The head of a mid-market buyout shop told me that he included a seller note this spring as part of a proposal to buy a “wonderful” property—a consumer products company that generates $15 million in EBITDA. It’s a company that generates great cash flow, but that has few hard assets, a narrow product line and a short operating history. “It’s a lending nightmare, quite frankly,” my source said.
Given the amount of leverage available on the deal—a turn of senior and 1.2 turns of mezzanine—my source just wasn’t able to model the kind of returns he needed without asking the seller to accept a turn in the form of a seller note.
At press time, the seller had come back to my source asking for slightly more money, and a reduction in the seller note to half a turn, equivalent to about 8 percent of the purchase price. The seller note would pay 10 percent cash interest, in quarterly installments, with the principal due at the end of five years. Although he didn’t have a signed letter of intent in hand, and hadn’t yet gotten sign-off from the mezzanine lenders, my source said he believed he had won out over the only other bidder left standing.
To be sure, seller notes remain a rare feature of the buyout market. You tend to see them only at the small end of the middle market. My source hadn’t proposed them once in the previous five years, and in selling eight companies over the past two and a half years was never offered them. And for good reason: Sellers bristle at the idea of waiting years to get paid a portion of the money they feel entitled to today, especially given the prospect of a hike in the capital gains rate. But the credit crunch has leverage multiples falling faster than purchase price multiples. As a result, some sellers have been willing to accept a seller note as a way to sustain their asking price.
Seller notes are “becoming more and more in vogue,” said Ronald Kahn, a Lincoln International managing director who secures senior and junior financing for small to mid-sized transactions of $25 million to $250 million in value. Over the past year, some 10 percent of the 50 U.S. buyouts that Lincoln International has worked on have involved seller notes, Kahn said. And in the three years before that? Not one. “You would never even suggest it to a seller because they would say, `Not in a million years.’”
Indeed, notes hold little appeal for most sellers. Seller notes sit below mezzanine debt in the capital structure, meaning holders stand only ahead of equity providers in the line to get repaid if the company goes into default. Amortization of the principal is out of the question. Cash interest payments are rare, Kahn said, although sellers may be able to negotiate payment-in-kind (PIK) interest, or even “pay as you can” interest in which cash interest gets paid so long as the company meets certain financial benchmarks. Ten percent is a “good, middle-of-the-road” interest payment for seller notes, but they can be all over the map, said Kahn. In some cases a buyout shop may agree to guarantee the note to make it more palatable, and more cash-like, to the seller.
Buyers, of course, love seller notes. If the seller turns out to have made any misrepresentations, the buyer may be able to offset the claim with the seller note, according to Kahn. Seller notes also represent a vote of confidence of sorts. The seller “really has to believe in the future of the business to take a seller note,” my source said. “If he thinks it’s going to have hard times he probably isn’t going to want to take one.” And then there’s the main benefit for the buyer: a healthy boost to returns.
“It really is a cheap form of capital,” my source said.