A leveraged recapitalization can be a creative way to obtain liquidity without selling your business. Leveraged recaps involve converting an owner’s or shareholder’s equity position to debt and then using the proceeds to purchase stock or pay a dividend. The M&A advisors at Doeren Mayhew explain.

How Does it Work?

Leveraged recaps can be structured in one of two ways:

1. Sell a significant portion of an owner’s equity (typically between 60 percent and 80 percent) in a business to a private equity group. The private equity group uses a combination of cash from its general investment fund and bank debt to finance the transaction.
2. Company shareholders borrow money — typically from a bank — and use the proceeds to purchase the selling owner’s or shareholder’s stock, or to pay an extraordinary dividend to shareholders. In either case, existing shareholders realize liquidity from their stock holdings while retaining a meaningful equity position in the company. This means they may have additional opportunities to sell company stock or earn dividends in the future.

As with any major transaction, several critical ingredients make a leveraged recap successful. M&A advisors will tell you a company should have a strong management team willing to invest significant equity in the business and, if necessary, to personally guarantee bank debt. The business should also boast a history of profitability, realistic growth opportunities, predictable cash flows, an underleveraged balance sheet and adequate collateral.

What Are the Benefits?

Our M&A advisors note that the main advantage of leveraged recaps is that they can help you achieve diversification by liquefying a portion of your otherwise illiquid equity, allowing you to pursue other investment opportunities. Yet by retaining an ownership position, you can still provide continuity for your family business, preserve its culture and protect the jobs of valued employees. This type of financing can also be used to:

• Transfer a family business from one generation to the next while providing the funds necessary to cover tax liabilities.
• Generate liquidity for meeting capital expenditure requirements and foster growth.
• Buy out select shareholders.

The potential to sell remaining shares at some point in the future, combined with the dividend paid at the time of the leveraged recap, can actually make a business more valuable than if you had sold it outright. Furthermore, a leveraged recap enables you to offer ownership opportunities to your management team and enjoy watching the company reach its full potential.

What Are the Pitfalls?

Before you pursue a leveraged recap, however, you should realize that these deals can potentially hurt your company. While each deal is different, businesses using this form of financing become more highly leveraged. This means that even relatively low-risk companies can become higher risk overnight. What’s more, management is generally personally responsible for repaying any senior debt. And owners hoping to raise cash should realize that, with a leveraged recap, they won’t necessarily receive all of the proceeds in that form. There are also special concerns for companies partnering with a private equity group. Private equity groups typically expect to generate an internal rate of return of 25 percent on their investment, and their time horizon is relatively short — between five and seven years.

Is Now the Time?

Following some weakness in the early part of this decade, private equity group and lending activity is picking up. Now is a relatively good time, therefore, to pursue a leveraged recap deal. Owners considering this option, however, must be committed to the business following the transaction (especially when the business is facing a crisis, or during economic or market-related downturns). Otherwise, new investors may shy away, fearing that existing shareholders no longer have an incentive to create long-term shareholder value. With one of the nation’s top investment banks in-house, Doeren Mayhew’s M&A advisors guide business owners through the buy and sell processes, from determining value and identifying key value drivers, to negotiating with buyers and maximizing sale price, all while maintaining a keen eye on tax, family and estate issues. For more information, contact an M&A advisor in Michigan, Houston or Ft. Lauderdale.