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 single asset – the company. Since equity 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”) as a means to “take some chips off the table” while continuing to operate and control the business going forward. Conceptually, recaps encompass a whole range of possible financial alternatives, from a modest re-leveraging of the business to fund a one-time dividend (a so-called “dividend recap”) to the sale of a majority (but less than 100%) of the equity to an outside investor (a “majority recap”).
Dividend Recap – In this structure, the excess debt capacity of the business is used to fund a one-time cash 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 (typically 20 to 40 percent) to an 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 the sale of more than half the ownership (60 to 80 percent) 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 below. In the balance of this report, however we focus on the first of these transaction scenarios, the Dividend Recapitalization introduced above.
Dividend Recap: An Effective Tool for Estate Planning
Renewed interest on dividend recaps has emerged in recent years, driven by a confluence of economic forces including the formation of many new non-bank lending institutions, sluggish demand for new loans across corporate America, and historically 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.
Example of a Dividend Recapitalization
The following example illustrates the economics of a Dividend Recapitalization:
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 overall debt market and the 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 recapitalization. Through a competitive process targeting 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
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 soon retire, 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 is 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-levered 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:
Proper Planning is Critical
Every business owner has personal and business goals that are unique so it is important to work with experienced wealth, 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 suited for every business owner, if the 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 Headwaters MB has worked with numerous business owners over the years to recapitalize their businesses and structure dividend recapitalizations 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 then leverage our robust network of institutional lenders to secure the best financing package that is available from today’s market.
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.
As noted, the amount of the cash distribution that can be generated through recapitalizations is a direct function of both the underlying debt capacity of the business and the equity ownership position offered to the new investor.