22 Apr Private Equity Recapitalization — Taking Some Chips Off the Table
Any business owner, whether young or old, has investigated a succession plan or at least wrestled with the idea of selling their business. Sometimes this can happen during a period where significant growth lies ahead, or in times when economics look bleak. What business owners often overlook is the alternative financial technique known as a private equity recapitalization (recap). A recap is where business owners can sell a portion of their business to Private Equity (PE) firm/partner. This gives them a cash reward, whilst still giving them the benefit of forecasted growth, or a turnaround in the economy.
More so, PE firms not only provide capital they can add value as a business partner. This additional benefit can come in the form of industry, operational and organizational expertise; all used to increase the value of your business.
How a PE recap works
It is hard to explain this with text, so let’s work through a simple fictional example. Sam founded Widget Co., a manufacturing company that specializes in widgets. Widget Co., like many companies in the manufactory industry, has weathered many storms over its years. However, during this recent downturn, Sam has realized that too much of net worth is tied up in Widget Co. Sam is now 60 and Widget Co. is his retirement fund. Sam believes the market will turn around, and growth lies ahead in foreseeable future. Sam is, therefore, reluctant to sell his company during its current downturn, but sees the need to de-risk himself in case he is wrong. He plans to de-risk in two ways; limit single person risk by reducing his involvement in daily operations, and to get some cash in return for equity. Sam is a micro-manager and Widget Co. has very little in the way of secondary management or future leaders in its ranks to offer ownership to.
Sam seeks advice from a sell-side advisor and they do some research into some possible options. After investigating a few options and reasons for performing a recapitalization, Sam decides to pursue a PE recap. Sam finds a PE firm that is willing to invest, and a management team willing to drive this change. Like many small businesses, Widget Co. is debt free and the negotiated enterprise value (EV) of Widget Co. is agreed upon by both parties to be US$10 million. The two agree on the structure of the acquisition, with the deal financed with 40% equity and 60% debt. Once the transaction is complete, Widget Co. will carry US$6 million in debt and Sam will continue to own 30% equity of the company.
The value of the equity after the recap will be as follows:
But the story is not over for Sam, and he will have another option to sell soon. After a period of time, generally five to seven years, the PE firm will execute a liquidity event for the business. Generally, this is through a sale to another larger PE firm, or through an IPO.
Below we show how Sam’s equity value changes in the second sale if, for example, they were able to double the enterprise value over this five to seven year timeline:
So, in this example, Sam walks away with US$14.2 million versus the US$10 million that he would have earned on the initial sale of 100% of his business. Use these tables as a benchmark and play around with the enterprise valuation multiple. In PE recaps it is not uncommon to see a two or three times increase, or alternatively less than a 100% increase. PE firms are known for aggressively growing their portfolio companies. This does mean you need to somewhat keep an eye on their practices, as growth at all costs can affect your customer relationships. Remember, not only did Sam profit from the growth, he was able to step back from the management team and diversify his personal investments.
But what are the risks of a recap?
The example above was meant to be very simplistic, with lots of fictional assumptions. This subject can and will be complicated, but we wanted to address it as a viable option for you to choose. Although our example illustrates the upside for this type of transaction, there are also downsides you must consider before you jump into this decision. In our example, Sam is no longer his own boss. As mentioned above, the PE firm will set up an advisory board with aims to invest in the new management team’s goal to drive the business to a new level. Most business owners, in particular, enthusiastic entrepreneurs, find it difficult to cede control.
Most small business owners avoid debt as this is generally the most prudent thing to do. After a recap, however, the company will carry a significant amount of debt on its books. As most small business owners are cautious about high debt levels, this may make them feel uncomfortable. Ceding control also means passing on the decision making. The value of the company on the second exit is not guaranteed, and bad decisions of the PE firm may result in a lower than expected value or a lack of one at all. Money and support can be good or bad. In order to try and avoid bad money, research the PE firm and their successes and track record. Do they own a competitor, as sometimes they might try and snowball you!
Investigate your options, or seek advice
Every situation and company is different. A PE firm can be a great partner and a good solution for a business when the owner is optimistic about the future and not needing to sell the entire business urgently. More so, this option looks attractive if the owner simply wants to diversify his/her personal net worth but stay involved in their business. However, it is not all plain sailing and going down this road is as difficult, if not more difficult, than a sale. Like always, seeking out a sell-side advisor can help navigate the murky waters, and avoid a bold PE firm taking too much power. Investigating your main options with the help of an expert will allow you to put together the best possible deal when the time comes.