Business Resources
Leveraged Recaps...More Cash?
By Valentina Midura, Managing Director, BDO Capital Advisors, LLC
WHAT IS A LEVERAGED RECAPITALIZATION?
A leveraged recapitalization (“leveraged recap”) is a transaction where a private equity firm uses outside debt from a bank together with its own capital to buy a controlling interest, typically 70% - 80%, of the ownership of a privately held company. Shareholders are able to create liquidity for themselves and diversify their investment portfolio through the transaction while at the same time maintaining economic ownership in their company. The residual ownership interest also allows the seller to share in the upside and growth of the company monetized through a future sale or liquidity event via a “second bite of the apple”.
A leveraged recap not only provides privately held businesses with an alternative to an outright strategic sale but it can also be used to address multiple objectives faced by small business owners and diverse shareholder needs including:
• Allowing for the buyout of all or a select shareholder
• Facilitating the transfer of the business to the next generation
• Funding tax liabilities associated with family succession
• Attracting capital to fund future growth
Not every business is a viable leveraged recap candidate. The primary requirement is the ability to utilize debt including asset-based and/or cash-flow based financing to fund the transaction. Businesses considering a leveraged recapitalization should have a consistent and predictable stream of cash flows. Secondly, the transaction requires that the selling shareholder(s) be willing to use some of their sales proceeds to buy back equity of the “new” corporation and assume the risk associated with this equity stake. Additionally, this deal structure requires that the selling shareholders or existing management team continue with the new corporation for some pre-defined period of time in order to run the company until the second bite of the apple or subsequent liquidity event.
EXAMPLE OF A LEVERAGED RECAPITALIZATION
A company is 100 percent owned by a single shareholder. It has sales of $40M and EBITDA of $4.0M. Historically, EBITDA has grown at a CAGR of 5 percent and is expected to continue this growth trajectory for the next five years. The shareholder has received two offers to sell the company’s stock: a strategic all cash offer of $30M and a financial sponsor bid of $24M.
The residual ownership interest in a leveraged recap allows the seller to share in the upside and growth of the company monetized through a future sale or liquidity event via a “second bite of the apple”. As per EXHIBIT 1 the private equity (“PE”) firm can only secure 3x total financial leverage for the deal and proposes funding $12.0M of the purchase price with bank debt. The balance of the $12.0M purchase price will be funded with equity. To insure continued management involvement, the PE firm has proposed that the shareholders reinvest or “roll” approximately 17 percent of the gross sales proceeds or approximately $4M back into the deal. The balance of the equity proceeds or $8M will be funded with the PE firm’s equity contribution. It is important to note that under this example, the percentage ownership that the selling shareholders assume through their rolled equity position is computed off of the new capital structure of Newco allowing the sellers to own a heightened percentage ownership interest in the newly recapitalized company due to the leverage now incorporated in Newco. In addition, if properly negotiated the shareholder could be entitled to earn 10 percent equity promotes (stock options), whereby the company’s management team would also receive “free equity” over the next 5 years if the company hits on pre-defined performance hurdles.
Under the leveraged recapitalization proposal, the seller will receive $20.0 million of cash proceeds on the day of close and an approximate 33 percent economic ownership interest in Newco going forward.
Let’s assume now that the transaction is consummated and the company’s EBITDA continues to grow at a CAGR of 5 percent for the next 5 years. At the end of year 5, the management team and the PE firm decide it is time to sell the company and accepts a bid from a strategic buyer for $35.7 million. This equals a 7x EBITDA multiple and resultant equity value to the shareholders of $32.4 million as there is still some residual buyout debt on the company’s balance sheet. Based on the ownership structure of Newco and this fact pattern, the PE firm would be entitled to approximately 67 percent of the equity value or $21.6 million, while the original selling shareholder that participated in the equity roll would receive 33 percent of the net proceeds of approximately $10.8 million a strong return on investment of 22 percent.
Let us not forget however, that the original shareholder of the company is also entitled to 10 percent performance-based equity promotes as the company achieved its economic projections. The selling shareholder would receive an additional 10 percent of the equity proceeds or $3.2 million in cash, increasing his total return to 29 percent. At the end of the second sale, the selling shareholder earned a cumulative realized gain on the sale of his company of $34 million, $4 million more than the original bid of $30 million offered by the strategic buyer, certainly, a successful transaction for the shareholder.
Valentina Midura is a Managing Director with BDO Capital Advisors, LLC and head of the Technology Group. BDO Capital is a leading middle market investment banking firm that provides services in mergers and acquisition advisory, corporate finance capital raising, special situations advisory, and board advisory services.
