Unlocking private debt: A guide to sources and strategic uses

Private credit debt has become an increasingly popular financing option for businesses, particularly in situations where traditional banks are either unavailable or less advantageous from a flexibility perspective. Funding can be sourced through a variety of options such as senior direct lending and/or unitranche focused funds, mezzanine debt, real estate and infrastructure funds, distressed debt and special situations/opportunistic credit funds. It is subsequently becoming imperative for business owners to understand these options to ensure businesses secure financing tailored to their specific risk tolerance, return expectations, and strategic needs.

By clearly identifying the sources of funds for the proposed deal (i.e. equity, debt, or internal cash flows etc), and the specific uses of these funds (i.e. working capital, expansion projects, or debt refinancing), companies can present a well-defined and coherent financial plan to prospective lenders and investors. This clarity helps in tailoring the debt structure and source of debt capital to match the company’s borrowing profile (including cash flow and repayment capabilities), thereby minimising financial risks and enhancing the likelihood of securing favourable terms from lenders.

When is debt preferred over equity?

It is important to note debt will not always be the most appropriate source of capital. The decision between using debt or equity will depend on the existing capital structure of the business and its appetite for risk. Debt can be seen as a favourable option compared to equity, as it is a non-dilutive source of capital and can subsequently allow businesses to improve their valuation prior to an equity event (equity raise, merger, or sale). Since debt obligations are typically fixed in nature, we recommend businesses ensure they understand all obligations (repayment profile and covenants) to ensure the business can service the debt throughout the term of the facility, with consideration applied to downside scenarios (impact of temporary closures, impact of expansion, and accounting for ramp-up timing of growth initiatives).

Sources of debt funding

• Senior direct lending is the most typical form of financing for mid-market businesses.
• Mezzanine financing is a hybrid form of capital that sits between debt and equity on a company's balance sheet. It typically involves debt capital that gives the lender the rights to convert to an ownership or equity interest in the company in case of default, after other senior debts are paid off.
• Distressed debt comes into play when a company is facing difficulties in meeting their debt obligations or required to go through a formal restructuring process. Debt in these situations allows businesses to improve their prospects through operational turnarounds and balance sheet restructuring. This may also involve incumbent lenders willing to trade debts at a discount depending on their security position with the borrower.
• Special situations debt relates to investment opportunities arising from unique or extraordinary circumstances that create potential for high returns, often accompanied by high risk. These are often time-sensitive opportunities requiring fast and flexible capital to support corporate restructurings, mergers and acquisitions, or other events that significantly impact a company's financial standing or market position.
• Venture debt is a type of debt financing provided to early-stage, high-growth companies. It is typically used by startups that have already received equity investment from venture capital (VC) firms but need additional capital to fund their growth without diluting their equity further. Venture debt is often used as a complement to equity financing and can help extend the cash runway between equity funding rounds.

Typical uses of debt raising

Companies utilise debt for a myriad of different reasons including new locations, entering new markets, or increasing production capacity. By leveraging debt, businesses can accelerate growth without awaiting accumulated profits. Here are some typical uses of debt financing:

• Growth opportunities: Private credit can offer more flexible and tailored financing solutions compared to traditional financiers, enabling rapid scaling and investment in new markets. Flexibility can be provided through additional leverage or a back-ended amortisation profile to ensure it is tailored to the growth profile of the borrower or opportunity at hand.
• Working capital: Debt can be used to finance daily operations by securing funds against receivables, inventory, and trade credit, ensuring the business has sufficient liquidity. This helps maintain smooth operations and meet short-term financial obligations. Depending on the specific industry, bespoke facilities can be structured to unlock the value in unique balance sheet items specific to the industry of the borrower (i.e. funding against crop & livestock in agriculture, raw materials & WIP inventory in manufacturing or seasonal stock & high turnover products in retail).
• M&A: Debt can be utilised to finance mergers and acquisitions, enabling businesses to acquire other companies, assets, or intellectual property that can drive growth, increase market share and achieve strategic synergies. By using leverage on transactions, companies and investors can improve their return on investment and reduce their impact on equity and cash reserves to be used in other areas of the business.
• Capital expenditure (Capex): Borrowing can support significant capital expenditures such as purchasing new equipment, upgrading facilities, or expanding infrastructure. This investment can drive long-term growth and operational efficiency. We typically see debt support capex initiatives undertaken by businesses across capital-intensive sectors (i.e. manufacturing, energy & renewables, and healthcare), which utilise debt to bridge the cost, development, or implementation phase of assets while integrating the capex project into the business.
• Diversifying product or sales expansion: Debt can fund initiatives to diversify product lines or expand sales channels, mitigating risk by spreading revenue sources. This strategic investment can enhance market reach and competitiveness.
• Managing cyclical business needs: For businesses affected by seasonal or cyclical variations, private credit provides a financial cushion to manage fluctuations in revenue and ensure stability during lean trading periods.
• Research and development: Debt financing can support research and development efforts, allowing businesses to innovate and stay ahead of competitors through investment in new products, improved processes, and long-term growth. Funding can also be obtained from lenders using future R&D tax incentive benefits as collateral for a loan which can be a useful source of capital and liquidity for start-ups or early-stage growth companies.

We can help you navigate the most suitable approach for your private debt sources and uses. For more information, contact our debt advisory team.

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