Many companies face challenges arising from balancing the right amount of leverage with access to capital markets and the cost of debt service. Many senior lenders will cap out their senior debt investments at or around three times leverage. For companies that require additional debt to finance major corporate transactions, finding the right subordinated lender at the right price can be a challenge. In some deals we’ve seen recently, middle market sub debt pricing ranges from 10-12% per year with another 1-2% paid in kind or some type of warrant or other equity kicker required. And, that’s even before calculating the cost of typically above-market commitment fees.
Tax credit investment funds, like those that focus on federal incentives such as the new markets tax credit, have the potential to offer lower rates because their returns are supplemented by the tax credits. The New Markets Tax Credit under Section 45D of the Internal Revenue Code provides a credit of 39% of the investment claimed over a seven year period. This additional component of the overall return enables tax credit investment funds to offer below-market rates for subordinated debt. In some cases, the margins could be 5-6% over LIBOR or slightly lower, less than half the cost of traditional subordinated debt.
How do you know if you company is a candidate for this type of investment? First, the senior lender needs to get comfortable with the subordinated debt investment, which likely will be fully secured by a subordinated, second priority security interest. Most senior lenders will favor the financing of an accretive transaction or refinancing of higher-priced debt with a subordinated loan as long as the revenue projections and debt service are favorable. Second, your company has to fit the tax credit requirements. For a New Markets Tax Credit, the sub debt lender (which is a “community development entity”) must make a loan (or other approved cash investment) to a qualified low-income community business (referred to as a “qualified low income community investment”). There are a number of issues to consider in determining whether the investment qualifies for tax credit treatment, including the type of business activity of the borrower and the location of the business in a low-income community.
The lawyers at WF have closed many transactions with both traditional and tax credit-advantaged subordinated lenders. If you think your company may be a candidate for this type of transaction, please do not hesitate to contact us.