Planning business succession with a leveraged recapitalization
With the rise in valuations of many middle-market companies in recent years, owners of privately held businesses are once again confronting the decision of whether or not to sell. Owners who are not ready to retire completely but want to unlock the value of the equity they’ve built in their business have alternatives. One option is to transition ownership of the business to a partner or family member. For these owners, a leveraged recapitalization can be a valuable financial tool for succession planning. The desire to retain ownership of a business has been supported by a rising incidence of formal business succession planning by owners and their companies to guide the transition of ownership from one generation to the next. Leveraged recapitalization can be an important financial tool in business succession plans. This involves reconfiguration of a company’s capital structure consistent with the plans and goals of both the owners and the company. It enables business owners to gain some liquidity for their investment, retain a significant ownership (and thereby participate in the company’s upside potential) and continue to operate the business with considerable autonomy. A leveraged recapitalization can take the form of a buyout of other owners or the payment of a one-time distribution to provide diversity and/or liquidity for their estates. In some cases, the need for a leveraged recapitalization of the business can be precipitated by a fundamental disagreement among the owners of a business regarding its future or the desire of one of the owners to pursue interests outside the business. Outside investors Regardless of the circumstances for a recapitalization, a proper capital structure for the transaction is critical. At times, there is a desire by owners to structure a recapitalization to gain liquidity while minimizing or eliminating any loss of equity. While an all-senior debt recapitalization may be feasible in some cases, it is critical to ensure that the post-recapitalization capital structure leaves the company in a financial position to conduct its operations with a satisfactory margin for error. From a senior lender’s perspective, the decisions involved in determining the amount of senior debt that can be provided are similar to any other leveraged transaction. An extremely important concern for the lender is ensuring that the owners have a sufficient level of commitment to the business following a recapitalization. If the owners are being paid a substantial distribution as part of the recapitalization, a key question for the lender or junior capital investor is whether the owners have a sufficient continued economic need for the business to move forward. This is particularly critical if the business runs into difficulty and the owner’s attention is needed. If there is no outside capital investor in the transaction, or if the business owner’s commitment is questionable because of the magnitude of the proposed distribution, the senior lender may reduce the amount of senior debt it will provide and/or seek some form of support from the business owner, such as a personal guaranty. In some cases, in order to support the liquidity and growth needs of the business and to complete the recapitalization, it may be necessary to bring in an outside financial partner. If additional capital beyond senior debt is needed, there is a significant amount available in today’s market to round out the company’s capital structure. Because of the large amount of buyout funds raised in recent years, the competition for quality companies has increased significantly. A number of mezzanine and equity investors have decided to pursue investments in leveraged recapitalizations and growth situations to seek more reasonable leverage and investment return opportunities. These investors are generally looking for companies with above-average revenue and earnings growth, a significant market share or niche position, experienced management teams and excellent historical and projected performance. While some players will accept a minority position in a company, most of them will allow the owner to maintain day-to-day operating control. However, the private equity sponsor may insist on having voting control or shareholder agreements that enable them to take control of the company in a deteriorating situation. Debt considerations From the perspective of a borrower, there couldn’t be a better time to be in the market for capital. For senior debt, covenants have loosened, maturities have increased and lenders are competing on price. A number of trends have emerged in this credit cycle, including the migration of larger and better quality borrowers to asset-based structures and a growing use of second lien debt in lieu of traditional mezzanine financing. The net result for middle-market borrowers is a wider array of financing alternatives and the ability to create an optimal, total capital structure. While asset-based lending can require more reporting and monitoring, many companies have embraced asset-based lending as a long-term financing solution for their company because of competitive pricing, flexibility and covenant-light structures. Borrowers are often happy to avoid quarter-to-quarter covenant anxiety. This is particularly important for a company that is undergoing a recapitalization and taking on additional leverage. In addition, because of the underlying asset coverage, it may be possible to structure the leveraged recapitalization with an initial distribution to the shareholders as well as a percentage of excess cash flow on an annual basis thereafter that will maximize the cash flow to the owners. A leveraged recapitalization can be a powerful financing tool that can assist companies and their owners in meeting their business objectives. Following a leveraged recapitalization, company management tends to become more focused on the efficiency and effectiveness of its operations, resulting in improved operating performance and working capital management. Today’s market offers an ample supply of capital to consummate transactions, but it is important to select the right financial partners and the appropriate capital structure for the long term. Ira Kreft is executive vice president, group manager of Bank of America Business Capital.