SI Review: July 2010

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Capital Alternatives in Today's Changing Market, SI Review July 2010

By Greg Palmer

The purpose of this article is to frame the current environment found in today's capital markets and to use this information to make the most informed financial decisions for you and your business. The vitality of any business is access to the capital that allows you to fuel your growth and survival. Staffing and recruiting firms have relatively modest capital requirements, but there is a steady need for capital to fund workers compensation collateral, payroll funding, capital expenditures, general expansion and M&A.

In my role as an advisor to large and small staffing firms, I am constantly approached regarding various sources of capital. I need to confess that I am neither a commercial nor investment banker, I am a former CEO of a public staffing firm. I find myself most often positioned as an advisor to CEOs and boards. Therefore, it is from this perspective that I would like to discuss the markets.

Today's capital markets are presenting a set of unique challenges. It is no secret that most sources of credit are generally tighter than ever before and increasingly more expensive. M&A transactions are more difficult to complete due to this current conservative mood. Working capital for many firms is today's number one constraint for both survival and growth. There is also a lot of confusion as to the best sources of capital and what sources fit best for what situations. Let us now take a look at the most common financial alternatives staffing executives have at their disposal.

M&A Capital

It is important to discuss capital that is used to facilitate M&A transactions because M&A has typically used capital in large quantities to fuel growth and consolidation. It is essential to understand where we have been in the past in order to understand where we are in the present.

After 9/11 and the dot-com bubble, the government artificially created a period of rapid growth through easy monetary policy. In addition to significant growth in real estate, equities and GDP, the M&A market experienced a period of unprecedented expansion.

During this period of financial growth, financial buyers began to consistently outbid strategic buyers for the first time in history. Transaction multiples also reached all-time highs driven by artificially low interest rates, ample access to transaction capital, increased leverage multiples and the corresponding reduction in equity capital. In addition, financial buyers were ";flipping"; companies; i.e., the same company was repeatedly being sold, each time at higher transaction and leverage multiples. The period was affectionately known as the ";Financial Engineered Era"; of expansion. As rates began to return to normal levels, real estate was the first to suffer, due to sub-prime loans and ARM resets. In October 2008 banks completely retrenched from the market in an attempt to shore up their own balance sheets.

Between 2003 and 2007 total debt multiples increased by nearly two full turns of leverage. The increase was driven by low interest rates and a new source of debt capital, second lien debt. Second lien debt ultimately proved to be an unstable source of capital that has significantly reduced its lending efforts.

In addition to low interest rates, increased leverage multiples and new forms of capital, the period between 2003 and 2007 experienced a dramatic increase in the availability of private equity capital in the market.
Transactions became highly competitive resulting in further increases in transaction multiples. Since the peak in 2007, fundraising results have been dramatically lower, and 2009 was announced to be the most difficult fundraising environment since 2003.

The IPO market provided additional liquidity options for private investors to ";exit"; their investments at attractive valuations. With the severe market correction in 2008, the IPO market has been largely unavailable, creating another barrier for private investors to exit their investments. The extended investment holding periods for private investors is also delaying new fund investments.

Current M&A Market

While all sectors of the M&A market have experienced a significant pullback, the leveraged buyout market has been the most affected. The U.S. leveraged buyout transaction value is down 36% from its peak in 2008. Strategic buyers have pulled back but remain acquisitive. Private equity groups have shifted their focus to minority investments, with less leverage, in growth-oriented companies.

The M&A market has seen steep declines in activity, primarily driven by the lack of capital-to-finance transactions. Most deals were financed with a combination of equity and debt. With the cost of capital being more expensive and debt to equity ratio's having increased significantly the capital to complete these deals have substantially decreased for the foreseeable future.

Due to the capital markets shifting to a much more conservative gear, in recent quarters it appears to be either large (Comsys -- Manpower and Modis -- Adecco) deals or small, often times distressed transactions that have successfully been closing. In terms of the smaller transactions, they are often partially or wholly owner-financed without the help of outside funding. If M&A is part of your strategy, a well-thought-out plan taking into account today's unique capital environment is warranted.

Working Capital

Sources for capital come in many flavors, with primary uses including funding temp payroll, workers compensation collateral, capital expenditures and expansion. The primary sources and their corresponding benefits are compared below. When comparing the sources, pay particular attention to terms, fees, covenants and consequences of unforeseen events. Additionally, not only will you want to shop for the best ";deal,"; but also you will want to look for a funding source that shares your business' vision and allows for open and clear communication and reporting. There is nothing more uncomfortable than having a capital partner you are at odds with concerning direction and other strategic matters of importance.

It is impossible to predict just when the traditional markets will be more open and receptive. Some of the most traditional sources, money center and regional banks, have increasingly dried up as sources of funds. It has been reported repeatedly in the media that the banks are not lending regardless of the aggressive tactics the government has taken to stimulate the economy. This even occurs when the borrower has an excellent credit history. The proof is in the 177 bank closures since early 2009 and the 700 additional banks of the current FDIC's ";problem"; bank watch list. The TARP and related programs have not made their way to Main Street yet. The banks fear that many of the borrowers (including staffing firms) are simply not credit worthy enough. The fears are even more prevalent amongst local and regional banks that were previously focused on commercial real estate lending and have since seen major declines in these assets (about a third of the bank's assets).

These declines leave little room on the bank's balance sheet to get back to traditional lending, at least for the time being. Finally, there has been a lot written recently about the disconnect between what the Obama administration is saying, ";lend more,"; and what regulators are allowing. The regulators are downgrading the bank's assets because of the decline in residential and commercial real estate. When this occurs, funds that were available to lend never get in the market. The funds are instead used to shore up the balance sheets and keep them within the acceptable regulators' ratios. This problem is a double whammy for staffing firms because the area where jobs are created in the economy is being choked out due to tight lending at clients' sites. This current trend, combined with the staffing firms own inability to access capital for their own purposes, makes some of the alternative sources mentioned above more appealing and financially sound.

Operational Steps You Can Take to Preserve Cash

While considering your capital options, pay particular attention to practices that preserve cash. Take a closer look at your receivables (DSOs) -- a good target is 30 days; 45 days in most instances is too long. Consider cutting deals with clients to encourage quick payments, but if a client is pushing 60-day terms, get tough quick and/or add finance charges to their invoices. It's also time to consider renegotiating everything you can -- beginning with job boards, leases and all suppliers. In addition, I would recommend that you review all of your clients and be sure they are profitable or at the profit level you are comfortable with. It is critically important to know that some larger lower-priced accounts could be taking up precious working capital. It is amazing what new conclusions you may come to when you evaluate the contribution of certain accounts and measure their relevance versus your strained cash position.

Where to Turn to Secure the Most Appropriate Sources

CPAs, law firms, a board of advisors (if your company has one), other staffing firms who have gone through this treasure hunt, Staffing Industry Analysts and ASA can all direct you towards investment bankers and advisors with experience in staffing who have proven track records and good reputations. A good investment banker, for example, can advise you regarding the various capital sources available, the pros and cons, as well as the costs associated with each type of capital. I would not advise you to take this journey alone. I strongly suggest you find someone who can help you navigate the confusing sea of options available today.

Conclusion

There is an old saying: "When you run out of cash, you run out of options." Many businesses globally faced this harsh new reality, including many in the staffing industry over the last two years. With traditional banks still being conservative in their lending practices, it is important to know that there are alternative sources of capital available beyond the traditional.
As the economy and staffing industry turns around, it is important to first survive. However, also equally important is to plan your capital requirements to thrive well into the future.

Sources Pros Cons
Money Center Banks
  • Primarily focused on large credits of higher quality (BB and above)
  • New issue activity remains sparse
  • Any lending to the middle market is primarily asset-based
  • Will often exclude the smaller staffing firms
  • Usually only larger firms
  • Not many firms specialize in staffing
  • More conservative than in the past
Regional Banks
  • Recently retrenched from middle market lending due to overexposure to commercial real estate
  • They are currently raising capital to shore up their own balance sheet issues
  • Any lending done by regional banks is primarily asset-based
  • More conservative than in the past
  • Challenged with balance sheets heavily indebted to real estate which currently limits their ability to lend
Funding Firms
  • Specializes in providing funding for receivables
  • Asset backed and grows with the needs of the business
  • Many firms specialize in staffing
  • Funding firms are increasingly offering additional services, i.e., front and back office and consulting
  • Cost of capital is relatively high
  • First lien debt
  • Very expensive past 30 days -- DSOs
ESOP Financing
  • Tax advantageous treatment of payments to the ESOP
  • Lack of outside investors minimizes business disruption due to cultural changes
  • Attractively priced source of capital
  • Sellers can maintain control while debt is outstanding
  • Potential for company tension if payments become burdensome
  • Rarely results in the highest value to the seller
  • Exposes seller to long-term financial risk, prolongs their exposure to company
Mezzanine Debt
  • Stable source of capital
  • Minimizes equity dilution of current investor base
  • Accompanied with institutional processes that optimally position the company for a future sale
  • Enables company to achieve attractive/viable growth opportunities
  • High interest expense (12%+)
  • Can place burden on companies with deteriorating cash flow
  • Only companies with established/defendable cash flows can access
Friends and Family
  • An attractive source when starting out
  • Should be treated as strictly a business transaction first -- family second
  • Terms are usually more favorable
  • If things do not work out, it could cause a strain amongst the parties during family gatherings

Note: I did not include venture capital sources for two primary reasons: (1) Few are focused on staffing, and (2) VCs are usually used during the start-up phase of a business only. Of all the alternative sources, mezzanine financing is currently gaining more popularity as an attractive option.

See link below for a PDF of the accompanying charts.

Greg Palmer is the former CEO of Remedy Temp Inc and founder of GPalmer and Associates, www.GPalmerandassociates.com, a management consulting firm focused on the staffing industry. You can find the recently published GPalmer temp labor forecasts and related material on the GPalmer Website.

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