When two bites are better than one

The benefits of Private Equity Recapitalization

At some point, most business owners ask themselves, “Where can I get additional capital to grow my business?” or “How can I take some money off the table?” The question that often follows is “How can I do so without losing control of the business I’ve worked so hard to build?” In some cases, the best way to address these questions is a partial transaction through a private equity (PE) recapitalization with an eventual complete exit when the value has increased. This is also known as the “two bites” strategy.

The current environment for acquisitions and external investment presents some unique opportunities for owners. Enterprise values are at an all-time high, which is in part due to the availability of credit in the debt markets and historic low interest rates. PE groups and venture capital investors are deploying their own cash and healthy amounts of debt at unprecedented levels. In fact, available PE capital has increased from $700 million two years ago to more than double that today. The result of these dynamics is that, in many industries, financial investors are now competing with strategic buyers (also known as synergistic or corporate buyers) and are now more willing to offer more for businesses.

What Is a Private Equity Recapitalization?

The PE recapitalization strategy comprises transactions in two different stages (“two bites”). In Phase 1, an investor, often a PE, purchases a majority percentage of the business from the owner/executives, who maintain minority ownership in the business. After three to seven years, during which time the business has grown, the original owner/executives and the investors execute Phase 2. Phase 2 involves selling the business at a higher value than the original value. A key element of this strategy is that the investors are interested in buying successful businesses with growth trajectories. With their capital, expertise, and connections, trajectories can usually be amplified. Investors like this structure because owners maintain “skin in the game,” which ensures ongoing commitment and focus from executives (which investors often need, at least for the short term).

  One-Bite Approach Two-Bite Approach

Phase 1: First Bite

Current company value: $5 million

Owner sells 100% or $5 million

 

Owner sells 70% or $3.5 million

Owner retains 30% or $1.5 million

 

Phase 2: Second Bite

Later company value: $20 million

$0 Owner sells remaining 30%, which has grown to $6 million
Total Amount Received: $5 million $9.5 million

 

Financial Benefits

Business organizations that pursue this strategy realize many benefits. Infusion of capital can facilitate accelerated expansion plans and additional sales strategies, strategic acquisitions to gain market share, and the ability to seize other capital-intensive opportunities that arise.

Organizational Benefits

Organizational benefits of PE recapitalization include the ability to create a partnership with an investor that has broader experience and access to resources. The company can then leverage those relationships, which may include financing, marketing/sales strategy, legal guidance, operational assistance, etc. The two-phase approach also provides business owners an opportunity to choose a partner whose values and culture match that of their own and the existing business. PE recapitalization is a particularly strong strategy for sellers who prefer to avoid the hassle of an IPO and for businesses for which some family owners may not be active. It is important to note that investors in these types of deals are usually not interested in maintaining non-participating shareholders. If timing is right, however, investors can take the opportunity to buy out these types of owners.

Personal Benefits

Owners also benefit individually from this strategy. The biggest benefit, of course, is the potential to grow wealth even more by achieving a second sale for a potentially much larger amount. Effectively, you can diversify your personal portfolio of wealth by “cashing out” a large percentage of what is likely your largest single asset (your business), reduce your personal financial risk, and continue to be involved in the business you love. In the example above (see table), an owner may achieve $5 million from a one-time 100% sale today or $9.5 million from a two-phase sale, including an initial partial sale today and a percentage future sale some years down the road.

What Is Required for a Private Equity Recapitalization?

Sellers must prepare for this type of sale in many ways, including (but not limited to):

  • The company’s financials must be healthy, up to date, and accurate. Buyers will conduct a thorough due diligence process and will want to be confident the business has a sound financial foundation.
  • Any legal issues the company or owners might face should be prepared for and resolved. Phase 1 investors will be quickly turned off if they see potential litigation in the future.
  • HR agreements should be concretely in place, particularly for high-value and executive-level employees. Part of the benefit to the buyer is the ongoing leadership from current executives.
  • Long-term and future customer agreements or distribution arrangements should be captured in contracts.
  • Intellectual property should be protected. This is important both to sellers, who should protect their IP investments prior to opening themselves up to potential investor review, and to buyers who want to be protected from unexpected peer competition.

Potential Risks

In addition to some of the risks referenced above, there are others to both business owners and investors when using the PE recapitalization strategy.

The greatest risk may be to company culture. Communication with executives and employees of the company before and after the initial sale, and in preparation for the second-phase sale, is critical. Without a focus on clear communication, breakdowns can easily occur. For example, owners/executives and investors should agree, before the initial deal closes, on how to reward loyal employees during the different phases and when and how that information will be shared with these individuals.

Another risk comes from the burden of reporting and explaining technical elements of a business. Some members of the investor group may have difficulty understanding complex regulatory, testing, or other scientific processes. Timing, of course, is a third major risk. Industry cycles and market fluctuations can rapidly change the environment of a sale. Investor risks include concerns about management motivation once an initial majority sale is completed. Investors may also focus attention on risks associated with the second-phase sale, including issues related to a sale to a third party or potential IPO.

Conclusion

The “two bites” M&A strategy is right for many businesses, particularly given the current environment, and there are many potential benefits to organizations and investors. Preparing for such a strategy requires considerable due diligence; thus, company executives should have a trusted team of advisors (accountants, attorneys, bankers, wealth managers, etc.) throughout the journey. This team of advisors can help ensure a smooth and expedited transition and beneficial outcome for all parties involved.

Consulting partner, Paul Edwards, was a contributor to this article.  

Categories: Finance