Need money? You'd better get your house in order

Financing is out there (in spades), but it's discriminating and conservative
Sunday, January 1, 2006

A year ago, financial analyst Michael Barnes, a partner with Barnes Associates, made the bold statement that there is "more money seeking to be deployed in the security industry...[than] any time in history." Yet we had Security Finance Associates president Tony Smith tell us about a "shrinking marketplace for loans at this point in time." Huh?
Well, the money's out there--oh, yes, there's plenty out there--but that doesn't mean it's easy to get, especially for mid-sized companies doing between $10 million and $100 million in revenues. Lenders and investors are becoming increasingly discriminating in looking at management teams, the quality of recurring monthly revenue and attrition rates before handing over the cash.
"I think people are still looking to invest in security," said William Lynch, vice president at ProAssociates, which arranges financing in the security industry. "But they are very careful about where they're making their investments."
For example, "It is difficult for a small independent [integrator] to access money to take on an acquisition," said Bill Bozeman, president and chief executive officer of PSA Security Network, which has more than 200 member integrators in North America. "That's not an easy task. They have to be one of the larger independents. The bank is very concerned about the infrastructure of the company and the ability to manage an acquisition."
Of course Bozeman, coming at the situation from the integrator perspective, feels "there are gobs and gobs of money available for the RMR burglar companies because it's a different financial model."
Jack Mallon, an industry analyst and managing director of New York-based Mallon Associates, doesn't totally disagree: "It's true, investors and lenders are much more comfortable with recurring revenue," he said, and it's on recurring monthly revenue that alarm companies base their businesses. But "Integrators are expanding their recurring revenue through service agreements," and other new initiatives, he noted. "The alarm accounts clearly have visible multiples and are more marketable; they have more of a sense of having their loans collateralized. But as the integrators mature and show consistent profits they'll engender greater confidence from the lending community."
Plus, said Mallon, "There's lots of money out there."
However, "The lessons of the late '90s haven't been forgotten," said Bill Polk, director of CapitalSource, which has quickly become a major lender to middle-market alarm companies. "There's more skepticism," he said, "and a better understanding of what drives value for alarm companies."
He is, of course, referring to the salad days of accounts being purchased for sky-high multiples by the likes of Protection One and ADT--and those investments not exactly paying off. These days, potential lenders, investors, and purchasers are paying more attention to the quality of the recurring revenue: What's a company's attrition rate? Are the contracts spread out all over the country or tightly focused in a geographical area? What does it cost to service that recurring revenue?
"Some years ago," said Dan Linscott, vice president at Financial Security Services, which was recently purchased by IASG, "whether it was a source of financing or it was a buyer, there was the impression that all RMR is created equal, but that's far from the truth. It differs in the quality of the revenue, and the margin that's available in a given subscriber account."
Both Linscott and Polk agree that it's the middle-market companies, both integrators and alarm companies, that are under-served by the financial sector and which are seeing their financing options dwindle. While loans below $250,000 can generally be serviced by the local bank, and there are a fair number of Bank of America-level lenders interested in financing acquisitions in the range of $10 million and above, it's the area in between in which fewer and fewer lenders are working.
Why? "It takes a good deal of work and due diligence and collateral maintenance," said Linscott, "and it's difficult to get a significant return for the cost of the capital and the cost of maintaining the relationship. You can essentially make a million-dollar loan for the same time and energy of a hundred-thousand-dollar loan...So organizations are going larger and that is driving capital out of the middle market."
Linscott noted that in the past two years Security Resources, which worked in the middle market, sold to Security Alarm Financing Enterprises, "which is now only dealing with large financing entities"; National Alarm Computer Center was acquired by IASG in the same manner that Linscott's FSS was; and then Security Leasing Partners, who, like FSS, would finance down to $250,000, was acquired by CapitalSource.
So, said Linscott, "as you look around, from the perspective of a small to mid-sized company, access to specialized capital is somewhat limited. Many [financing houses] have either exited the market or been acquired."
Polk, who was president of SLP when CapitalSource acquired it in April of 2005, said CapitalSource sees potential in the middle market, but "it has to be looked at a lot more broadly." Polk said CapitalSource is interested in the many new players in the post-9/11 security world and how they'll affect the marketplace: biometrics suppliers, RFID, detection and screening, the list goes on. "We finance alarm companies, but we're looking at this new stuff," he said. "In many ways they look like alarm companies. For instance, those with government contracts." They're different from alarm contracts, but they're equally underwritable.
So, considering this financial prudence and the competition for capital out there, is it really easier for an alarm company to find money than for an integrator?
"I don't know if that's true," said Lynch of ProAssociates, "I think it's always challenging for any company to find financing, depending on the management. If [integrators have] good solid management and are generating good operating metrics, then there's not a great deal of difficulty."
Liscott agreed: "I know there's a significant amount of equity capital looking for the proper management team," he said. "Capital is no longer just chasing portfolios of accounts...Now it's based upon real economics and cash flow."
Parroting former chairman of the federal reserve Alan Greenspan, Linscott dryly noted that, "There was a high degree of irrational exuberance in the alarm industry for some time."
Thus, said Polk, "Integrators are of great interest, but the systems integration business is technically sophisticated and very competitive. It's not for those that can't compete at the highest levels." He said small integrators can actually sometimes be nimble enough to compete if they've adapted to the new business environment. "You're selling to two people now, the security director as well as the IT director," he said. "If you can't sell to both parties effectively then you're not going to sell at all in the most sophisticated integrations."
From a lender's standpoint, evaluating the integrator, "you're looking at free cash flow as opposed to recurring revenue," he said. And, as should go without saying, "Discriminating financing sources are looking for excellent and reliable management teams."
"It all goes back to that old adage," said Lynch. "It's management, management, management."