by Mr. Heinz Jäger, CEO der JP Mergers & Finance AG

The January 2009 edition of the JP Director's Report "Provision of Liquidity during the World Financial Crises (I)" describes the causes and consequences of capital deficiency in medium-sized companies and the multifarious difficulties in interaction with banks (see JP Director's Report at www.jpmergers.com).

In the following part 2 it is exemplified how the equity base of the company can be optimized by integration of a private equity company and the utilization of mezzanine capital.

Restructure of Liabilities -
Creating financial scope

We have a worldwide recession. But after the economic contractions there will come a new boom. But it is precisely in he cyclical upturn phase that the liabilities side of the balance sheet often hampers growth. In particular, this is just the time when medium-sized firms which have a good market position in certain segments and want to expand it further are often reliant on new sources of finance.

A creative and forward-looking business finance package, aimed at securing financial scope for growth and reorganisation, is crucial to success. The financial structure must prove to be stable and flexible in both good and bad times. Many financial arrangements are often designed purely for "fair weather" and are not adjusted for years at a time. As a businessman, if you don't want to be suddenly taken by surprise by a shortage of finance, you need to address the restructuring of your liabilities in good time. Active capital structure management does not only improve financial security; depending on the goals of the business and the partners, structural measures may be the only way of facilitating strategic options such as business succession, changes in the partnership structure or in the business portfolio. As a rule, restructuring of the liabilities optimises the debt situation and thus improves the performance of the business.

Normally, there are three aims in restructuring the liabilities side of the balance sheet:

1. Optimising the balance sheet structure, so that the debt/equity ratio ensures adequate liquidity at all times.

2. Creating the right mix of borrowings with due regard for the key criteria, such as cash flow management, reliability and stability of the finance, financial expenses and matching maturities, etc.

3. Optimising the capital structure with the focus on debt reduction

The various types of equity: It's the equity that counts

The growth dynamics of medium-sized firms are determined largely by the availability of adequate equity capital. There are various ways of obtaining equity capital: Apart from flotation (IPO), it is possible to find strategic or financial investors and private investors to put money in. Equity capital can be raised by increasing the share capital. There are also other ways of boosting the equity, such as hybrid / mezzanine finance, participation certificates, dormant equity holdings, profit-participating loans, etc.

The decisive factor is making the right choice and perhaps combining the various sources of equity capital in the light of the needs of the entrepreneur or company.

Venture capital provider: a temporary capital partner

One way of adjusting the capital base to future needs is partnership with a capital investment company. Do not be confused: Momentarily the modern advisors talk about "PEs" meaning Private Equity companies. Round about 10 years ago, in the age of "Start-ups" and "New Economy", the term "Private Equity" was almost a swearword - too conservative, too old-fashion, simply said - from yesterday. At the turn of the century the magic word was "Venture Capital", which one should not use unless you wanted to be turned away by an evil eye.

Capital investment companies (also known as private equity or venture capital companies, etc.) almost all want the same thing: financial involvement in a business for 3 to 5 years, and after that "exit" (by selling their stake or the business), aiming to make an average annual return of around 30 % on the capital. This high profit expected from the investment can only be achieved if the following conditions are met:

1. Excellent management performance

2. Long-term market expansion

3. High business growth (well over 20 % p. a.)

4. Above-average profitability

If you want to look "sexy" and attractive to a capital investment company, then your business has to meet the set criteria. Do not expect any favours. On the other hand, if you manage to persuade a capital investment company to enter into a commitment, then you are usually assured of a professional partner who will not interfere in the business.

Most venture capital providers limit themselves to a minority stake. When the capital investment company is brought in, the businessman remains independent, in contrast to an industrial partner. However, that independence is retained only so long as you stick to the budget. In the event of persistent budget slippages, the financial investor will take action. When entering into the commitment, he reserves those rights under the contract.

Some capital investment companies aim at a majority stake of up to 100 %. In most cases, these are not venture capital providers. Nor do they want to exit in the medium term, but plan to keep the shares in their holding company portfolio.

When choosing a capital investment company, you must make sure that - if possible - it has expertise in your sector. The right investment partner, often having contacts all over the world, will then be able to offer you substantial support, e.g. in the international marketing of your products. This means that, apart from the financial contribution, the partner should also provide strategic input with his experience and contacts, e.g. as regards developing markets or products. A good capital provider sees itself as the businessman's coach. You are well-advised to accept this 'hidden' advice because the investment partner often has an amazing amount to offer. For that, there has to be the right 'chemistry' between the entrepreneur and the investment company's managers, because your shared road is a long and sometimes difficult one.

The intermediate level: mezzanine - subordinated loan

Mezzanine - in the building industry, this originally French term refers to an 'intermediate level' - combines the characteristics of debt and equity capital: mezzanine finance fills the gap between loans (senior secured loans) and equity capital. The term mezzanine finance is used in particular where a long-term loan is linked to an 'equity kicker', e.g. a call option (warrant) or conversion right (convertible loan). Normally, the loan is subordinated. The option is usually tied to fulfilment of certain conditions, such as the sale of shares in the business, an IPO, etc.

For large international businesses, mezzanine finance is routine. For smaller corporate customers, mezzanine solutions are particularly appropriate for businesses with high growth potential. Projects requiring heavy investment in the initial stages and not generating a profit until later present the ideal opportunity.

For your business, 'intermediate capital' offers the great advantage that mezzanine allows you to improve your capital ratio. That makes this form of finance the perfect instrument for addressing the capitalisation of medium-sized German firms - which is very low by international standards.

For medium-sized businesses, mezzanine is an alternative if equity capital is difficult to obtain and borrowings have been exhausted. The target return for mezzanine finance is around 15 - 20 %. That is intended primarily to compensate for the risk, which is higher than on standard loans. Bankers take the view that the various types of capital are in competition with one another in the event of insolvency. What matters is the order of priority for claims on the insolvent assets. Loans are repaid first. Equity capital, and hence also venture capital, comes last. Mezzanine lenders come in between.

In the light of this, when restructuring the liabilities it is always important to involve the capital providers in the discussions and pursue an open communication policy.

Financial Engineering: The benefits for the entrepreneur

Dealing with the restructuring of the liabilities has five practical advantages for the medium-sized business operator:

1. Clear improvement in the transparency of the strengths and weaknesses of the business finance

2. Realisation of profit and liquidity potential, and hence increase in the firm's own contribution towards the finance

3. Securing stable, crisis-proof business finance

4. Reducing financing costs

5. Gaining new financial scope

JP Mergers & Finance AG advises in the capacity of a financial engineer. The JP-Senior Advisors together have over 50 years' experience in corporate finance, not only as advisors but also as responsible business managers in real life.

Mr. Heinz Jäger, Dipl.-Kfm., is the Chief Executive Officer of JP Mergers & Finance AG and possesses many years of experience as managing director and chief executive officer of several industrial -, trading-, and finance service companies.