Nashville isn't regarded as the "Wall Street of the South" that it once was. Gone are the large commercial and investment banks and insurance companies that once called Nashville home.
Showing promise of filling some of that void, an investment sector known as "mezzanine" financing grew rapidly here in the mid-1990s under the leadership of go-go stock Sirrom Capital Corp. Typically, such financing -- making business loans in return for interest and warrants to buy stock in the borrowing company -- is extended to firms too mature for venture capital but not quite ready for a public offering.
But the strategy, which in Nashville focused on making $2 million to $5 million loans to small companies, fell apart in 1998 when the public market for small-cap stocks came unglued. With the market's decline came a meltdown of Sirrom shares and the end of Nashville's emerging role in this mezzanine niche.
Or so it seemed. Now, from the ashes of the Sirrom swoon, several Nashville firms are building major mezzanine finance operations. With assistance from a suddenly tighter-fisted lending stance by competing bank officers, the prospects for this type of financing again look promising.
But today's practitioners are avoiding some of the risks that Sirrom took on its way to managing a $600 million portfolio. The new business model is less sexy, but it is sure to be more durable.
"It's a wonderful business right now," enthuses Mike Blackburn, a partner of Petra Capital Partners, one of the larger locally based firms operating in this sector. "We don't have Sirrom to compete with. There really are no dominant players and we're seeing very high quality deals that are structured prudently and are priced well for the risks we are taking."
Mr. Blackburn should be able to recognize a good market. After 12 years as a commercial lender at First Tennessee and as a venture capitalist with Richland Ventures, he joined Petra in 1998 as it was preparing its own initial public offering. But he wasn't there long before Sirrom hit the skids, undermining the mezzanine market and wrecking Petra's chance for a public stock sale.
"Still, I felt like this business -- when done properly -- is a very good business," Mr. Blackburn says.
So what did Sirrom do to cause its share-price to plummet from $34 to $2.50 in only a few months? To begin with, it exposed itself to some profound risks simply by electing to sell shares publicly three years earlier. Also, some believe that it had begun making riskier loans than it did when the company began in 1991.
By 1995, Sirrom was a publicly traded company controlled by institutional shareholders who demanded consistent quarter-to-quarter financial performance. That sort of stability is elusive in the mezzanine niche because "you're dealing with small companies that can grow or fall very rapidly," says John Harrison, a vice president with Sirrom from 1994 to 1999. "You can't control things as tightly as banks, which set up reserves against losses. Here, you take gains and you take hits, so you have lumpy earnings up and down."
For Sirrom, the lumps in July 1998 were all down. Four months after selling additional shares to the public, Sirrom shocked its investors with a large write-off of troubled loans. The larger institutional investors -- mostly momentum traders who move in and out of the hot stocks of the day -- bailed. The stock plunged. Banks lending to Sirrom and to its portfolio companies got nervous.
Ultimately, Sirrom was sold in March 1999 to Phoenix-based Finova Group Inc. (FNV) for $343 million in Finova shares, valuing Sirrom at $8.72 a share. Thanks to problems at Finova unrelated to Sirrom, the value of the swapped Finova shares today amounts to roughly $1.25 per Sirrom share. Meanwhile, Sirrom's stock price collapse prompted shareholder lawsuits that were settled earlier this year for $15 million.
"It's a bad public model," concedes former Sirrom executive Mr. Harrison. He and two other Sirrom alumni recently formed a Nashville-based mezzanine financing unit for Harbert Management Corp. of Birmingham, Ala. Its fund, Harbinger Mezzanine Partners, raised $30 million in June, is closing on another $15 million and intends to get $5 million more to bring its equity total to an even $50 million.
A second area where the new firms deviate from Sirrom is that they may be investing in somewhat more stable companies than Sirrom did after its capital grew so large. A commonly heard criticism of Sirrom -- generally disputed by those working there at the time -- was that the influx of capital induced it to invest in companies that couldn't as easily support the interest payments.
Says a veteran of local financial circles: "As long as the stock market was so high, you could get these companies public (and get your money out). But then the music stopped, and the companies, which everyone had said would go public and now were not going public, were losing lots of money and couldn't pay interest. That's a big problem."
Aware of the problems with Sirrom's business plan, the new mezzanine firms are positioning themselves to build a more robust model.
Like Sirrom, these financiers of small business are capitalizing on a major benefit from federal government. Most of the funds are set up as Small Business Investment Companies, which makes them eligible to receive low-interest rate loans in amounts several times their original capital. Specifically, SBICs can borrow three-times their initial $17 million of capital, two-times the second $17 million and once on the next $17 million.
For Petra, which last year raised $21 million in equity, its SBIC status has made another $59 million available. The Harbert fund has applied for an SBIC license, and, if approved, can draw down another $100 million from the federal program to give it $150 million of investable assets. The current rate SBICs pay for their borrowings is roughly 1.75%-2.5% above the 10-year Treasury note, which recently yielded 5.8%.
Harbert and Petra seem to be pursuing conservative. Both look for companies with minimum revenue growth rates of at least 20%-25% and say that service companies meet their investment criteria more frequently than other types of companies.
Their niche -- investments of $2 million to $6 million -- is not very crowded. Most mezzanine financing involves larger companies borrowing at least $10 million. The former Sirrom, now a unit of Finova, is a big player in the larger-company market, as are commercial banks and insurers. First Union operates a major mezzanine financing unit and Donaldson, Lufkin & Jenrette recently closed on a $1.6 billion fund that makes $25 million-$250 million investments.
Two other SBICs in Nashville are Equitas, an affiliate of Rodgers Capital Group, and Commerce Capital L.P., a fund with $24 million in investable capital managed by Andy Higgins and Rudy Ruark. Mr. Ruark notes a fortuitous circumstance for today's firms -- recently rising interest rates and closer scrutiny of loans by banks that make the lending climate less competitive. A report from the Federal Reserve Board last month said as much: "Commercial and industrial loans at banks have expanded briskly, even as a larger percentage of banks reported in Federal Reserve surveys that they have been tightening standards and terms on such loans."
Tighter bank lending standards mean more potential SBIC borrowers, who pay a nice premium above the SBIC's cost of capital for their money. The mezzanine firms earn the difference, any capital gains from stock warrants should their portfolio companies increase in value and a service fee of 2%-3%.
This may sound like expensive money, but in fact it's attractive to many fast-growing companies who lack the assets and history to get cheaper bank credit and are far enough on their way to avoid giving away much of their companies to venture capital firms.
"That's the real exciting thing about our product for businesspeople," Mr. Harrison says. "It's a stable, permanent source of capital that's not overly dilutive.