio definitions are sort of interchangeable that's the most important covenant to us leverage is important but but cash flow is is our

19:08 number one covenant in there and that what that means is you're taking the operating cash flows of the business divided by the fixed charges which would be principal interest distributions capex and taxes those are the five generally that go into the denominator and sometimes it's a deed up from the new you know I don't even get into all of the definitions and whatnot there there can be various definitions but it really shows that the business is performing at a level that can repay the debt and what generally is the covenant there then in a fixed charge it falls anywhere between 110 to 120 depending on your definition that's generally the range that we would like to see and if there's a covenant trip we the reason for the covenant is to give us a signal that there might be a problem to bring us all back to the table it doesn't mean the end of the world and you're gonna throw us the keys and we're throwing you out of the bank that's just definitely not what it's meant to do it's meant to re-engage the conversation about okay you had a misstep or maybe you had a one-time

20:10 activity you built you had a huge piece of machinery that you wanted to pay out of cash flow because you didn't really need to borrow any money on the work yeah so you know that through you that's who you are for that year how I describe that to people is that maybe you had some cash on the balance sheet that you had been saving over numerous years and so you really wanted to use that cash you didn't pay for it out of operations all in the same year I I sort of look at that like when you go to buy a home you didn't you didn't earn your downpayment all in one year right you know so maybe you saved some money or you know maybe you you you funded that capital expenditure through another loan so you know you would borrow to do that and then you'd add to your principal payments for that that's a great example yeah and we also view we view growth catbacks very differently than maintenance capex but what we're trying to look at is that the maintenance capex in the in the fixed charge is what do you need to spend year in and year out in order for to produce the same EBIT job that you did you know you're clearly

21:14 if it's growth maybe you grow grew like I heard prior you were roux in to a new building yeah well you're not gonna buy a new building every year that's definitely a growth move that you have to do every so often but generally speaking you that's not an every year activity so but but anyhow does going back to fixed charge coverage that just shows the ability to repay and in the banking world that's a that's big in the risk rating system which it just shows the performance of a loan and that the better the risk rating is for us means we don't bank has to reserve less capital against that loan and so when it falls below that one especially at a one time we have to reserve a lot more capital against that loan and so that's why we proceed with well it's perceived to be riskier in that scenario and that's why I cost the bank a lot more money so and then on the leverage side we generally focused on the leverage covenants in terms of funded debt to EBIT a like we just talked about and so we'll start we like to see those closing numbers less than three by four but we don't under

22:17 right right to that those numbers because we know that you've got a you got to allow some cushion and right we're not looking for defaults believe me I'm not looking for a default so we give some some cushion and we look at the plan and then we sort of we set benchmarks to try to see that leverage come down over the years so when you're looking at a an operating plan you know during the the diligence side how how much are you discounting 20 percent 20 percent Thanks that's that's basic depends on how lofty the plan is but as a goal I'll take the plan that you give us the owners or I'm seeing whomever has provided and will try to give you at least a 20% to the Covenant yeah well Kelly thank you so much for taking the time I really enjoyed the business owners would get a lot of thank you yeah no thank you I appreciate it thank you for taking the time to watch another episode of well capitalized please subscribe to our channel below if you have any additional questions please leave them in the comment section thank you