For business owners seeking an opportunity to convert a portion of the accumulated equity in their companies to cash, a leveraged recapitalization, or recap, may be a creative way to obtain liquidity without selling the company. Leveraged recaps involve converting an owner’s equity position to debt and then using the proceeds to purchase the shareholder’s stock or pay a dividend.
A recap offers business owners an opportunity to satisfy two often conflicting objectives: the need for capital to fund continued expansion, and a reduction in the business owner’s personal risk. A recap may also be used to transfer a family business from one generation to the next while providing the funds necessary to cover tax liabilities.
Basically, leveraged recaps can be structured in one of two ways:
- Shareholders sell a significant portion (typically 60 to 80 percent) of their ownership in the business to a private equity investor group, which then uses a combination of cash and bank debt to fund the transaction.
- Company shareholders borrow money and use the proceeds to purchase the selling shareholder’s or owner’s stock, or to pay an extraordinary dividend to shareholders.
There are certain key attributes that make a company attractive for a leveraged recap, including:
- A strong management team
- A history of growth and profitability
- Realistic growth potential
- A defensible market position
- Predictable cash flows
- Minimal or no debt on the balance sheet
- A viable exit strategy
When a private equity group is involved, the valuations for leveraged recaps are heavily influenced by the availability of debt financing (senior and mezzanine), the future growth potential of the company, and the likely strategy for exiting the investment in five to seven years. Private equity groups may expect to earn an internal rate of return of 25 percent or more on their investment. Business owners should also remember that such a recap strategy entails establishing a long-term business relationship with an equity investor, where attendant issues of personality, control, governance, and exit strategy come into play. Therefore, a compatible philosophical fit among shareholders, management, and the equity investors is critical.
Unlike an outright sale of the business, a leveraged recap enables the selling shareholders to maintain a meaningful equity position in the business (typically 20 to 40 percent) and often continue to manage the business. While a leveraged recap may not be suited for every business, if the circumstances are right, it may provide an opportunity for the owner to take some chips off the table, but still remain in the game. It is worth considering as an alternative for unlocking illiquid wealth in a private company.
Mark G. Metzler can be reached at Email or 215.441.4600.