Finance Leaders Group: The Use of Debt in Search Fund Companies

Thank you for everybody, everybody for coming. This is our second sort of Pacific League Finance Leaders Forum. The first time around, we had five people. I think we’re going to have somewhere between eight and 10. This time, it’s great.

And good news, I think we should have people introduce themselves. For those who came the first time, I apologize. But what I did last time, and I think we should do, and try to restrain yourself from extended speeches, but maybe 60 seconds worth of, hi, my name’s, in this illustration, Mike Lyman, and I work for X company, this is what we do. And then I’ll ask you to say, where are you in the search fund finance process? Are you in stage one, which I would describe as early post- acquisition chaos?

Stage two, out of the chaos, but certainly not stable and highly professional. Stage three, everything’s fixed. I have better software, better processes, better people. So why don’t we start, who’s done this before? Jason’s done this before. So we’ll have Jason repeat, and everybody can follow Jason. Okay, easy enough.

My name is Jason. I work for a company called Impros. We are a software company that does stuff in the pharmaceuticals, mainly POS systems. I would say we’re somewhere between a two and a three. You guys caught me on a fun week. Both my coworkers are out having a baby right now. So I am solo ship, but everything is on the track so far. And that’s kind of me in a nutshell.

Great.

Shall we have volunteers now? Who wants to jump in?

John?

My name is Sean Foley. I’m the COO and CFO for Discover Health. We’re a concierge medicine practice, basically a managed service organization. I would say we’re probably in stage 2 of our development, and I’ve actually been in this space for 30 plus years. There’s a reason why I’ve got this much gray hair. I’m excited. I’ve been with Discover for about 10 months, and so we’re making some good progress and still have some more progress to make. Discover, did you guys used to have a different name?

No.

Well, you might recognize us as MyDoc Plus, but our DBA is Discover Health.

Got it.

You’re buying up PCP practices, is that right? Concierge PCP practices, yes.

Got it.

Next.

I can go. My name is Jeff Traxler. I’m Senior Director of Finance and Operations with Performio. Performio does incentive compensation management software, otherwise commission software. I would say we’re between a two and a three. We’re a couple of years post- acquisition, but we’ve been running the finance team without a controller for the last couple of months, which has been fun.

I’m Jess Reser. I work for Tactic. I’m the controller there. We are a software provider to support the direct store delivery model, so manufacturers, vendors, retailers supporting in many ways there. I think I’ll always be hesitant to say it’s not a little chaotic here, because even though we’re three years post- acquisition and we just completed our third audit, there’s always something new going on.

Yeah.

Stage two plus, I think, somewhere in there.

Great. I’m happy to go next. My name is Kevin Gritters. I am the Vice President of Finance here at NovoPath. Based in Denver, I’ve been with NovoPath for about three years. I came in about six months after the acquisition, and so we’re, like other people have said, in between stage two and stage three. But what NovoPath does, we’re a SaaS provider to primarily independent reference labs, and we sell a workflow software that helps labs process patient samples and cases.

Great.

I can go next. Hi, everyone. My name is Mia Stein. I’m the Vice President of Finance and Accounting for Eleven Software. What we do is Wi- Fi authentication. The best way to explain that is you go into Hilton, which is our exclusive partner, and you’re a customer and you’re trying to get into Wi- Fi, and you have to put in your room number or loyalty to authenticate. That’s the software we provide. Hospitality and multi- dwelling units, MDU, basically apartment buildings is what we mainly serve. I would say we’re in the thick of stage one.

We are in the middle of our audit, year two, but we did an acquisition last year, and it was going from a domestic company to multinational. So we are in the thick of it, and you can ask me where I’m at after April 30th, when our audit is due.

Great. Yeah, I’m talking to Alex at 2. 30 Eastern time, and the yacht is always on his list every week he wants to chat. So have we got everybody?

No, not yet.

I’m Jennifer Mazur.

I’m the CFO and controller at NCFDD. We provide professional development and mentorship access for university faculty. Specifically, our biggest customer are those on the tenure track. We sort of help them with tips and tricks and ways to get themselves locked in to tenure, which is their goal. We are, I would say, between a two and a three. I’ve been with NCFDD six years. We were acquired shortly before I joined, but then we were, that was prior to the Pacific Lake acquisition, which was three years ago.

So we’re sort of in, we’re two acquisitions away from the founder, although our founder is still on our board.

I can go next. Can you guys hear me okay?

Yes.

Good.

I have a bit of background noise. We have some work going on in the house, so I apologize for that. My name’s Catherine. I’m the controller for Revive Med Spa. I’ve been with the company for a year and a half. Joined six months post- acquisition. We are at the tail end of our first audit. So just trying to complete that. So I say we’re at the tail end of stage one, entering stage two. And we are a multi- entity, multi- site company currently just in the state of California, but looking to expand in other states in the near future.

And we provide med spa services such as Botox, injectables, and things of that nature.

Great. I clearly have lost count, but I’m pretty sure that’s everybody. So onto the next bit of the agenda. Karen Leeshing is here today. She is, I think, founder and one of the two principals of Prides Crossing, which is a lender to the search fund world, in addition to being the lender to at least one of the people on this call. But also I think Prides Crossing lends more broadly outside the search fund world. But Karen, I think, has been, I think, at least for as long as I’ve known her, she’s been a lender of one flavor or another.

We met, I think, almost 20 years ago now when she was working with Usatonic Partners. We keep track of each other through the ages of our children. But anyway, Karen has agreed to chat today about the use of debt in the search fund world. We’ve got a handful of questions that we’ll sort of try to treat in some sort of bizarre podcast- like format. And then we’ll have a Q& A session afterwards. I think if you have a burning and highly pertinent question, feel free to jump in. So Karen, why don’t you start with introducing Prides Crossing?

Sure. So thanks for having me. I know you’re all really busy, and I know it’s audit season. So thanks for making time. And my hope is that this is just useful for you. So please do interject with questions and feel free to email me after if things pop up and you want to talk. I’m always happy to just feel the question or try to be helpful. So I appreciate the introductions. I think I’ve looked at almost every one of your companies. We’ve financed a few. We’re a current lender to a couple, and we’re the former lender to a couple more.

So it’s a familiar audience, and I think that’s great. So I’ll give you a brief bit on my background, and then I’ll talk a little about Prides. But again, trying to make this useful for you. So feel free to direct me where you think that’s most useful. So my background is kind of a combination of debt and equity. I spent the first 15 years of my career as a commercial banker. I’ve always been in the Boston market. I worked at State Street Bank as a commercial lender until they sold their bank at the end of 1999.

And then I joined Housatonic Partners in January of 2000. And I spent the next 13, 14 years in the private equity industry. That’s where I met Mike at Housatonic. And I was a partner underwriting equity deals.

While at Housatonic.

One idea that Will Thorndyke and I had was to start a private credit fund, which ended up being the roots to Pride’s Crossing. So I’ll take a minute on that because it also explains how our history and search began and where that connection comes from.

So around 2006, while I was at Housatonic, we cobbled together a small- ish debt fund called Housatonic Debt Investors. And we did that because we were trying to fund small- ish buyouts in a variety of industries.

Most of them had companies you work at now, recurring revenue, business services- type companies without lots of tangible assets on the balance sheet to serve as collateral. So that’s confusing to a lot of lenders. A lot of lenders are asset- oriented and they want to value what’s on the balance sheet and know what the liquidation value of that is to sell it. And that’s how they make a loan decision.

The other kind of lending is what I’ve always done, which is sort of enterprise value lending based on cashflow generation potential, not necessarily actual cashflow generation. And there’s a difference, as you all know. So I had done that kind of lending pretty much through my whole banking career. We were making investments in those kinds of companies at Housatonic. And so we thought offering a credit product to that same audience in the same industry set would make some sense. And so we launched a small debt fund in 2006, which I ran.

And it took maybe 20 or 25% of my time. It was sort of a non- core business line for Housatonic. And it ended up that at least half of the loans we wrote had nothing to do with Housatonic fund company. They weren’t owned by any equity fund.

So that was kind of how PRIDES got born because probably around 2012, Housatonic was growing.

It was over a billion dollars in assets under management at that point. And we were raising our third institutional fund, I think. And the LPs kind of looked at the debt fund and said, what is that?

That’s non- core, it’s a distraction.

You should really be focused on equity. And so for all the right reasons, Housatonic did not continue on in the debt fund space, which sort of gave me an opportunity to be entrepreneurial and kind of start my own fund. So that’s how we were born.

It was all very amicable.

And Will Thorndike is an investor in all of our funds and some of the other partners at Housatonic and a lot of the operators that I worked with at Housatonic, a lot of whom are individual investors in CERF. Some of them are probably investors in your companies. So there’s a lot of overlap, less so as the years go by, but there was a lot of overlap initially in our LP base at PRIDES and kind of the greater search fund investor base in general.

So we launched our first fund in 2013.

My partner is Peter Sherwood. He worked with me in banking before I went to Housatonic. And so I asked him if he would do this private credit fund adventure with me and I’m glad that he did. So we founded in, I think we raised our first fund in 2013.

We’re currently investing our third fund. And I guess the easiest way to think about us is we’re structured just like a private equity fund. So we raise committed pools of capital.

They’re generally 10- year funds with a couple of years extension. Our investors include institutions, high net worth individuals, family offices, some nonprofit foundations.

And our mission is to generate current income to our investor base. So every quarter our portfolio companies pay us interest and we pay our bills, take our fees, our carry, and we distribute all of the net income to our LP. So we’re sort of a fixed income fund made up of private company investments for our LPs. And so that mission drives how we structure our deals at least in terms of payment.

So generally we get paid interest quarterly. We don’t bill monthly like a lot of banks do.

And we care about current interest. So we tend not to pick a lot of our interest.

We like current pay. We don’t rely on equity co- investments or warrants or anything like that to get our yield. We’re really kind of focused on our interest rate.

So that’s a lot of detail on our structure. I think it’s important to know who your lender is and we can get there, but banks are very different than non- banks. They have different missions. They have different structures. They’re funded differently. And unless you really know your credit partner, you’re not gonna really understand how they can interact with you, how they can serve your relationship, how they can work with you if you have a default or a deeper problem.

And so it’s important to know kind of who your lender is. So.

I’ll pause there on background, but, well, I guess I’ll say one more thing. So, search, you asked Mike about our involvement with search. I’ve been involved in the search for a very long time.

Before I went to Housatonic, I started looking at search deals when I was in commercial lending, including a company called Mr. Rescue, or Road Rescue, it became Asurion.

And then when I was at Housatonic, of course, Housatonic sourced a lot of its equity investments through search, and I just got to know the world of search even deeper, and it’s only grown exponentially since then.

So, I’ve probably done 25 or 30 search deals, both in equity and debt. We’ve probably done 30 since I started Prides.

And it actually has moved, I did this math for our third fundraise.

It used to be a little less than half of our sourcing effort, and now it’s over 75% with our third fund. And I think that’s a function of the growth in the search ecosystem as much as anything.

So, it’s a very important sourcing mechanism for us, for deal flow, but we’re not exclusive to search. And we don’t really think of search any differently than we think of any other buyout, which may surprise you. It’s a great sourcing mechanism, but it’s really an ownership construct as much as anything.

At the end of the day, it’s a buyout transaction, and we need to know kind of the same things about any other buyout deal as we do about a search deal. It’s just that in search, we tend to know a lot of the investors, which is super helpful.

So anyway, I’ll pause there.

That’s enough background on Prides.

No, that was great. Thank you very much. I actually hadn’t heard that story, so that was very interesting to me. All right, so we sort of crafted 10 questions. We’ll try to go through them. They don’t need equal weight, and I’m sure one will spill over to another, so we’ll see where it heads. It was interesting. When I started, I thought, oh, well, let’s talk about interest rates, and let’s talk about banks versus non- banks, and a few other things, and we’ll get there.

But one of the things you mentioned in our discussion was the importance of reading bank documents. And maybe you can talk about that a little bit, about who reads them, how. Go ahead.

So that came up. Mike and I were doing a little prep session, and just thinking about the profile of the audience, it came up that you guys have primarily inherited your credit relationships, probably. Some of you may have been there before the buyout, but maybe you weren’t working with the searcher on the actual credit relationship and closing it, so it’s a good… And I’ve worked with finance people on search teams and CEOs of all different experience levels related to credits.

A lot of searchers have never dealt with negotiating credit documents or adhering to reporting requirements and credit documents before. And then, of course, if you’re part of the finance team and you’re either brought in or you’re there pre- existing the buyout, you’re kind of inheriting a relationship, right?

So I guess, and you probably all have varying degrees of primary responsibility for managing that relationship. I would think from a career development standpoint, it’s something you probably want to maybe migrate to, maybe not during audit season, but I think it’s a good experience set just as you grow your own professional experience. So part of that starts with just understanding the documents, and they can be dense.

So the credit agreement or note purchase agreement, as it’s sometimes called, is going to have all kinds of sections. I mean, normally everyone goes right to that financial covenant section because they want to know when they have to report financial statements, when the audits due, what the covenant calculations are. But there’s a whole lot more to it than that, that I would encourage you to kind of get familiar with.

Things as simple as moving, taking on a new lease for a new office space in this virtual world that seems less relevant, but we still have that happen a lot.

And so banks generally file UCC liens to perfect their collateral, and they need a physical address to do that. So if you move office, I’ve had borrowers move and I don’t know for a year, it kind of screws up our collateral filings. It’s just not good hygiene.

So just little things that you might not think are that important, just check in with your lender or better yet, just take an hour or two to familiarize yourself with the document. Even use it as an excuse to do an introductory call with your lender, if you’ve never talked to that person and built a relationship, you can say, look, I’m new to this relationship, like to make sure I’m familiar with the documents, I don’t miss anything.

It just shows ambition, motivation, intent to do the right thing, to get the relationship off on the right foot. And you might be surprised at even if they feel like small things, things that you kind of learn. You can’t, a lot of things require lender consent. Taking on more debt, that could capture credit card debt, honestly.

So we try to do carve outs when we were negotiating the no purchase agreement for credit card debt, but if your employee base grows, more people are getting credit cards. So there could be inadvertent defaults that, you know, it’s just not necessary and they’re not a big deal, but it’s more just understanding that lenders, private credit and banks are kind of the same in this regard.

The documents are pretty far reaching.

And then reporting compliance. I’ll add one thing because everyone mentioned the audit pretty much in the intro and I know it’s audit season. Last year, and I don’t know if it’s true this year, with workforce shortages across multiple industries, our audits from all of our port companies were really late last year, portfolio companies. So they would all, everyone was calling saying, I need an extra month, I need an extra two months. I don’t know when it’s gonna be ready. It’s the first audit, they’re complication. We didn’t care.

We didn’t get some of our audits till August. It’s not a big deal. So at least for us, don’t panic about it, but I would say call your lender and just tell them, say, the audit, they’re short- staffed, they’re whatever. And so it’s, things like that are not a big deal, but it’s always good to just call and say, it’s gonna be late, is that okay?

Right. One of the things that is evident, if you’re looking at balance sheets for search fund companies, you’re gonna see, on the debt side, you’re going to see, I guess, I will put them in three categories. You’re gonna see seller debt. You’re going to see bank debt, often from a bank whose name you don’t know. And then you’re going to see prods or Bain Capital or someone else in, that I would call non- banks.

And you and I had this discussion a couple of days ago, most of the people who fit into the last category, the people that I have never had relationships with before, but maybe you could sort of talk about the broad important characteristics of those three categories. Like you’ve made it, you’ve sort of stressed, know who you’re dealing with. And I suspect that’s gonna play a big role in the answer here.

Yeah, so banks versus non- banks is really the question and what are the primary differences? So the primary differences are regulation, and how they fund themselves. So surprisingly back in the financial crisis of 08, a lot of non- bank lenders, BDCs, Business Development Corps are publicly traded and they actually had funding issues. So companies that had a revolving credit and thought they could just make a phone call and ask for an advance, sorry, there’s no money.

So you can’t take even the most basic things for granted because when the markets crashed, a lot of those BDC stocks went down. The way they raise capitals, they issue new shares. They can’t do that if their shares are underwater under a certain price. So I think that surprised a lot of borrowers, you know, because we’re kind of all accustomed to banks. Banks just have unlimited capital. It’s sitting in a vault somewhere. It’s always available, right? And the world has changed a lot in 20 years.

So kind of knowing how your companies are funded, your lenders are funded to make sure they’re gonna show up. And then knowing how they’re governed and how they’re regulated, because that really dictates the toolkit they have to deal with the companies if they get in a default. So a couple of examples, we’ve had some search deals that, you know, didn’t go according to plan. A lot of companies, they don’t have to be search deals. A lot of buyouts or other businesses just hit rough times.

And our approach is, okay, we’re not gonna get out of these loans by liquidating or… First of all, we don’t have a workout department. Banks, what happens in a bank is you go to the workout department, right? Banks basically have two sets of employees. One are the sales end and one are the workout guys. So when you’re dealing with a bank to make a loan, that front end person is a relationship person. Oftentimes they’re in bank speak, but they’re a salesperson.

They’re compensated on volume generation and they have to hit a certain, they have to book a certain amount of asset volume. And that’s how they get judged at work. So they’re in sales mode. They then take a deal to credit committee. They hope it gets approved. Sometimes it gets changed significantly. It’s a long process, go on a committee. It comes back, hopefully it closes. Now you might get handed off to a relationship manager. Sometimes it’s the same person, not all the time.

And then if the relationship doesn’t go well, you’d get handed off to a workout department. And that workout guy is compensated on recovery. So they might sell the loan. It depends on how bad the situation is. If it’s deemed a highly leveraged loan, the bank has to reserve against it, which means it’s no longer a profitable asset, which means they want to move it out. So they have, that person doesn’t care about, and the salesperson doesn’t care. They’re on to the next thing. And the workout person just cares about getting it off the books.

And so they might sell it to a firm that buys loans at a discount. They might just be difficult and say no to everything to try to force you to refinance or do something. So it’s not a relationship that is geared towards being helpful at that point. Private credit, and they do that because of regulatory reasons, right? So they’re not bad people. That’s just their business model.

Private credit generally has more flexibility. We don’t have the FDIC or the OCC or any other regulatory agency telling us we need a debt service coverage ratio of X or we have to reserve. We don’t have, we have no SBIC, we’re not an SBIC fund. So we don’t have the small business administration telling us what we have to do or coming in every year to audit. We can sit down and understand the business and find out what went wrong. How’s it going to get fixed? What are the investors going to do about it? What can we do about it?

And we kind of, our hope is we come together as a group who own this company in common and who want to get it to the other side. And we’ve been in some search deals or other deals six, seven, eight years to give business strategies a chance to completely pivot. As long as everyone’s kind of on board, we can actually defer payments. We had a loan with a venture, not a search deal. It was a VC backed company. We didn’t take interest for a year and a half while they tried to sell the company.

They said, look, we need to put money in to fix some things, make it saleable. We’re not going to put enough money in to cover interest, but we’ll do all the right things as an owner. And then we’ll put it on the market and sell it. And we’ll pay you when we sell it. And we said, okay. And we monitored, everything went well, thankfully. They were able to get to their side. They sold the business. We got all of our money out and all of our accrued deferred interest. So we can do that. A bank can’t do that.

And again, not because they don’t want to, they just can’t. So non- banks generally cost more, private credit. We’re funded differently. We don’t have the low cost of deposit capital. We have return hurdles to make for our LPs, just like equity funds do. So there are reasons for the cost, but there’s also benefit to the cost if you value that benefit, right? We’re not a fit for everybody. And I won’t pretend that we are, but it’s hard to value that until you’re in the moment of truth and you need that partner to show up.

And then you’re happy you paid a high rate because you can save the company or reinvent the company, whatever it takes. So there are trade- offs and flexible structuring is another big one, not just in a workout situation, but I think part of the role of debt is to help value creation. So there’s, at its most basic level, right? Debt is helping you fund an asset purchase of some kind, but it should also help create enterprise value. And we view that as part of our job.

So if you’re a SaaS company and you’re investing in sales and marketing because you’re gonna be valued as a multiple of recurring revenue, you don’t really wanna be tested on a leverage multiple based on EBITDA, you’d rather be tested on multiple recurring revenue and be allowed to drive your EBITDA down so that you can create value. So we will underwrite to that strategy. Again, it’s harder for non- bank lenders to underwrite to that strategy.

So there’s the reasons lenders behave differently and then the set of flexibility that they’re allowed to bring to structuring and to monitoring and managing relationships. Sorry, that was kind of a long- winded answer, but. Not at all. Can I ask one follow- up on that, actually? Absolutely, yeah, please.

So you mentioned regulation a lot for banks, non- banks, and I think you were kind of touching on Dodd- Frank or Glass- Steagall, at least those are the ones that come to my mind, but when you’re, as a private credit lender, is it fair to say that there’s no regulation and you simply dictate your own business terms and the return that you’re looking to generate? Yes, yes. I mean, there’s regulation to the point of FINRA, we just have to report, right?

They care if we use an intermediary and fees, they wanna make sure everything’s all kind of up and up, but there’s no regulation in terms of how we underwrite credit and how we monitor it. There’s regulation in terms of how we market to market and report, you know, honesty, that kind of stuff, but not as far as the actual business model, yeah. Yeah, interesting. It’s just a different way of thinking about things. So, you know, whenever I talk to new searchers, I explain how we think about things, right? And our approval process.

I mean, it’s my partner, Peter, and I make all the decisions. We’re a very flat organization, we don’t have a credit committee, so we can be quick. You know, I’ve been in board meetings when I’ve had an observer seat and things weren’t going well, and they’ll say, you know, we’d like to do this, but that would default to covenant, and I’ll say, fine, don’t worry about it. And that is fine, don’t worry about it. I don’t have to go back and wait three weeks. So it’s, you’re just dealing with a completely different animal.

It’s an apple and an orange, and I, you know, and you may perceive value in that, and you may not, depending on the circumstances of your business, but it’s important to know the difference and think about what you need.

Okay, I don’t want to scare you, Karen, but I’m going to change the questions.

That’s fine.

So based on how this is going, which is, it’s going wonderfully. So, but I’m feeling like we’re answering a bunch of questions kind of in the context of the early ones, right?

Sorry, I’m long winded, sorry. They’re all real.

Super informative. So if I’m a searcher, I come to you, I’ve got a $ 5 million ARR SaaS business. I’ve got the traditional equity partners, Pacific Lake and everybody else who seems to always be on the same cap table. And I come to you and, you know, for, you know, you’ve been recommended to me, I’d like a debt package from you. How do you, you know, take me through, like, how you think about that? How much debt is appropriate for my little business that’s, say, breaking even, but has great growth potential? What interest rate I might think about?

Or how you think about, you know, where’s, what does the interest rate take to? And then how you think about amortization of principal?

So I’ll take the easy parts first. The question of how much debt is so unique to every business, right? But, and every, especially, I think you asked specifically about SaaS company. There, we see SaaS companies that are making a lot of money, you know, this rule of 40, they’re crushing it, you know? And then we see companies that have super high growth and they’re not making any money or they’re still, like, good growth, but not making much. So they’re all over the place, right? And so for us, it’s just, we really want to understand the business.

We want to understand its competitive position, how it’s going to grow. Has it demonstrated the ability to bring on new customers? Some customers are super profitable and they’ve got, like, 20 customers, you know? So they’re all just so different. And so we really just try to, we view ourselves as investors, not, like, it sounds silly, but we just invest in credit, not equity, but we’re going to ask all the same questions that your investors are going to ask. We just care, we’re looking at it from a different lens, right?

We just have a more senior position in the cap table. And for that, we take a fixed lower yield, right? We don’t have upside, but we’re still investors. So every business can support a different amount of debt, depending on its maturation, its development, its long sales cycle.

But to try to put some parameters around it, we’re generally lending one to maybe one and a half times ARR. We don’t like to be at one and a half times too long, but we might fund there in the beginning and then kind of step down through growth or, you know, pretty quickly, maybe over the first year or so. Interest rates, we are generally charging in the low teens and we fix our interest rates. It’s just because of how we’re sourcing our capital that we’re able to do that.

Generally, bank lenders and other non- lenders are going to float and some non- bank lenders float too. And some force an equity co- investment. Our model is just fixed rate and our fees are pretty much similar to all other lenders, closing fees and some prepayment fees. So how much debt? I mean, the hardest ones are when the companies are making money and it would be like a crazy high multiple of EBITDA and a relatively low multiple of ARR. Like you just, we have to find that balance, right?

Of whether we’re going to covenant something on a multiple of EBITDA or a multiple of ARR. If it’s not making money, it’s pretty easy. It’s got to be a multiple of ARR. But lately we’ve been seeing companies, everyone’s focused on profitability. So there’s been a shift in that SaaS world. And the companies that we financed that weren’t profitable are moving towards profitability, intentionally cutting overhead, things like that in this market.

So I don’t know, I’m not really answering the question, Mike, but it’s really, for us, it’s a holistic picture of how much equity is coming in the deal. It’s not even necessarily about debt service coverage because if the company can’t service its debt, we care about liquidity on the balance sheet. It’s more about the loan to enterprise value and an assessment we make about how much that can drop before we’re at risk. Does that?

Yeah, that’s great. On the interest rate side, how do you, so do you peg your interest rates to some benchmark?

No.

I mean, you know, when we’re fundraising, right, that’s an LP question at fundraising is what’s my return going to be if I commit to 10 years in this private credit fund? I think our investors look at, you know, 10- year treasuries, kind of easy to beat those. It’s been easy to beat those for a while. You know, over the last two years, as rates have been going up, up, up, we’ve been able to increase our rates just because that’s what the market that we’re lending into allows. But we haven’t, we’ve intentionally not increased our rates in lockstep.

We don’t need to. And so we’ve, frankly, used that as a to our competitive advantage, because all of a sudden, we look a little more competitive with bank rates, and we’re a flexible, more flexible product.

So to the extent that you can contrast your rates with with bank rates in the same in this same sector.

So what we’ve seen recently, you know, we’re kind of proposing still in that, I don’t know, 12. 5% range, generally, I would say the range is 12. 5% to 15% in our portfolio today. We might have a few at 12%. And banks we’re seeing are still quoting at prime, prime plus one, if the leverage is like below 2x or 2. 5x EBITDA, and maybe, you know, prime plus two. So I think prime today is 8. 5%. So that would be 10. 5%. And it’s floating rate.

So it’s, you know, a couple points difference at the, you know, at the low kind of mid range of our of our pricing structure where most of our credits are.

Great. And talk about the on the amortization side. I see about that. I see everything from no amortization to to, you know, straight annual amortization over five years. I mean, what goes into that thought process? And what is privacy?

So we’re generally five years interest only, because the companies we’re financing are usually growing, and they don’t want to use their cash to pay us back, they want to use their cash to invest in the company, right. So and we even allow distribution sometimes to the equity. So I know we did that with at least one of the companies that’s on this call, when we first underwrote the loan, there was just a trigger where if certain earnings hurdles were met, they could just take distributions and return dividends to their investors.

So we are companies generally don’t choose us, you know, a slightly higher price lender, because they want a plain vanilla seven year amortizing loan. I mean, if they want that, they could get that from a bank at a lot less cost. Usually we’re with fast growing SaaS companies, they’re hiring more salespeople and trying different marketing initiatives. Sometimes they’re opening, we have a lot of healthcare businesses that are opening new clinics or acquiring clinics, they can use the cash for things that are accretive, not repay the loan.

And what happens if you’re growing and you need your cash flow, a lot of it like a less flexible bank structure is not a great fit for that business strategy, because you’re constantly restructuring the loan, right? Every time you make an acquisition by another concierge medical practice, for example, you have to open up the credit facility again. And a lot of banks will say, okay, well, this note was on those three practices. And this notes on these two practices.

And now you’ve got like these simultaneous layers of debt that are all amortizing differently. And really what you want is just one facility that’s easy to manage, that’s interest only. And you have, you might have to go to your lender for consent to make that next acquisition. But if you’ve kind of defined the parameters, they should say yes, right? And then you can draw and make an acquisition. So we try to align the structure with the business strategy that you’re executing and make sure it fits and it works.

So for that reason, a lot of what we do is interest only.

So I want to, at some point, I wanted to get into the nasty question of defaults and how to deal with defaults with your lender. And so why don’t we talk about if you would talk about two things, just sort of typical, typical covenants, typical negative covenants. And then what if I’ve got bad news for you with respect to.

to one of those covenants or what if, you know, what if I’m projecting to have bad news for you? How do you, how should I deal with you?

Okay.

So first negative covenants. Negative covenants are things you can’t do. They’re not, they’re different than the financial covenants.

So negative covenants are, you can’t form a subsidiary without letting us know. You can’t upstream money to your parent holding company without letting us know, without our permission. You can’t make an acquisition without letting us know. You can’t distribute cash to your equity investor. So those are, there’s like a series of things you can’t do, which are all kind of obvious.

The financial covenants are the tests, right?

Your leverage test, your liquidity test, your debt service coverage test.

Each of those should serve a discrete purpose for the lender. And so we will sometimes have just two or three covenants depending on the business. A lot of times we have a liquidity covenant, again, because of the nature of our portfolio, our companies are generating a lot of, they have, they don’t have working capital issues, but maybe because they collect in advance, but they’re maybe not that profitable just given what they’re trying to execute.

So we want to make sure there’s plenty of cash on the balance sheet. We don’t like the, we can’t make payroll Friday phone call.

No lender does. So, but occasionally it happens. So, you know, we want to make sure if you’re not making money, there’s got to be a good chunk of liquidity on the balance sheet at close. And there might be a test that keeps liquidity. And generally we peg that to two and a half to three months of payroll, including benefits, just so that there’s a decent amount of working capital, you know, at the ready all the time.

So that would be some kind of liquidity test.

Sometimes it includes receivables in healthcare. A lot of times it includes receivables under, you know, a certain date from the invoice date, but generally it’s cash. Another one is a leverage test. So for us, it’s either geared towards EBITDA, debt to EBITDA or debt to recurring revenue.

If we have a debt to recurring revenue test, it’s generally because the company’s not profitable. And then we’ll probably also have an attrition test, a net revenue retention, something like that to make sure you’re keeping your customers and they’re not churning. We want to make sure you’re growing. We might have a whole number ARR test.

We’ll have some other tests. So one will be geared to debt to ARR. That’s our loan to value test. And the other will be some kind of a test on customer stickiness, so that we know that the customer base is solid and growing and not deteriorating. Because if you’re not earning profits and you’re not growing, that’s a problem. So you better be doing one or the other, right? So that’s the reason that we would test those things. Sometimes we test CapEx.

It’s not a very meaty test, but a lot of times, sometimes we have asset heavy businesses that they need to have, they have a fair amount of maintenance CapEx. We want to make sure that a good amount of that is built into the budget every year. And so we test the unfinanced portion of that to make sure that they’re not just like way overspending.

And they don’t, we want to just have a conversation about that to make sure they have a funding source figured out for it, if they’re gonna, or they have the cash. That’s, I don’t think I’m forgetting any, oh, debt service coverage.

Banks will always have a debt service coverage test.

They have to for regulatory reasons. Obviously, if our companies aren’t generating enough cash to pay their interest expense or their principal on it, we, you know, we don’t have one.

We will sometimes do a set of ARR covenants, debt to ARR, ARR growth for a period of time.

And then those will drop off and convert to fixed charge coverage of a hundred percent. So that’s meant to follow the trajectory of the growth plan so that in the early years, when you’re growing, not generating cash, as you’re growing into profitability, we’re testing that growth and that ARR stability, but then we’re less concerned about that. And we want to make sure you can, you know, cover debt service and eventually, you know, maybe convert to some kind of debt to EBITDA test.

Generally what I do with every portfolio company, every year when you’re doing your budget, I like to have a meeting with the team at the portfolio company and go through the budget.

And especially with new searchers, I’ve run into, they don’t really line up the budget with the covenants. And so to me, that’s a great moment to say, okay, what are you, are you doing anything differently in 24? Is that going to trigger any covenants? And if it is, let’s talk about it now. We’ll just reset them. So we’ll, you know, in order to avoid a default, it’s a kind of refresh on the business plan, right?

Like you’ve learned something in that year that’s just ended and you might be pivoting or getting in a different direction or something worked well. So you’re going to invest more in marketing because you want to grow faster, but let’s have that refresh conversation and make sure the covenants still fit. And at a holistic level, they’ll still fit because the theme is still the same, right? But you might need, I just redid one, I don’t know, this year. He wants to grow a little faster.

So I just waived the debt to EBITDA covenant for like three quarters because he wanted to hire some salespeople and he was going to catch up pretty quickly.

And I could have stepped it down differently, but you know what, I don’t care. If you don’t make it in June, you make it in September. So, you know, we work together. And again, this gets back to partnership, know who your lender is, know what their decision, you know, process is, their authority. To me, that’s a way better relationship than, you know, saying, oh, I can’t put that in my budget because I’m going to default a covenant.

That’s dumb. Like the lender should not drive how you manage the business. You know, you should have somebody flexible enough to work with you on that stuff so that you can create value.

So that’s, it’s all a philosophic approach.

Everyone’s going to be different. Good to know who you’re dealing with again, and what their toolkit is.

So, bad news, defaults, I think I covered that by, you know, just have that conversation when you’re new in the budget every year. Try to head it off. And of course, if you can’t and things just change during the year, the minute you think there’s going to be tightness in a covenant, just pick up the phone or set up a call and say, I think third quarter is going to be tight and here’s why and here’s what we’re going to do about it. We’ll keep you posted.

You know, it’s, it’s, I would say more than half of our portfolio companies will eventually have a default and it’s not a big deal. And probably 2% of them have something serious happen. So defaulting doesn’t necessarily equal really bad, it equals conversation. And let’s make sure we’re doing still makes sense, you know, relative to the debt we have, but it’s not really a reason to panic, especially if you just have a good, you know, communication channel open with your, with your debt partner.

Yeah.

Okay. And so that answer, you and I had a discussion previously about, about dealing with banks and I don’t know, perhaps some people on the phone have had the same experience that I’ve had where, where, you know, you’ve, you, you’re approaching a default, you’re, you’re anticipating a default, you pick up your phone, you call the lender and what you get is not a discussion that is at all what you have just described. And it’s because you’re dealing with a bank that doesn’t have the flexibility of, of.

Yeah. So I’ll, that’s a good distinction. So I worked, as I said, I worked at a bank for 15 years and managed credit relationships. So what happens on the other side of that call, right?

So giving your, if you have a bank lender, it’s even more important to get on it early because they have an approval process on the other side, they might have to do a write- up, a memo, and they have to go to a credit committee, depending on the default, if it’s a leverage default, they have to go to somebody, they can’t just sign off on it, which means they have to explain it, which means they’re going to need more information. And it’s going to be, you know, a written memo that it’s, everything is very rigid.

So, and it takes, it could take weeks to get an amendment and then it has to go to the lawyer and get documented. And so it’s a process on their end, if it’s a, if it’s a bank and, and even a lot of private credit funds, we’re ridiculously small and flat. So we’re probably an odd ball in that sense, but like even big credit funds will have some kind of an internal process. So give them time to do their process on the backend and, and get you, you know, an approval.

Yeah. Yeah.

And I guess what I took away from your conversation, our earlier conversation was sort of make sure that your lender is the right match for your business plan, your, where you are in your evolution. You don’t want to be, you don’t want to be in a situation where the future is pretty unpredictable with a lender who’s extremely rigid.

And it changes a lot in search because a lot of times searchers will get the cheapest debt at the close or they’ll, they’ll get, you know, a business is bumping along, it’s steadily profitable and, and it works right. An amortizing debt facility from a bank works. And then they’re in it two years and they think, oh wow, I have an acquisition or I, if I invest more here, I can grow faster and create more value.

And I, you know, I want to be out of this thing in six years or if I, whatever it is, we get a lot, I would say more, we, well, we do a lot at the buyout stage recently, but in the last five years, we’ve done a lot of kind of refinances of search where they’re bumping up against a covenant and they really want to grow faster and the covenants restricting them and the bank just says, no. So we’ll see. So we do a lot of refinance. So it’s not always the right, the right lender is not the, the answer to that question is not the same, right? All the time.

Things can change.

So.

Yep. Yep. Well, look, I, this has been super helpful for me. I want to give other people a chance to ask questions, big or small that may have been triggered by the, this conversation. So if you have them, now would be the time to raise your hand.

Okay.

So Kevin, Kevin Grittis is the only one who had a question triggered by this conversation.

Kevin Grittis

I learned a lot. I’m absorbing it, because my boss handles the relationship. He’s getting me more exposed, but this is very helpful.

Great, I’m glad to hear that.

OK, well, look, so Karen, thank you very, very much for taking an hour and doing this and doing the preparation with me in advance. I learned a lot. And it’s every time you talk, I say to myself, my God, all you have to do is just give her a fragment of a sentence, and then she goes off. It’s not so much, but I’m sorry. It’s obvious that you have some very, very deep knowledge in this area, and we have benefited from it for the last hour. So again, thank you. Thank you very much.

You’re very welcome. And I’ll just say, we do a ton of work with Pacific Lake. They’re great partners. You’re lucky to be working with them. And we’ve been with them in things that have gone well and things that have gone very badly. And they’re a good partner in both. And I think they would say the same about us. So call me any time.

Email me.

My email is just kleashing, the last name, at pridescrossingcapital. com. I’ll be happy to help you navigate a situation if you need that or answer any questions and just try to be helpful to the best of my ability.

Fantastic. Yeah. Thank you. As to sort of last bit of the agenda for the other participants, one of the things we should think about is, what do we want to do in 60 days? We’ll set up another call like this. I’m happy to. I’ll send out an email with a few notes on the conversation today. And then some of you have recommended possible next topics. But I’m eager to get something that you guys are strongly interested in. Today, I was strongly interested in this. So I sort of forced the agenda. And it’s only our second meeting.

So I didn’t feel too badly about that. But I do want to be somewhat more democratic in the future. So please respond to my email if you would post- meeting. Anybody have other topics they want to bring up?

I have a random question due to everyone being in audit. And this is my second audit. First one, I was there for like two weeks when I joined. Is everyone’s due date April 30th? Or are there different due dates based on your lenders?

Ours is April 30th. But we had to get a delay talking to our lender and letting them know we’re going to be a little late.

Ours is May 29th, lender- driven.

Ours is April 30th. Originally, it was March 31st. We asked for the extension the first year just prophylactically. And it’s worked out well for us. We still had our audit done before March 31st. But we know, based on what’s happening out there, that it’s possible we could be delayed. So we’re at April 30th now.

You could save a lot of money sometimes, too, as you guys all know, by pushing it. We’ve had a lot of customers asking us to push it to the end of May instead of… We were almost never the end of March. It’s just so tight. But pushing from the end of April to the end of May.

That’s what I heard. That’s actually not a big ask.

I wouldn’t, I mean, honest, I wouldn’t be afraid to ask for that.

And we found we were able to get a great team and save some money by going really quickly at the end of the year. Just the way… So at the beginning of the year, I should say, we have our audit very early just because of the way we do things, we’re able to do that. And that also works out well.

Interesting. And is everybody providing K- 1s in the April timeframe? I send out estimated K- 1s before March 15, and then we finalize our taxes later in the year. And I send finals about mid- year.

Okay.

And as a tiny investor in Pacific Lakes, one of Pacific Lakes funds, I can tell you that’s exactly what they do, too. They send me an estimated K- 1 early and then they come in just under the deadline for the final.

That’s what we plan to do.

Anything else? Any other random thoughts, questions, comments, topics? All right, guys. Thank you. Thank you to everyone. I will be in touch shortly. And Karen, special thanks to you.

Thanks.

Nice to see everybody.

Thank you.

Thanks, y’all.

Bye, guys.

Thanks.