Financial Firm Profits When Companies Need More Money Than Banks Will Lend

Sept. 26--AVON -- When you haven't saved up enough profits over the years to put your business expansion plan into action, how do you get the money?

Business owners can borrow from a bank, but banks are reluctant to lend more than two times the free cash flow, which is earnings minus the working capital needed to stay at the current level of operations. What if you need three years' worth of free cash to fulfill your ambitions?

That's where Ironwood Capital steps in.

The small Avon financial firm is a mezzanine lender and private equity investor in companies on the smaller end of the middle market.

Mezzanine lenders fill the gap between a business owner's equity in a project and the amount the banks are willing to lend. They are in a secondary position to the banks if the loan goes bad, and they charge higher interest rates than traditional bank loans.

"You charge more, you get paid more, you take on more risk," said Carolyn Galiette, one of Ironwood Capital's four founders.

Ironwood doesn't just lend money, currently at 12 percent interest. It also takes a little slice of ownership of the company, on average, 10 percent.

It doesn't intend to hold onto that ownership for the long haul -- instead, it is Ironwood's way of capturing some upside if the expansion plans pay off over five years. At the end of the period, the owners will buy out the ownership share at the new valuation and also pay deferred interest, typically 2 percent of the loan. Loans range from $8 million to $15 million.

Ironwood Capital's owners recruit pensions, insurance companies, university endowments and wealthy families to invest in funds that go to dozens of these investment opportunities. Ironwood has many deals in the Northeast and is looking to gain more market in the Southeast, even hiring a man in Birmingham to help find companies.

The first fund, launched in 2001, of $83 million, is almost entirely done paying out. The second fund, which was $172 million, has had 10 companies where the loan payments and equity buyout are done and has 10 investments that are still waiting to pay off.

The third fund, of $307 million, is 40 percent invested, two years after the fund was fully subscribed by investors.

The process of finding companies to lend to generally takes five years, they said. They do about six deals a year, Galiette said, culling through 250 proposals. One reason is most aren't attractive investments, and another reason is that Ironwood has competition from both other financing arrangements and other mezzanine investors. President Marc Reich said once Ironwood enters serious discussions with a potential client, it gets one out of 10 to sign, maybe one out of eight.

In 2009, demand was so low, and there were so few plausible growth strategies, that the firm went nine months without signing a single deal.

Galiette, Rich and the other two founders were private placement lenders at Aetna in the late 1980s before spinning out their own company in 1990. For the first 10 years, they had a different business model before getting into mezzanine lending.

About half of Ironwood's portfolio companies are changing ownership, and the new owner, or a former partner who is taking over the whole company, doesn't have enough cash to buy the business outright. But Ironwood wants those new owners to also have a growth plan.

It will lend to what it calls "steady Eddie" companies, growing at 3 percent a year, but the deferred interest at the end will be higher, and that means the owners will have to pay themselves less to be able to make that payout at the end of five years. About 12 percent of its investments are of this type.

Reich said mezzanine lending isn't well known among the manufacturers, trash haulers, IT service companies and other businesses that end up borrowing from the firm's funds. Often, Reich said, these owners think you either own your company, or you sell -- at least a majority stake.

"We'll come in," he said. "We'll lend you $10 million. It's not cheap, but it's not threatening either."

Because Ironwood Capital can borrow capital itself at about 3.5 percent through a Small Business Administration program, it starts with an advantage.

Paul Chute, head of the alternative investment department at The Phoenix Cos., said he invested less than $3 million in Ironwood's first fund in 2001, well below a typical investment of $5 million to $10 million. Ironwood had no track record, he said, but the fact that the leaders came from Aetna was reassuring.

"All of the insurance companies kind of have the same mentality, they're pretty conservative," Chute said, so he felt comfortable with Ironwood's philosophy.

Chute said he believed that first fund did about 15 percent in internal rate of return, but, to him, what was even better was that the Phoenix will get all the original capital back and double its money.

He suspects the second fund will perform similarly, given the profits so far.

"They've certainly been an out-performer by a long shot" compared with other mezzanine lenders, he said. "They're probably Hartford's little secret."

Even private equity investors that take control of companies often only return twice the capital investment, he said.

"Like most mezzanine funds, you're going to have a couple investments that don't work out," he said. "These are small companies, you're putting a lot of leverage on them."

Chute said that the average person might think a company that does $25 million to $50 million a year in sales is doing a lot of business, but he said, "In the grand scheme of things, these are pretty fragile companies."

Chute said the failures are more than counterbalanced by a couple of investments that tripled or quadrupled the original capital.

The Phoenix has increased its investment in each of the subsequent funds, and "we're glad we have," he said.

Ironwood Capital now does both Small Business Investment Company funds and unrestricted funds, which allows them to recruit and deploy larger amounts of money. An SBIC fund is limited to $225 million.

When Ironwood closed its last fund, it hired two more workers to screen deals and help consult with business owners after the investment. It now has 18 employees. When it does its next fund in about two years, it probably will add one or two more.

In the conference room, the white board reminds employees of how to coach the companies' management, and warnings about how to choose opportunities wisely.

"Models are not evidence," one slogan said. "Seek out expertise before committing."

___

(c)2014 The Hartford Courant (Hartford, Conn.)

Visit The Hartford Courant (Hartford, Conn.) at www.courant.com

Distributed by MCT Information Services