The leveraged recapitalization Featured

6:44am EDT February 2, 2004
Business owners who are considering a sale to achieve liquidity often overlook a viable and potentially attractive transaction alternative -- the leveraged recapitalization or "recap."

Through a recap, sellers can monetize a portion of their investment now and reduce their risk profile, while maintaining an ownership stake in the business and the opportunity to receive another -- and potentially even higher -- payoff down the road.

In a recap, the seller hires an investment banker to raise new debt and equity securities to finance a sale of a portion of the business (generally 30 percent to 80 percent), resulting in a cash distribution to the selling shareholders.

Recaps are appropriate for business owners who are bullish on the future value of their businesses, but may, for any number of reasons, desire some near-term liquidity. In this case, sellers may achieve substantial liquidity today, but retain equity that will be monetized in three to seven years when the financial sponsor leading the recap sells its position.

The combined proceeds realized by the sellers in the recap and subsequent sale often can exceed the value that would be realized in a full sale of the business through an auction today.

Recaps also can be used to create a "floor price" in an auction setting. If a full auction process fails to yield a price in excess of the expected value of a recap (a value that can be conveyed to auction participants at the outset of the process), the auction can be cancelled and a recap pursued.

Several market trends favorable to recaps will persist throughout 2004. First, strategic acquirers continue to focus on asset divestitures and internal profit improvement opportunities rather than on acquisitions to drive earnings.

Second, domestic institutional equity funds have billions of dollars in capital, causing them to pursue investment opportunities aggressively. Finally, credit markets eased substantially over the last six months of 2003, permitting the use of substantial leverage to finance a recap.

In short, strategic acquirers are not paying up, and the private debt and equity markets currently make recaps financeable at high valuations.

Structuring recaps

When structuring a recap, sellers and their advisers need to address three key issues:

* An acceptable and achievable valuation for the business

* An appropriate and achievable capital structure for the business

* The selling shareholders' desired ownership retention

For example, consider a company with greater than 10 percent revenue growth, high operating margins, a defensible market position in a strong industry, a leverageable balance sheet, manageable capital expenditures and working capital, and greater than $10 million of annual EBITDA. As illustrated, with a moderately leveraged capital structure, this company could pursue a recap at approximately seven times its EBITDA, or $70 million.

This valuation may exceed what a strategic acquirer is willing to pay and, at a minimum, this valuation should set the floor for an auction.

Assuming the business were debt-free at the time of the recap, the seller would receive a pre-tax cash distribution of nearly $62 million ($70 million less the $8 million reinvestment) and still own 30 percent of the company. In addition to the large cash distribution at close, the selling shareholder's retained ownership could be worth an additional $20 million upon exit in year five.

As business owners consider exits during 2004, the expected value of a recap should always be analyzed by sellers and their advisers. Depending on the sellers' need for liquidity and their desired ownership retention, an auction sale to strategic acquirers may still be preferable, but the expected value of the recap should represent the minimum acceptable bid in the process.

Steve Miles is a director at Brown, Gibbons & Co. mergers & acquisitions and corporate restructuring practices. Reach him at (312) 658-1600 or smiles@bglco.com.