Exploring Leveraged Recapitalizations as an Alternative to Selling a Business
www.capstoneheadwaters.com Introduction to Leveraged Recapitalizations
Many owners of mid-sized private companies spend much of their working lives building a business yet ultimately reach a point where they seek to enjoy some of the financial rewards of their life-long efforts. However, many of them soon realize that the bulk of their personal net worth is tied up in a singleasset–thecompany. Sinceequity positions in closely-held companies are fairly illiquid, most owners believe that it can only be monetized through the complete sale of the business, a belief that can sometimes lead to a decision to sell before the timing is right.
Instead of an all-or-nothing ownership choice, however, many such private company owners have turned to recapitalizations(or“recaps”)asameansto“takesomechipsoffthetable” while continuing to operate and control the business going forward. Conceptually, recaps encompass a wholerangeofpossiblefinancial alternatives, from a modest re-leveraging of the business to fund a one-time dividend (a “dividend recap”) to the sale of a majority (but less than 100%) of the equity to an outside investor (a “majority recap”).
Range of Financial Options to Gain Liquidity
Leveraged Recapitalizations
Do Dividend Minority Majority Complete Nothing Recap Recap Recap Sale
No Equity < 50% Equity > 50% Equity 100% Equity Sold Sold Sold Sold
Dividend Recap – In this structure, the excess debt capacity of the business is used to fund aone-timecash dividend to shareholders to provide a meaningful amount of liquidity without any dilution in the ownership or management of the business.
Minority Recap – This structure involves selling less than half of the business (typically20%-40%)toan institutional investor, while providing a business owner with a greater level of personal liquidity and a well- capitalized partner without ceding operating control of the business. Minority recaps are typically used when the company’s debt capacity alone is not sufficient to meet the owner’s liquidity needs. The new investor will eventually need liquidity themselves which is typically triggered through an exit mechanism after a certain period of time (often five years) – at that time the company is often sold or the minority position is repurchased.
Majority Recap – Often referred to as a leveraged buyout (LBO), a majority recap results in thesaleofmorethan half the ownership (60%-80%) and typically uses both debt and equity to finance the transaction. The business owner continues to have a minority ownership in the company post-transaction, a key operating role in managing the business, and typically enjoys what is sometimes referred to as a “second bite of the apple” when the investor eventually sells the business some five to seven years later.
In each of these recap transactions, the business attracts incrementally greater levels of new capital to provide significant liquidity to existing shareholders while potentially meeting other estate planning goals of the owners. This new capital can take the form of debt or a combination of both debt and equity capital depending upon the amount of liquidity desired and the longer term goals of the owners. Illustrative examples of these recap scenarios are included in Exhibit A on page five. In the balance of this report, we focus on the first of these transaction scenarios, the dividend recap.
Page | 1 Dividend Recap: An Effective Tool for Estate Planning
Renewed interest in dividend recaps has emerged in recent years, driven by a confluence of economic forces including the formation of many new non-bank lending institutions, significant fundraising by new lenders, and relatively low interest rates that have made it easier and cheaper to borrow debt. Given the pressure faced by lenders today to put their money to work, the market remains quite receptive to dividend recaps.
These transactions are not limited to professional investment firms and larger corporations alone but are increasingly available to owners of mid-sized private companies as a cost-effective means to meet their owner’s twin goals of wealth diversification and liquidity.
Dividend Recap Example
Background – Pickett Snack Company is a family-held manufacturer equally-owned by four shareholders (25% apiece). Financially, the company generates about $100 million in revenues and $12 million in earnings before interest, taxes, depreciation and amortization (EBITDA). In years past, Pickett had secured bank financing (secured by personal guarantees) that had been gradually reduced to only $18 million (or 1.5x EBITDA). Given the health of the overalldebtmarketandthe aggressiveness of lending institutions currently, this level of debt would be considered conservative in today’s market.
Financing Transaction – After reviewing the financial goals of its shareholders and weighing the pros and cons of seeking outside debt and equity capital, Pickett shareholders decided to pursue a relatively conservative dividend recap. Through a competitive process conducted by an investment banking firm that targeted institutional lenders, management received several proposals before selecting a financing package consisting of both senior debt and junior debt totaling $48 million (4.0x EBITDA), a level modestly below the company’s perceived debt capacity. After refinancing the existing debt, the net proceeds of the capital raise were distributed equally among the four shareholders as a special one-time dividend.
New Financing Structure – The new capital structure in this example consists of a revolving credit line, senior term loan, and junior term loan secured from institutional lenders on favorable terms that reflect current market conditions. Due to the shareholder dividend, Pickett’s overall debt leverage is now higher than it had been previously, yet still prudent in relation to the company’s credit capacity and levels that are common in the broader market.
Transaction Results – By pursuing the dividend recap, Pickett’s shareholders were able to accomplish several key objectives: • Diversified (in part) their personal net worth away from the family business • Forestalled the date at which a complete sale would be pursued • Maintained complete ownership of the business among the shareholders • Secured competitively-structured debt capital with no equity dilution • Reset loan pricing, covenants, amortization, and other terms to today’s more aggressive levels while eliminating personal guarantees on the new company debt
Page | 2 The Rationale for Dividend Recaps
Private companies often reinvest their earnings and cash flow right back into the business and, as a result, their owners can find that the vast majority of their net worth becomes tied up in the business. Dividend recaps have emerged as a way for private owners to finance a one-time cash dividend as a means to gain partial liquidity, diversify their net worth, and meet other goals (i.e., eliminate personal guarantees on debt) while deferring the need to sell the whole business.
While the financing strategy offers liquidity and wealth diversification to its shareholders, company owners should also consider the inherent risks and potential consequences before pursuing a dividend recap. The most obvious consequence of such a transaction is the creation of incremental debt on the business without any increase in revenues or cash flow, which could hinder a company’s ability tofunditsongoingoperationsor weather unforeseen events.
Advantages/Benefits Risks/Other Considerations
Diversification of family net worth Debt-funded dividends are too large to Take some “chips off the table” now while allow the company to weather preserving control of the business unexpected downturns Defer the need to ultimately sell the business Excessive leverage constrains operating Eliminate the personal guarantee on debt financial flexibility or limits ability to Reset loan terms (rates, covenants, pursue new opportunities amortization) to today’s more favorable levels Additional reporting requirements
Candidates for Dividend Recaps
While attractive, dividend recaps are not a viable option for every shareholder nor every company. For older business owners who plan to retire soon, a complete sale of the business to a strategic buyer likely makes the most sense. However, for more middle-aged owners, a dividend recap may represent a good solution to protect their personal net worth while continuing to control, manage, and grow their business until retirement becomes more imminent.
Furthermore, not every company is a viable candidate for a dividend recap since the primary requirement is the ability to utilize new debt in the form of asset-based and/or cash flow-based financing to fund the transaction. Highly-leveraged businesses, volatile or capital intensive businesses, and those experiencing financial difficulties find it difficult to pursue such a transaction. Characteristics of ideal dividend recap candidates include:
Prime Shareholder Candidates Prime Company Candidates
Owners with majority of wealth concentrated Current outstanding debt is relatively modest in the business History of revenue growth and profitability Owners seeking some personal liquidity but History of consistent, predictable cash flows not near-term retirement Modest capital expenditure requirements Strong company (defensible market position, minimal regulatory or technology risk) Deep and experienced management team Lack of customer concentration Positive industry dynamics (mature, stable, low cyclicality)
Page |Page | 3 Proper Planning is Critical
Every business owner has personal and business goals that are unique so it is important to work with experienced wealth advisory, investment banking, tax and legal advisors to develop a comprehensive wealth and tax planning strategy that is best for them. While a dividend recap may not be suitable foreverybusinessowner,ifthe circumstances are right, it may provide a great opportunity to unlock illiquid wealth in a private company while remaining in control for years to come.
The Debt Advisory team at Capstone Headwaters has worked with numerous businessownersovertheyearsto recapitalize their businesses and structure dividend recaps that allow for significant wealth diversification and liquidity creation. In connection with these transactions, we analyze the business to develop actionable financing options, work with owners to develop the right solution, and thenleverageourrobustnetworkof institutional lenders to secure the best financing package that is available from today’s market.
CONTACT US Tolearn more about how we can help recapitalize your business, please contact:
Kent Brown Managing Director, Head of Debt Advisory Group [email protected] | 303-951-7127
Kent Brown, Managing Director and Head of Capstone Headwaters' Debt Advisory Group, brings nearly 30 years of corporate debt placement and advisory experience havingservedasthesenior banker on 100+ closed corporate debt transactions during his career for both corporate and sponsor-backed clients.
Kent has extensive experience in arranging various forms of middle-market corporate debt, including leveraged loans, asset-based loans, subordinated debt, second-lien and unitranche facilities, syndicated credit facilities, venture debt, equipment leases, private securitizations, sale-leasebacks, and mortgages, among other structures. Client engagements have involved most industry categories, including financial services, healthcare, consumer products and services, retail, technology, industrial, commercial services, and business services, among others. In particular, Kent has gained considerable experience within the Financial Services industry, having completed over 20 engagements involving senior debt, junior debt, equity capital, and M&A transactions for non-bank specialty finance clients within both the commercial and consumer finance sectors.
Previously, Kent was a Managing Director at William Blair & Company, a global investment banking and asset management firm, where he worked for over 25 years within the firm’s corporate debt advisory group. Kent began his career with Arthur Andersen & Co. where he worked with corporate clients within both the audit and corporate tax divisions. Kent holds an MBAfromtheUniversityof Chicago and a BS in Finance from the University of Colorado at Boulder. He is also a Certified Public Accountant, and a Series 7 & 63 Registered General Securities Representative, Series 23 Registered General Securities Principal, and Series 79 Registered Investment Banking Representative.
Disclosure: This report is a periodic compilation of certain economic and corporate information, as well as completed and announced merger and acquisi- tion activity. Information contained in this report should not be construed as a recommendation to sell or buy any security. Any reference to or omission of any reference to any company in this report should not be construed as a recommendation to buy, sell or take any other action with respect to any security of any such company. We are not soliciting any action with respect to any security or company based on this report. The report is published solely for the general information of clients and friends of Capstone Headwaters. It does not take into account the particular investment objectives, financial situation or needs of individual recipients. Certain transactions, including those involving early-stage companies, give rise to substantial risk and are not suitable for all investors. This report is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such. Prediction of future events is inherently subject to both known and unknown risks and other factors that may cause actual results to vary materially. We are under no obligation to update the information contained in this report. Opinions expressed are our present opinions only and are subject to change without notice. Additional information is available upon request. The companies mentioned in this report may be clients of Capstone Headwaters. The decisions to include any company in this report is unrelated in all respectstoanyservicethatCapstoneHeadwatersmayprovidetosuchcompany.This report may not be copied or reproduced in any form, or redistributed without the prior written consent of Capstone Headwaters. The information contained herein should not be construed as legal advice.
Page | 4 Exhibit A: Illustrative Leveraged Recap Scenarios
In the illustration below, we have assumed that shareholders of a business with $12 million in operating cashflow and modest borrowing levels seek to monetize a portion of their equity stake in the business. The desired size of the cash distribution at closing will typically dictate the type of transaction to be pursued.
($ in millions) Current Option 1 Option 2 Option 3 Situation Dividend Recap Minority Recap Majority Recap Current % $ Resulting % $ Resulting % $ Resulting % Business Valuation Structure Owned Change Structure Owned Change Structure Owned Change Structure Owned EBITDA (1) $12 Enterprise Value Multiple (1) 6.0 x Enterprise Value $72 $72 $72 $72 Less: Existing Debt (2) 18 18 18 18 Less: Incremental Debt (3) ‐ + $30 30 + $30 30 + $30 30 Equals: Equity value $54 ‐ $30 $24 ‐ $30 $24 ‐ $30 $24
Resulting Equity Value & Ownership Existing Shareholders $54 100% $24 100% $18 75% $6 25% New Shareholders ‐ 0% ‐ 0% 6 25% 18 75% Total Equity Value $54 $24 $24 $24
Cash to Shareholders Today Through Incremental Borrowings $30 $30 $30 Through New Equity Investment ‐ 6 18 Total Cash to Shareholders at Closing $30 $36 $48
(1) Assumes the business generates ~$12 million of EBITDA and would be valued in the open market based on a 6.0x EBITDA multiple (2) Assumes the business currently has ~$18 million of debt outstanding (about 1.5x EBITDA) (3) Assumes that the balance sheet could be further leveraged in today’s market up to 4.0x total debt-to-EBITDA multiple
As noted, the amount of the cash distribution that can be generated through recaps is a direct function of both the underlying debt capacity of the business and the equity ownership position offered to the new investor.
Dividend Recap Minority Recap Majority Recap Complete Sale
Page | 5 BUILT FOR THE MIDDLE MARKET
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