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Two Bites at the Apple - A Liquidity Strategy for Closely-Held Businesses

Robert W. Benjamin

In view of recent activities in our capital markets practice, conditions appear favorable for using a combination of a private equity investment with a leveraged recapitalization to offer cash liquidity to founders or controlling equity holders in closely held companies. The pricing and level of interest in a recent leveraged recapitalization led by private equity funds indicates a strong market for this type financing transaction given the right business with experienced management and a team of professionals working together. Given the right circumstances, as discussed in this article, this approach offers a viable way to secure outside capital, retain operating control, and diversify founders’ or equity holders’ financial exposure. 

Current Market Conditions 
In August, Williams Parker acted as counsel for a client company in one of the largest private equity transactions on record involving a Sarasota based company. The client company utilized this leveraged recapitalization technique, resulting in a post sale valuation in excess of 5.8 times trailing 12 months earnings before interest, taxes, depreciation and amortization (EBITDA). The founding equity holders received slightly more than five times their original investment and retained equity of 49.5 percent of the client company going forward. Evidencing the availability of private equity funding for transactions of this type is the fact that the private equity consultant in this case was successful in obtaining two acceptable term sheets from private equity funds, with two other funds expressing strong interest but not willing to issue term sheets in the face of the outstanding bids already received by the company. The two term sheets were obtained within 60 days of completion of the client company presentations. 

How It Works 
A private equity led leveraged recapitalization involves a successful operating business and its founding or controlling equity holders, a private equity fund and a bank or a second private equity fund specializing in mezzanine lending. In its simplest form, a private equity fund purchases a new class of preferred equity from the target company. The amount of equity is negotiable, but will, in almost all cases, be sufficient to give the private equity investors ultimate voting control. The investment is priced at a multiple of trailing 12 months EBITDA. Concurrently with this equity purchase, the target company borrows funds with a 5-10 year maturity from a bank or mezzanine fund equal to a multiple of the target company’s trailing 12 months EBITDA. The target company then redeems equity from existing holders in exchange for the purchase price received from the private equity fund. The target company retains sufficient cash for normal operating needs and expanded growth. The balance of its cash, including the borrowed funds is distributed to the existing equity holders. Usually, existing management is retained on multiyear contracts (with significant non-competition arrangements) with some form of future equity incentives. Unlike a purchase by a competitor, most private equity funds do not have reserve management personnel to interject into a target company and prefer to leave existing management in place. This form of leveraged recapitalization affords the existing equity holders an opportunity to sell a portion of their appreciated investment and retain a significant amount of the equity in the target company to share in future company growth. 

The Main Ingredients 
The most important ingredient for this type of transaction is a successful, well-run business with growing EBITDA. A good management team needs to be in place, willing to carry forward with a new controlling equity holder. The business should have a strong balance sheet, with little or no long-term debt. Any long-term debt that does exist would be refinanced as part of the mezzanine financing. It is most helpful if the business has financial statements audited by independent certified public accountants. 

Another key component of a successful private equity led leveraged recapitalization is retention of a qualified financial advisor with expertise in private equity transactions. The financial advisor consults with the target company on the feasibility of attracting private equity investment, prepares its financial and business presentations for a capital raise, identifies and contacts the most compatible private equity funds and mezzanine lenders. The target company will also require counsel with sufficient business, security and tax experience to negotiate the extensive and complex legal documents covering a purchase of the preferred equity by a private equity fund, a recapitalization of the company, a partial redemption of the existing equity holders and a significant loan transaction with a mezzanine lender. 

For further information on this type of transaction, please contact Robert “Doc” Benjamin directly at (941) 329-6615 or rbenjamin@williamsparker.com.
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