Mezzanine Financing by Credit Unions Prepared for: CBOS Product and Tools Sub-Committee and

CBOS Business Development and Service Delivery Sub-Committee April 14th 2010

Canadian Business Owner Strategy Mezzanine Financing by Credit Unions

Page 1

Mezzanine Financing by Credit Unions This article offers insights into what it means to deliver mezzanine financing to qualified business members.

It includes insights and experience from Vancity Community Capital, one of the providers in this unique niche market.

What is mezzanine financing? You may have heard it called ‘mezzanine financing’, ‘junior debt’, ‘structured equity’ or ‘quasi-equity financing’. The myriad of names all share a common principal: subordinate financing is basically a hybrid of debt and equity financing. It is unsecured, cash-flow-based financing, and primarily offered to fast growth, profitable companies in Canada.

It shares some of the characteristics of debt financing because the borrower has the obligation to repay interest and principal over a term of five to seven years. On the other hand, mezzanine financing also mimics equity financing because repayment is based on cash flow rather than depreciating company assets. The uniqueness of mezzanine financing is that there may be an equity sweetener attached to the loan in the form of options or warrants. These give the lender the right to convert to an ownership or equity interest in the company. This can help boost their income beyond fees and interest payments, particularly if the value of the company stock increases. Lenders can also convert to equity if the client has issues repaying their loan in full or on time. What's important to remember is that the word ‘subordinate’ basically refers to the fact that the security of the mezzanine lender ranks behind or is secondary to senior lenders. Ultimately, the risk is shared. As sub-debt financing ranks below senior debt in its priority the cost is higher, in the region of 15% to 20%. In the long run it can prove more cost effective than equity, with many business owners acquiring their business outright in five to seven years. Mezzanine financing is not a formula-driven solution and can be highly customized to specific needs, depending on factors such as business seasonality, working capital requirements and repayment structure. In terms of pricing, the mezzanine lender may obtain a return on its investment through a combination of fixed interest rate, and a variable return, based on: royalty on sales or profits or EBITDA (Earnings before interest, taxes, depreciation and amortization); bonus interest (fixed or tied to performance and/or the value of the business) and warrants (the option to purchase an ownership position in the business) In terms of fees, commitment fees and monthly administration charges are the norm. So what's the key advantage of this type of financing for a small or medium-sized business? Subordinate financing provides the capital necessary for a business to fuel its growth or secure its continuity. Repayment is not based on diminishing asset value but more on cash flow potential. This financing is a great option for businesses lacking tangible assets, such as knowledge-based or service businesses.

About the Canadian Mezzanine Market

The Canadian mezzanine market is a small niche market, estimated to be $1.5 billion to $2 billion in size by Lee Davis, Vice President of Vancity Community Capital. It is less commoditized and has few competitors than the Canadian Business Banking market: an opportunity for Credit Unions considering entering the market.

The industry is typically focused on larger transactions at five million dollars and over for more established, higher revenue companies. Key market players include Bank units; private niche providers; The Business Development Bank (‘BDC’), and Vancity Community Capital, a division within Vancity Savings Credit Union. Bank providers are typically focused on larger transactions over five million dollars and financing for

Canadian Business Owner Strategy Mezzanine Financing by Credit Unions

Page 2

existing bank clients. The major players here are Roynat (a subsidiary of Scotia Bank), BMO Capital, CIBC Mezzanine Financing and HSBC Capital. Private niche players, often described as specialty finance companies, also tend to be focused on the higher-end market. The many include the Wellington Fund (Toronto), Bond Capital (B.C.) and Crown Capital (Saskatchewan). Fewer providers offer mezzanine financing for smaller transactions below three million dollars. The key providers in this market segment are ‘BDC’, Vancity Community Capital, BMO Capital and Roynat. For deals under one million dollars, ‘BDC’ and Vancity Community Capital (sometimes in syndication with other Credit Unions) are the primary players. Vancity is the only credit union organization known to be actively operating and marketing itself in the mezzanine financing market through Vancity Capital. However Vancity Community Capital has started partnering with other Credit Unions in B.C – including Envision, North Shore Credit Union, Prospera, Kootenay Savings Credit Union, and North Peace Credit Union – for syndicated sub-debt deals. It also has received referrals from Credit Unions looking to better serve their business members through mezzanine financing as one component of a fuller business solution. Vancity Community Capital is prepared to act as lead investor as well as a participant in a subordinate financing transaction.

Trends impacting potential market growth

Here are the most important trends positively impacting the growing need for mezzanine financing:

• With an aging demographic, many 50+ business owners are looking for ways to exit their companies in the next ten years. Subordinate financing can provide the necessary funds for an acquisition or management buy-out or buy-in. Basically, lenders can help entrepreneurs fill the financing gap in a transaction.

• The growing number and importance of knowledge-based and service businesses in Canada, lacking tangible assets. Knowledge-based businesses include technology, cleantech and digital media companies.

• The fast pace of R&D innovation, meaning that businesses are increasingly seeking new financing to keep ahead of their competitors, and

• An increased comfort with cash flow based financing by entrepreneurs as they become more educated and sophisticated.

What businesses are eligible for this financing, and how does it work?

Mezzanine financing is typically provided to more established and fast growth businesses that want to take the business to the next level. These businesses typically need growth capital to finance a one-off business event (for example an acquisition or management buy-out), and/or working capital to enable them to grow at a more aggressive pace than their primary lender may be comfortable with.

Financial providers tend to have the same eligibility criteria for businesses qualifying for mezzanine lending. These are a strong track record of profitability; an experienced, sound management team, and an existing line of credit.

Lee Davis of Vancity Community Capital offers other insights into the characteristics of these businesses: “They are usually world-class at what they do, and innovators with a competitive niche. Often export-orientated, they are keen to expand across borders or internationally. Their management team is forward thinking and eager to partner with experts.”

Canadian Business Owner Strategy Mezzanine Financing by Credit Unions

Page 3

Startups and businesses without a track record of profitability do not qualify, although this could be a potential new market for Credit Unions, Lee offers. Businesses that tend to need this sort of financing include knowledge-based and service businesses, tourism and hospitality businesses, and manufacturing or distribution companies. As Lee states, “These companies are the growth areas of the future.”

In addition to small businesses, charities and non-profit organizations are an important target market for this type of financing, as they lack tangible assets, and have values strongly aligned to Credit Unions. Social Enterprises are another important target client for Vancity Capital. An example would be First Nations communities evolving towards green energy projects in lieu of declining fishing or forestry assets.

Mezzanine financing deals tend to fall into two categories, as Kristi Miller, Investment Manager at Vancity Community Capital explains. “Fifty to fifty-five percent of our transactions are due to a change in business ownership, estate buy-outs or divorces. The other forty to forty five percent are to provide growth capital, where the business is growing faster than the company’s primary lender can finance. The sorts of companies that fall into this second category tend to be younger businesses that lack a tangible asset base in service or knowledge-based industries.” So how does it actually work? Kristi gives an example. “A business may have good growth prospects, and want to finance its growth beyond the reach of its traditional lender. This is when they may come to us. We will give them financing charging them a fixed interest rate on the deal, plus take a small equity interest in the business, with the agreement to sell back the equity stake based on a pre-established valuation formula based on the company’s earnings.”

A success story: West Coast Launch

West Coast Launch is a family business in Prince Rupert. For many years it has successfully run world-class eco-tours in the Great Bear Rainforest and a water taxi service. Northern Savings, its credit union,

has provided multiple business loans for three passenger launch boats. It wanted to help its member take its business to the next level, by helping to finance a state-of-the art catamaran with 100-person capacity. In

2006 the credit union turned to Vancity Community Capital for a collaborative partnership.

West Coast Launch’s existing business was analyzed and business projections based on the future potential of the business with added boat capacity was built. In syndication, senior and subordinated financing was provided by Vancity Community Capital (partially guaranteed by Western Economic

Diversification and EDC); Northern Savings provided additional financing, and financing and equity loans were also provided Export Development Canada, Western Economic Diversification, Ecotrust Canada and

the owners.

The new boat was built in Vancouver and has significantly improved the tourism industry in Prince Rupert. West Coast Launch’s success has exceeded business expectations, and Northern Savings has retained

and deepened its relationship with its business member thanks to its innovative financing approach.

What are capabilities required to deliver mezzanine financing in-house?

• Experienced commercial bankers: For example, Vancity Community Capital has an experienced team of four commercial bankers with chartered accountant qualifications and/or extensive experience in strategic acquisitions, management buy-outs and growth financing.

• Aligned Credit Risk Management Tolerance. A different set of credit risk expectations; risk tolerance level

and credit review process are required if your credit union wants to competitively offer mezzanine financing in-house.

Canadian Business Owner Strategy Mezzanine Financing by Credit Unions

Page 4

• Financial analysis, client relationship and portfolio management: More sophisticated financial and business analysis, reporting and a deeper level of partnership are required for unsecured mezzanine financing compared to commercial mortgage or term loan business lending. As Kristi Miller explains: “If a client company has strong financials and a strong management team, we will tend to analyze the business financials quarterly. If the business is going through a specific change we will do more hand-holding, and analyze performance monthly.”

• Patience! Vancity Community Capital has been in the business for twelve years and it took a number of

years for the subsidiary to break even (it is now nicely profitable). Patience is also required in terms of deal flow and sub-debt portfolio maturity.

• Treasury people expertise (to provide advice on risk mitigation) and industry experts within the commercial

sales force, are additional ‘nice to have’ capabilities, according to Lee Davis. What are issues and risks for Credit Unions wanting to enter this market?

• Sourcing bankers: If Credit Unions want to provide mezzanine financing in-house, the challenge of recruiting the qualified commercial bankers to deliver this financing could be a challenge (for example in rural parts of Canada). These bankers tend to be located in commercial centers like Toronto or Vancouver.

• Building Risk Tolerance: Credit Unions tend to come from real-estate based lending backgrounds and

philosophies. From a credit risk management perspective, mezzanine financing is a different ball game. • Sourcing Deals: The number of qualified prospects is fewer, and deal flow is slower than for commercial

mortgage or term loan business lending. Vancity Capital’s team delivers twenty sub-debt and mezzanine transactions a year. Sourcing the right partnerships takes skill and time.

• Handling Complexity: Mezzanine financing deals more intricate to structure and deliver than straight

business loans. For example, it can be difficult to value a company’s equity to get the financing in place. Solutions are highly tailored, and a real business advisory role is required to effectively meet client needs.

• Delivering Scale: Some would argue that Credit Unions lack the geographic reach, scale and/or service

delivery capabilities to effectively compete with national-reach banks or specialty providers for products like sub-debt financing. Collaboration and syndication can help build scale and spread portfolio risk geographically. What are the opportunities? There is a competitive opportunity for Credit Unions to compete particularly in the lower-end part of the market (transactions of three million dollars and under) where competition is less intense. Mezzanine financing is a more complicated but higher-value product and service Credit Unions could offer to their high potential business members. It enables them to provide a fuller business solution to these businesses and retain profitable fast growth businesses over the long term. The deeper relationship involved facilitates the uncovering of additional business and personal banking opportunities over time. It also represents a tangible way for Credit Unions to become great community partners and demonstrate their values by sharing the risk as well as reward for their business members’ success.

Canadian Business Owner Strategy Mezzanine Financing by Credit Unions

Page 5

Refer and Partner with Vancity Community Capital For Credit Unions that prefer to focus on their core business banking products, a good avenue for providing sub-debt solutions to their members could be through collaborating with Vancity Community Capital. Their team is highly responsive, and eager to partner and help transfer knowledge on mezzanine financing delivery, so that over time, Credit Unions may also provide these solutions to their members directly. Syndicate Syndication is the recommended route for Credit Unions wanting to provide mezzanine financing on larger sub-debt deals whilst pooling capabilities and sharing risk. Credit Unions are already starting to syndicate in B.C. with Vancity Capital, with good success. Summary As a defensive strategy, Credit Unions should not ignore the opportunity of offering mezzanine financing to their fast-growth business members. Why? Many growth companies of the future will or already have the need for financing based on their intangible assets and future business potential. Innovative equity-based financing is simply an extension of innovative products and services that are part of Credit Unions’ DNA and differentiation, like microfinance. Providing mezzanine financing also provides a unique great way for Credit Unions to become true community partners and advisors to business members in their communities. Collaboration and syndication by Credit Unions in this new product area is a natural extension to partnership in other product areas, such as Commercial mortgages. A deeper equity-based partnership with shared risk and reward, Credit Unions will now be able to truly take a stake in their members’ success. For more information on mezzanine financing opportunities contact robert_napoli@vancity.com or call 604 877 8284, or kristi_miller@vancity.com or call 604 877 7571.