Keeping it simple

The $73 billion North American municipal solid waste (MSW) industry is a capital- and equipment-intensive sector. This demands that companies make crucial decisions about how to fund ongoing capital expenditures and growth.

Traditionally, companies operating with 50 or fewer frontline collection vehicles have funded fleet and equipment purchases through traditional equipment leases and/or term loans. This is common for small to midsize companies for a variety of reasons:

• Leasing alternatives generally offer fixed-rate financing of specific equipment with up to seven-year repayment schedules.
• Equipment term loans commonly are structured as floating-rate obligations and could include a designated interest-only draw period, after which any outstanding loan balances are converted to a fully amortizing term loan.

Although these financing alternatives have proven effective, as an MSW company’s operations increase beyond $20-$25 million in annual revenue and become more diversified, financing options can become more flexible, particularly when an industry-knowledgeable lender is engaged. This happens because industry-focused lenders offer financing structures based on the value of the company’s predictable recurring cash flow rather than hard asset values.

The flexibility of a cash flow lending structure can be enhanced if a company’s collection operations are integrated with permitted waste transfer, processing and/or disposal facilities, given the incremental margin capture and expense control that vertical integration in the solid waste industry provides.

Cash flow lending

Based on a company’s scale and business mix, a popular industry-appropriate lending structure involves a multiyear, general purpose revolving credit facility. Revolving credit facilities typically have the following key structural features:

• an agreed-upon borrowing limit that can be paid down and reborrowed based on maintenance of accepted financial covenants tied to cash flow, not asset values;
• required payments that include interest, monthly or quarterly, with repayment of outstanding principal due at maturity, typically three to five years (in many cases, revolvers are renewed with the outstanding principal amount rolled over);
• borrowing proceeds available to fund working capital, capital expenditures, acquisitions and other growth initiatives often initially paired with a consolidation term loan, under which some or all the company’s existing term debt is refinanced on a single amortization schedule, simplifying ongoing loan administration.

As opposed to a leasing or similar asset-based financing structure, under which specific assets are financed and making monthly principal and interest payments is the primary requirement to maintain compliance with the financing agreement, a cash flow structure with a large revolving credit facility component requires more limited principal payments in exchange for the borrower agreeing to maintain agreed financial covenant levels. Typically two primary financial covenants are included under a cash flow lending structure:

1. cash flow leverage—Typically defined as total funded debt divided by trailing 12-month EBITDA (earnings before interest, taxes, depreciation and amortization); and
2. fixed charge coverage—Measures the company’s ability to service required debt payments and is typically defined as EBITDA less taxes, distributions and unfinanced capital expenditures divided by required principal and interest payments during the measurement period.

Financial covenants are set at levels intended to allow for ongoing refinance or renewal of the revolver at maturity.

As the company and its cash flow grow, the financing commitment can scale accordingly, assuming covenant ratios are maintained.

Equipment financing

Cash flow lending structures greatly simplify a company’s typical equipment financing cycle. Under an equipment lease or term loan financing structure, individual assets are financed with the resulting debt amortized as required from ongoing operating cash flow generated by the business. Given operating cash flow is used to service scheduled monthly principal and interest payments, new truck purchases require documenting a new equipment loan or lease for each material capital outlay.

By contrast, under a cash flow revolver structure, trucks and equipment are purchased with drawdowns from the revolver. Given they are not placed on an amortization schedule, operating cash flow can be used to pay down the revolver, thereby refreshing availability for additional, incremental truck and equipment funding later without documenting a new loan so long as compliance with the agreed-upon financial covenants is maintained.

Another benefit of a cash flow structure is its scalability. As the company and its cash flow grow, the financing commitment can scale accordingly, assuming covenant ratios are maintained. Consequently, borrower loan administration and origination activities can be greatly reduced, freeing up management to focus on business operations versus financing activities.

One size does not fit all when it comes to financing ongoing operations and growth initiatives within the solid waste industry. That’s why in addition to understanding financing options, it is equally important to work with a lender that has extensive waste industry expertise.

Doug Donovan is Wells Fargo’s commercial banking market executive for the Chicago market. He can be reached at douglas.donovan@wellsfargo.com.