Many of companies simply plan wrong and any meaningful change to inventory could trigger a borrowing base issue with inventory borrowing outpacing accounts receivable. Second lien capital enables clients to obtain additional capital to pay down payables and work through inventory over time to generate cash flow and hold margins constant rather than be forced to dump inventory at any cost to raise cash. Seasonality is also a tremendous source of deal flow. Super G has now financed ice cream in the winter and candles in the summer, which reflected the lowest working capital points that prompted a need for second lien capital as both companies were not able to obtain over-advances.
Collateral always comes in the form of a blanket second lien behind a senior lender, but often times there is good asset coverages with lenders lending low availability percentages against inventory and the underlying IP or trademark typically available. This especially comes into play once a consumer brand reaches at least $10 million in wholesale sales, which at a keystone margin implies $20 million in retail sales, and would provide enough scale for a potential acquirer to get interested. As with other industries mentioned, there is no shortage of senior debt capital providers as well as equity providers given the value associated with consumer brands.
Software -- Specifically SaaS
SaaS companies create an interesting paradigm as there are no tangible accounts receivable as in the other industry verticals mentioned. However in return, there is recurring revenue, which can be valued based on the net churn of a company’s customer base. There is just as big a void in the SaaS sector as in niche manufacturing and many senior lenders focus on SaaS companies including venture debt firms, but there are very few second-lien players who will write a $1 million to $3 million check to the SaaS company that has yet to become eligible for subordinated venture debt. Lending to this sector presents challenges as many of these firms are breakeven-to-a-slight loss on purpose in order to re-invest all cash into sales and marketing. Second-lien capital provides a non-dilutive means to grow with the assumption that management would have to scale back sales and marketing and become profitable if projections are missed. Other criteria include major customer wins and proven product, but the key metric would be recurring revenue that is spread out over a non-concentrated client base as that MRR (monthly recurring revenue) can be valued and lent against. Super G has been successful lending to SaaS companies in a second lien position and recently created a new division just for SaaS and tech clients called www.saasfunding.com. This is a wholly owned division of Super G dedicated to tech entrepreneurs.
Conclusion
The lower middle-market second lien market is only going to expand over time as the multitude of small committed and independent sponsors try to institutionalize this market. These smaller equity providers will not be able to obtain traditional mezzanine capital for all deals and second lien debt should serve as a bridge to get deals done and enable a path to obtaining traditional mezzanine debt that is more patient. Small private equity funds are just a subset of the provider opportunity to work with owner-operated businesses that are not backed by private equity.
To date, 80% of our transactions have been completed with entrepreneurs and 20% with small private equity funds. Most companies in America are non-sponsor backed and generate less than $5 million in EBITDA. Both the market and the corresponding need are quite large. The need remains the same regardless of whether a company is owned by an entrepreneur or is private equity owned, as large funds cannot afford to write small checks to a riskier asset class. We anticipate the need for second lien capital to continue to grow and be more widely utilized as more banks consolidate independent ABL groups and traditional mezzanine firms continue to raise larger funds.