What Credit Crunch? Recaps Give Business Owners Another Option
by Franz von Bradsky
The credit crunch that has frozen credit markets has turned what was a seller’s market for privately owned “middle market” companies a year ago into a buyer’s market, resulting in a severe reduction in the number of merger and acquisition transactions.
With thousands of baby boomer business owners across the nation wanting to exit their businesses over the next few years, it will only serve to exacerbate the problem.
The crisis of confidence gripping the financial markets makes a leveraged recapitalization transaction — generally referred to as a recap in industry parlance — one of few viable options baby boomer business owners have during these troubling times to effect a timely business transition at a reasonable valuation.
Business owners who want to effect a business transition find themselves with few choices: wait until the financial markets recover, accept a valuation significantly less than a year ago, or find another solution like a recap to gain liquidity from the asset that very often represents the majority of their net worth.
Since waiting may not be a viable option for many, and accepting a lower valuation is not likely to be of great interest, a recap is something to consider carefully. A recap results in a restructuring of a company’s balance sheet. Generally, the company takes on significant additional debt with the purpose of either paying a large dividend or repurchasing shares from the owner, resulting in a highly leveraged company.
Usually, a recap has a private equity group as a sponsor, though often the transaction is done directly with a mezzanine lender.
In addition to providing the bulk of the equity needed to consummate the transaction, the sponsor will arrange new senior bank debt and possibly mezzanine/subordinated debt. The end result is that an owner’s stock will have been exchanged for cash and a portion of the capital stock of the newly capitalized entity.
A recap can be very attractive for owners of businesses with favorable prospects who want to retain an ownership interest. A recap provides an owner with the opportunity to receive another payoff in the future when the sponsor exits the investment. Proceeds from the recap and subsequent sale can often exceed the value obtained through an outright sale.
In addition to obtaining substantial liquidity, business owners continue to operate the business with considerable autonomy while gaining access to capital needed to support future growth. Today, many sponsors will even accept minority ownership positions.
Most investment firms seek established companies with consistent growth in revenue and earnings, a significant market share or niche position, experienced management, and projected operating results that meet or exceed historical results.
Having the owner-operator as a partner whose interests are now aligned with theirs provides investment firms with another level of comfort when entering into a transaction.
If all goes well and the company continues to grow as projected to the investment firm, the equity stake retained by the owner could be worth from 25 percent to 50 percent of the initial payment the owner received upon the sale of the company at the end of that period, usually three to five years.
The foregoing assumes that stability will have returned to the financial markets. As we all know, it took the financial markets four or five years to recover from the savings and loan crisis of the early 1990s.
A leveraged recap is not suitable for every company. Ultimately, a sale to a strategic acquirer may be the preferable option. However, given the turmoil in virtually every sector of the financial markets — which is not likely to abate quickly — a leveraged recap may be a viable option to consider for those wishing to transition sooner versus later.
Franz von Bradsky is president of Green Tree Capital. Franz can be reached at MandA@greentreecapital.com or 360.510.3490. The article was originally published on April 25, 2008 in the Puget Sound Business Journal.
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