While the client is minding the store, who is minding the

The Client

Jack Strong is contemplating the future of his firm. He is the 55-year-old chief executive and owner of a Midwest-based steel supplies company—Midwest Steel Services, Inc. (MSS). In the past 30 years, he has built MSS into a $50 million revenue company generating $6 million of earnings before interest, taxes, depreciation and amortization (EBITDA).

Over the years he has sold some of his original 100% share holding to enable certain key managers to co-invest in the business. His sharehold-ing now represents 60% of the issued share capital, with 40% owned by the managers themselves. His offspring now summer

gracious-ly at Dad’s expense on the beaches of Cape Cod. Yet MSS is part of an industry noted for cyclicality, maturi-ty, and an overall “old economy” profile.

These are the circumstances under which Jack now ponders the alternatives before him at this stage in both his own professional career and the company’s development.

The Bank

Midwest National Bank Corporation (MNB) has been MSS’s principal commercial banker for the last 15 years. The relation-ship manager, Roseanne Morris, has known Jack since that beginning of the banking relationship and has provided many of the bank’s

com-mercial banking facilities to the company.

The bank provides a revolving line of credit for working capital needs; in addition, MNB and two regional competitor banks have pro-vided a $10 million term. MNB also provides most of MSS’s cash man-agement support as well as letter-of-credit and bills of exchange through its Trade Services Group.

The Conversation

As Roseanne calls on Jack one day to discuss some of the major shifts in the economics of the steel industry in the U.S., ranging from tariff issues to the impact of the strengthening U.S. dollar vis-à-vis emerging markets’ currencies, she

78

Corporate Finance-Based

Relationship Management

Part I

by Michael Pimley

W

hile the client is minding the store, who is minding the

client’s future needs? It’s likely that competitors are invading

turf with solutions the bank may well be able to offer itself.

This is the first in a series of articles to address tactics to strengthen and

broaden the customer relationship.

learns of one of Jack’s recent visi-tors.

He has been approached by a Chicago-based investment bank offering ideas on what investment banking alternatives he might con-sider with respect to his company. Ideas ranged from corporate restructuring to leveraged buyouts to selling the company to a strategic industrial competitor.

Jack’s interest in the ideas are counterbalanced by his concerns that he had never met the young investment banker before. He also is concerned that all of the talk about transactions and doing deals was premature at this stage.

While he had genuinely been considering strategic alternatives, albeit in the vaguest of terms, it was the meeting with the investment banker that provoked him into for-malizing his thoughts. It also caused him to realize that he would much prefer to explore his options with a respected commercial professional he has known and come to trust.

The Dilemma

More and more commercial bankers managing corporate cus-tomer relationships are today con-fronted with company profiles typi-fied by MSS. The value of the much-needed services bankers have provid-ed over the years suddenly pales against the prospects of a once-in-the-company’s-lifetime investment banking transaction.

The initial reaction of most of us is to steer clear: “This sounds like an investment banking transac-tion and is not for us.” But is that the appropriate response?

Many banks have developed their own in-house corporate finance capabilities by recruiting

investment bankers from bulge bracket firms or regional brokerage houses. Alternatively, they have acquired and attempted to integrate regional investment banking and brokerage firms into their business-es. Yet such moves have often failed to capitalize on longstanding rela-tionships with existing clients.

The principal reasons for this failure to leverage corporate rela-tionships include:

• The constant pressure to do deals and sell investment bank-ing products in order to legit-imize the investment made.

• The incentive payment schemes demanded in the industry which in turn reinforce the emphasis on the quick sale. As a result, many commercial bankers find themselves acting sim-ply as “traffic cops” directing the client to the investment banking specialist. In so doing, they retain only the most superficial grasp of the issues at hand. Worse, without the continued involvement of the relationship manager, the newly arrived investment banker may well raise client expectations only to dash them later. This is the result of issues ranging from adverse market movements, to lack of institutional credit appetite, or simply failure to execute on the transaction.

The Opportunity

A more considered approach to challenges presented by such clients as Midwest Steel Services would be for commercial bankers like Roseanne Morris to realize that, when challenged by questions like Jack Strong’s, her response can cre-ate a truly meaningful and value-added contribution both to the client and to her own bank. This role

requires an in-depth knowledge of the client and the client’s needs and a conversational, but by no means encyclopedic, grasp of the various strategies that the client could pur-sue.

Such a role is vital: It enables the bank truly to leverage the poten-tial of the client relationship through the person who knows the client best. Further, if industry sur-veys teach us anything, they teach us that clients get very ticked off at having to re-explain their business every time a new product specialist from the bank walks through the door.

Finally, investment banking product specialists—because they are fairly scarce commodities within commercial banks—will be used more effectively if the relationship manager has fully and legitimately qualified the client. This qualifica-tion process comes not from being a master of the investment banking universe, but rather from a deep understanding of the client’s busi-ness, value drivers, and objectives.

Agenda Setting

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Critical to successful corporate finance business building is the con-cept that this is not about selling products. It is about generating ideas. To maintain a meaningful dialogue with Jack, Roseanne’s first relationship management objective is to identify and understand his own personal and professional objectives. Does he want to: • Generate personal liquidity

through the monetization of an otherwise illiquid investment in a privately held company. • Create such liquidity so as to

prepare himself for retirement in a tax effective manner so as to consolidate his estate plan-ning objectives.

• Continue to control the compa-ny and gratify the inevitable

ego issues that come with run-ning a business.

• Ensure the continuity of and eventual control by the very managers he has helped to cul-tivate over the years.

• Safeguard the interests of the employees who have helped build his business.

• Grow the company and dedi-cate future cash flows to acqui-sitions rather than paying off debt or dividends.

A good relationship manager will develop a sense of these priori-ties over time and be sensitive as to when and how to respond to them appropriately.

Agenda Solutions

Such a response from Roseanne

demands a conversational capability of being able to talk knowledgeably about alternatives without necessarily having a detailed grasp of the minuti-ae of individual investment banking solutions.

At this stage, company owners in Jack’s position need to appreciate the pros and cons of the different landmarks in the investment bank-ing landscape without necessarily picking one over the other. Roseanne should comfortably be able to describe the following gen-eral strategies for Jack to consider: • Sell all or part of his shares. This has the advantage of creating liquidity, although depending on how the shares are sold, it could create unnecessary tax liabilities.

• Buy all or part of the out-standing shares. Jack may be 55 years young, not 55 years old. He may wish to take advantage of fur-ther consolidation in the industry and reap 100% of the benefits of the company rather than just 60% based on his present ownership. It is not unusual for such managers to buy-out sleeping or less active partners within the firm.

• Grow the business.This could be done either by acquisition, in which case Jack would almost cer-tainly require financing advice, or by growing revenues and profits within the company’s existing framework.

• Take the company public. For companies with $6 million of EBITDA, these would certainly be on the radar screen of the potential Initial Public Offering (IPO) investors.

For Jack there are serious con-siderations. The liquidity in the company’s shares that many expect 80

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T O P A S S M U S T E R W I T H H I S A C C O U N T A N T S

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To maintain a meaningful dialogue with Jack, Roseanne’s

first relationship management objective is to identify and

understand his own personal and professional objectives.

from taking a company public may not arise, since the company may not attract the breadth of equity ana-lyst coverage in the market. In addi-tion, many heretofore private own-ers bristle at the disclosure demand-ed of their now public companies in general and their personal financial position in particular.

• Recapitalize the company by paying a one-time dividend. This so-called leveraged recapitalization or leveraged cash out has the dis-tinct advantage of giving Jack cash today, while leaving the distribution of the original shareholding untouched.

Think of this as nothing more than a corporate home equity loan: your child is about to go off to col-lege and you take out a second loan against your house to finance it. You still own 100% of the house, albeit on a releveraged basis.

Be careful here: Such a pay-ment may well be taxed at the mar-ginal income tax rate as opposed to the capital gains tax rate, and it is imperative that, as bankers, we make Jack fully aware that we are not tax experts and that such struc-tures need to pass muster with his accountants.

• Do nothing. It may just be too soon. Forcing a transaction on com-pany owners when the definition and clarity of their agendas still require greater consideration is clearly inappropriate.

Now that the dialogue is start-ed, Jack realizes that with

Roseanne’s responses thus far he can rely on someone who can walk him through the different alterna-tives sensibly and in an unpressured context without ever mentioning an investment banking product.

The Response

Six weeks after this initial dis-cussion, Jack calls Roseanne to announce that he would like to relinquish control of the company and create liquidity for himself. To preserve the continuity of the com-pany that he has worked so hard to build up, however, he feels that sell-ing to management and/or the employees makes the best sense.

He has discussed the ideas in general with the managers, but before taking the discussions any further he would like to receive some direction on the different ways by which the shares could be purchased.

Implementing the Solution Again, Roseanne must be able to position herself and MNB as a provider of good commonsense ideas without necessarily focusing on products at this stage. The temp-tation is to slip into the general investment banking “chat” of doing a leveraged buyout. Such a response is satisfactory for the first 10 sec-onds but tells us nothing of the dif-ferent ways in which this could actually be executed.

Roseanne’s credit training will position her well, since many of the required answers build on her finan-cial analytical disciplines. One of the first disciplines is “Who is the Borrower?” The types of answers that she could give include:

• The managers buy the shares personally. Here the managers could buy the shares from Jack directly and personally. While this achieves the overall objective, it may be dif-ficult to accomplish, since many managers do not have the personal liquidity needed. Borrowing the money may be difficult, and the bank is unlikely to lend without additional security to the shares in the company itself.

Jack may be prepared to take a note back for part of the purchase price, but this hardly achieves his objective of liquidity.

• The company buys back Jack’s shares into treasury. Treasury stock repurchases are quite com-mon. They have the advantage that the company itself becomes the bor-rower, and therefore the assets and the cash flows used to secure and repay the loan respectively are those against which the bank may be more prepared to lend.

There are still serious credit considerations, however. The loan is being used to replace equity as opposed to buying tangible assets. Further, treasury stock repurchases are recorded at the price at which the shares are repurchased, creating in many cases a negative book equi-ty which makes many lenders inex-perienced with leveraged financing very nervous.

• The employees buy the shares

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A N D T H E I R P E R S O N A L F I N A N C I A L P O S I T I O N I N P A R T I C U L A R

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via an Employee Stock Ownership Plan (ESOP). Under such an arrangement, a loan is made, usual-ly to the ESOP, which then repays the loan from contributions made by the company to fund the ESOP and the resulting issuance of the shares to the plan participants.

Subject to the specifics of employee qualifications and the rel-ative size of the payroll, it means that the ESOP loan is effectively being repaid from pre-tax dollars since the ESOP contributions are operating or pension expenses and flow through that line in the income statement.

There is an additional consider-ation for a private company. If the ESOP ends up owning over 30% of the shares following the sale, the

gain—provided that Jack reinvests the proceeds in replacement securi-ties within a designated time-frame—will be deferred until such time as Jack sells the replacement securities.

Using this technique, Jack may have a tax-advantaged structure, create liquidity for himself, protect his employees and ensure continuity in the firm.

Proceed with great care with ESOPs: the tax benefits are con-stantly scrutinized and legislative changes affect the details of some of their operations. Again, be sure in such circumstances that full con-sultation with the firm’s tax accountants is carried out in setting up such structures.

In addition, workers’ unions—

particularly in the steel industry— are highly skeptical as to the advan-tages of an ESOP. In what is already a volatile industry, the ESOP puts all the eggs of the employees—both as existing work-ers and as potential pensionwork-ers—in the one basket of the company’s financial strength. This concentra-tion should give rise to genuine and legitimate concerns.

• Management buys the shares in conjunction with a financial part-ner. Those managers who wish to stay team up with a financial investor and together they form a new company. This “acquisition company” merges into MSS on the day of closing with MSS as the sur-viving legal entity.

The structure has the advantage

82 Figure 1 Owner Agenda Estate Planning (Minimize Taxes) Personal

Liquidity PersonalEgo ManagementContinuity

Employee Job Security Company as Going Concern Take Co. Public (Dilutes owner-ship; requires public report-ing) Pay One-Time Dividend (Leveraged cash out, higher tax

liabilities) Sell All or Part of the Shares Do Nothing Grow the Business (Acquisition vs. internal) Buy All or Part of the Shares Sell to Managers Personally

(May not provide needed liquidity) Sell Back to the Company’s Treasury or Holding Company Sell to Employees Sell to Financial Buyer (Provides liquidi-ty, tax deferred,

CEO remains) Sell to Competitor Sell to Strategic Buyer

that the loan to acquire the company ends up residing at the level of the company itself. As long as the com-pany is solvent immediately follow-ing the transaction, the bank can take the assets of the company as security for the loan.

This approach has the advan-tage that “new money” comes in from new equity owners whose own time horizons of three to five years will mean that the managers can eventually buyout and take control themselves in time.

The disadvantageis that many equity sponsors like to exercise con-trol of the voting shares at the beginning of the deal. Some spon-sors are comfortable in a minority position, but this tends to be the exception rather than the rule.

Finally, such transactions can usually be completed with large amounts of bank debt. Again, this creates concerns from a credit per-spective, since, clearly, equity is being replaced with debt. Such structures are necessary to give the financial investor their minimum required rates of return—typically 25-30% today—but it does mean that management’s objectives do not always coincide with those of their financial partners.

Also, with such high return expectations, financial buyers typi-cally cannot afford to pay the same types of purchase prices offered by strategic or competitive buyers, whose return expectations may be lower.

• Management buys the shares with a competitor or a strategic partner. For Jack, this has the advantage of providing him with the greatest chance of getting the best purchase price. Furthermore,

that purchase price will be paid for in cash, or, occasionally, if the acquirer is publicly traded, the pur-chase will be made with shares of that company. This latter purchase method may have the advantage of offering Jack certain tax deferral opportunities.

The concern for Jack is that his co-managers now will almost cer-tainly not get the control that was important to them. In addition, the character of the company may change as it is absorbed into a larg-er conglomlarg-erate. What was an inde-pendent legal entity with its own corporate brand name might very well end up as a division of a group or a subsidiary of the acquirer.

Conclusions

In reviewing the ideas that Roseanne has discussed with Jack, summarized in Figure I, it is inter-esting to see how little discussion has taken place about specific prod-ucts. She has talked knowledgably and sensibly about the pros and cons of different approaches, never once “selling.”

This courtship is an integral piece in corporate finance relation-ship planning. The next article in this series will show that many of Jack’s objectives will be met through commercial banking rather than investment banking solutions. That the commercial banker will require certain corporate finance skills and investment banking knowledge is inevitable. These skills will be covered in subsequent articles.

What is vital to remember, however, is that when working with clients such as Jack Strong, the value of solid corporate relation-ships, developed by experienced

commercial bankers imbued with plenty of common sense and a good credit perspective, should never be underestimated. p

Pimley may be contacted by e-mail at [email protected].