Maximizing Value through Private Equity Recapitalization
Many business owners view the sale of a business as a one-time event taking place shortly before retirement. While this approach towards the sale of a business is perfectly rational since it rewards the owner with one large payout, it may not be the most lucrative transaction structure available. Now this may sound a bit odd, but the most lucrative sales typically come from selling your business multiple times under a private equity recapitalization structure.
Recapitalization is broadly defined as the restructuring of a company’s debt and equity mixture in order to optimize its capital structure. For example, the process may involve the exchange of one form of financing for another, such as replacing preferred shares with bonds. While recapitalization strategies are traditionally associated with public companies looking to raise stock prices, private equity groups have adapted the approach towards the acquisition of both public-traded and privately-held businesses.
Under the private equity recapitalization model, the private equity investor acquires a majority stake in the business while the owner retains a minority stake. Usually, this results in the business taking on debt roughly equivalent to the value paid to the owner so that the new majority shareholder doesn’t risk pulling too much cash out of the business and avoids spending their own cash resources. As a result, the company’s debt-to-equity mix is altered and the owner realizes some of the inherent value of the business in the immediate, while retaining the right to future value from distributions or the business’s eventual sale several years later. Some owners may even go through multiple sales from one investor to another, while being incentivized to stay on with the business through an equity stake.
Above and beyond the owner cashing out a portion of the business’s value, numerous other benefits exist from private equity recapitalizations. In particular, we believe the following five key benefits are important since they impact the owner, investor, and management team:
Multiple owners with different backgrounds creates greater opportunity for strategic decision making since a single individual is no longer making all of the business decisions, and the investor may have connections that facilitate rapid growth.
Business risk is diminished since the business is no longer reliant on a single owner.
Management is normally granted the opportunity to invest in the new entity, which aligns its long-term interests with that of the business.
Greater financial resources to support strategic acquisition and growth strategies.
Capital gains from the sale of the business several years later – presumably at a much larger valuation.
To be clear, private equity recapitalizations are not without risk and don’t work for all size businesses. One of the greatest risks to the business is overleveraging. Despite the common knowledge of this risk, there are countless stories of businesses going under or filing bankruptcy due to insurmountable debt burdens. Recently, the much-loved children’s toy store Toys “R” Us filed bankruptcy due to the interest payments related to the roughly $5 billion in debt investors Bain Capital, KKR & Co. and Vornado Realty Trust placed on the business.
In addition, private equity firms have their own investment requirements that may prevent them from recapitalizing a business that falls below a specific revenue size or profitability requirement. Most U.S. private equity firms are seeking companies with at least $20 million in annual revenues or $2 million in normalized EBITDA.
Lastly, timing and investment horizons, while not necessarily a risk, is something that ownership needs to consider. Private equity firms typically acquire a business with the intent of growing and divesting the business over a roughly seven year window, so an owner needs to consider how well the investment horizon aligns with their personal timeline. If the owner wants to sell the business and retire within the next two years, then this might not be the right strategy for them. Alternatively, if the owner is interested in staying with the business for the next 5-15 years, then this strategy better aligns with their personal timelines and allows them to maximize the value of their equity stake in the business.
Ultimately, private equity recapitalizations are a double-edged sword. It can provide significant value to owners in the immediate with greater value in the long-run, but may also result in diminished value in the near- and long-term if the ownership team poorly managers the business. Toys “R” Us should serve as a reminder that even the most recognizable and established companies can only handle so much debt before it becomes crippling and growth prohibitive, which is why ownership needs to maintain objectivity when assessing value.