By Conrad Tan

GEORGE Lee, head of group investment banking at OCBC Bank, noticed a curious pattern among the bank's small and medium enterprise (SME) customers years ago.

When they reached a certain size - usually an annual turnover of $15 million to $20 million - many of them either flourished, or failed.

'We came to the conclusion that when a company hits a turnover of $15 million to $20 million', it finds it difficult to borrow enough using conventional bank loans to fund further expansion of its business, he said. At the same time, the firm's own start-up capital - usually from the entrepreneur's own savings, or borrowed from family or friends - would be stretched very thin.

'Based on our own experience, that is the point when a lot of SMEs either make it to the big league or they die. At this stage of the growth cycle, there is a very high casualty rate.'

So the bank decided to come up with 'a slightly different proposition', he said.

It started the OCBC Mezzanine Capital unit, which sits within its investment banking division, to offer unusual financing solutions to companies that need them to grow.

'We deliberately call it mezzanine capital - most people call it private equity or venture capital - to emphasise the fact that we are more of a development- stage financier than a company that seeds new ideas,' Mr Lee said. 'We started this unit in 2003-04.'

His mezzanine financing team now comprises 19 people - nine in Singapore, one in Malaysia, four in Hong Kong and five in Shanghai.

The unit offers convertible loan or convertible bond financing; loans with equity options or warrants attached; loans with profit-sharing arrangements; and high-yield loans, which charge higher interest rates than usual, but offer a borrower funds that would not otherwise be available.

Flexibility

'Like most private-equity funds, obviously we do pre-IPO financing. That is most typical of venture capital. But because our objective is to help the companies to grow, we have great flexibility in our product offering, so it's slightly different from the normal private-equity fund.'

He cites an example of a transaction his team completed: A small developer bought a property and obtained loan financing from OCBC for 70 per cent of the price, with the developer funding the rest out of its own capital - a common arrangement for a bank loan. The developer then wanted to buy an adjacent apartment block but it didn't have enough of its own capital to fund the purchase of the second property, even with another bank loan.

'What the developer wanted was to be able to buy both properties, and develop them as a larger, combined project, but without having to put in more equity investment,' Mr Lee said. In such cases, the mezzanine capital unit can offer the developer loans with profit-sharing arrangements or high-yield loans (or a combination of both) to cover the rest of the purchase price, he added.

'This is what we've done. We've gone in with some of the middle-market property developers and helped them to develop bigger projects by giving them high-yield loans, but with a profit-sharing arrangement. Once the developer starts to sell its residential property, we have the ability to participate in the profit.'

Although the developer has to pay a steeper-than- usual rate of interest on the high-yield loan, the additional funding it obtains allows it to invest in a bigger project, earning it even more profit overall, he said.

'Typically, a developer will start to look at a project if it has an internal rate of return, or IRR, of about 25-30 per cent. When we ask for high yield, we ask for 12-18 per cent,' he said. So even with a high- yield loan, the interest costs are 'still way below the developer's IRR'.

Put simply, the extra borrowing, even at a higher cost, allows the developer to improve its overall return on its investment as well.

'But if the developer doesn't make money on the project, all it has to bear is the high interest costs. If it makes money, it shares some of the profit with us,' Mr Lee said.

High-yield loans proved to be a particularly useful offering during the recent financial crisis in 2008-09, 'where some companies - because of the liquidity crunch and the withdrawal of credit facilities by banks - were caught in a situation where they had assets but most of the assets were already mortgaged and they feared that they would have a liquidity crunch' and wanted to obtain additional bank loans, he said.

In one case, a shipping company had many valuable assets (ships) but most of the assets were already mortgaged. Fearing a liquidity crunch, it approached OCBC - it was an existing customer - and said it wanted to borrow more but admitted that it didn't have ships available for a first mortgage, Mr Lee said.

'So we said - we know you, and we are prepared to give you a second mortgage, or even lend you money on an unsecured basis, but at a higher yield.

'This is what this fund can do. We structure it such that it's of value to our customers, to help them to grow, so that we don't just offer pre-IPO financing.'

'In this particular instance, the company had no intention to list; it just wanted to defend itself with additional liquidity in a credit crunch and was prepared to pay a higher yield to borrow.

'Another thing we have done is to offer loans with options. This is something that we've done quite successfully with emerging companies. We give them interest-free loans; in return, they give us an option on the company so that when they go IPO, we have the right to invest in them.'

The mezzanine capital unit has also been offering such loans with equity options to the bank's SME customers, 'especially those where we believe in their business model', Mr Lee said. 'Should the company go IPO or have a trade sale, we have the ability to then benefit from the growth of the company.

'Over the years since we started this fund, we've invested in about 65 different companies, of which about half are pre-IPO companies and the balance are non pre-IPO - that would include loans with profit sharing, loans with equity options and high-yield lending, of which 20-25 would be loans with equity options.'

Five years

Loan quantums range from $1 million to $20 million for each transaction, typically for anywhere up to five years, Mr Lee said. 'We generally don't go beyond five years, because that's hazy. If we can't see good growth potential or exit opportunities within five years, then something is wrong.'

There are clear advantages for the borrowing firm. 'We give it a normal bank loan which may not otherwise be available at normal bank rates; all it gives up is the equity option. If the company doesn't grow and we don't exercise the option, it has nothing to lose in the meantime. More importantly, because we have an equity option, we have a vested stake in seeing the company grow, and we tend to then be much more involved in the company.

'Wherever possible, given our expertise and understanding of the markets, we give them advice and tips on how to grow the company, how to restructure.'

One of the senior bankers in the unit was hired 'specifically because he used to be the CFO of a manufacturing company, with the idea that if anything goes wrong, I can parachute him in' to fix the problem, Mr Lee said. So far, he added, that has not been necessary.

This article was first published in The Business Times.