Follow the money

As the economy demands conservatism, deals get more expensive, harder to complete
Thursday, January 1, 2009

Don’t fool yourself. The security industry is not recession proof. Frost & Sullivan security analyst Dilip Sarangan spoke bluntly: “In general terms, you’re going to see a lot fewer installations this year.” Especially in the commercial sector, “things are going to get a little bleak,” he predicted.

You’ve all read the stories about the shutdown of the credit markets, the widescale layoffs. Heck, Pelco’s selling the corporate jet.

Clearly, the halcyon days are over, and that extends to what once seemed like a bottomless pit of available capital to fuel industry growth and acquisitions. Just two years ago, Bill Polk, CapitalSource managing director, told this reporter that there was more capital looking to go to work than there had ever been in the history of the world. But, in March of 2007, he offered this warning at the Security Growth conference in Santa Monica: “Based on historical terms,” Polk said, “the structures and pricing would seem beyond the pale ... the volume seems outlandish, seemingly infinite.”

As it turned out, the structures and pricing (not just in security, but everywhere) were very much beyond the pale, were unsustainable, and eventually collapsed upon themselves, creating the credit crisis in which the world is now mired. “As a collection of institutions,” Polk said recently, “they bought into models that presumed certain things wouldn’t happen more than once in 10,000 years, and then they happened 30 times in a day. Everybody was blinded by the fact that there was so much money being made at the point of origination.”

Unfortunately, because of the way certain debt was leveraged, a $100,000 mortgage failure started causing multi-million-dollar ripples in the markets, and the industry now finds itself in a situation where it’s very difficult to put together large financing packages, both because lenders are wary of risk and because there’s simply far less cash available to be loaned.

“The difficulty we’ve noticed,” said Gretchen Gordon, director of Media and Communications at CIT, “is that it’s harder to find lenders to participate with. We’ve seen a pulling back by lenders who do more things than just security alarm.” Polk agreed it was harder to find partners to share the risk in a large deal. The result is a general agreement among those interviewed that the more money you’re looking for, the harder it will be to find.

“There has been a move towards more conservative leverage ratios,” Gordon said, “so instead of a couple years ago, or last year, where it was common to go above 25 times as a multiple of RMR [in valuing accounts as collateral], I have been rejected by other lenders in trying to go that high, or have seen a significant resistance to it.”

However, there’s also general agreement that, for small and medium-sized deals, the basic parameters of industry lending are the same.
“We’ve never lent higher than 25,” said Jim Wooster, president of Alarm Financial Services, which tends to lend to the smaller alarm companies in the industry. “We lend at 15 to 18 times ... We’ve always been very conservative, and maybe it’s cost us some deals over the years, but it’s serving us well now.”

“The market for credit is open for middle-market companies,” said Mark Melendes, managing director at the Private Bank, which lends to companies with at least $500,000 in RMR. “This industry is a bit protected from the credit markets at large because of the RMR and the cash flow from the long-term contracts.

For those mid-sized companies in the industry with quality management, good operating metrics, and who are focused on attrition, they’re finding access to credit.

“The media attention has been focused on the largest banks,” agreed Sean Forrest, also a managing director at the Private Bank, “and what’s not reported very often is that sound banks are still making loans and making money the old fashioned way: making loans to actual people and supporting those customers.”

However, Forrest said, “It’s a little harder to find partners, and deals in general are more conservative, a little more expensive, and everyone, borrowers and lenders, are moving at a more slow and careful pace. It’s not a bad thing.”

Gregory Spurr, a long-time lender to the industry as senior vice president of commercial banking at TD Bank, N.A., one of the few traditional banks lending to the industry, agreed with Forrest and Melendes’ assessments, but said things aren’t as rosy for middle-market companies with shaky balance sheets.

“What has changed,” he said, “is the situation for the marginal operator, who doesn’t have good financial reporting - maybe he’s losing money. Those guys don’t have anywhere to go now. That’s the difference. The good borrower always has lenders, but the marginal guys have very few options now.”

Also, said more than one industry lender, companies doing a lot of business with struggling parts of the economy - the new build market, retail, automotive - are going to be seen as larger risks, even if their balance sheet is strong. Even companies that are simply doing business in parts of the country suffering from high unemployment, like Michigan, are going to be viewed with some skepticism.

And because of that, said Wooster, “strong companies are using their position of strength to come to us and get money to buy other companies or buy accounts. A lot of guys are using this time as a time to just throw their hands up and say, ‘I’m done.’ And now the strong guys are in a position to go and make acquisitions, and that’s the positive that we’re seeing.”

Everybody also agreed that acquisition multiples have yet to fall, so it’s a good time, said Wooster, for integrators who have a small amount of RMR built up in service contracts and the like, to cash that RMR out and use it to keep them growing in the down economy.

“As the business is maybe suffering a bit,” he said, “they’re looking for ways to raise cash to keep going, and those are some assets that they can now go and sell. That’s one thing that we have definitely noticed.”

But if you don’t have that RMR to leverage, you might be out of luck. “We’re interested in companies with RMR,” said Forrest. “They can be a commercial company, but we’re looking for recurring revenue. We like that commercial business, by the way, but if they strictly install, that’s not what we do.”

So, if you’re looking for financing to acquire or grow, it’s best to emulate the good, strong companies: Increase your RMR base, lower your attrition, shore up your management team, and make sure your financial reporting can withstand rigorous due diligence.

“In this economy,” said Polk, “a strong CFO is a good investment.”