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Diversifying Wealth While Retaining Independence
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Cronus Partners
Last issue’s column, “The Forces Behind Consolidation” (March/April issue of ODT), discussed the notion of financial buyers or private equity (PE) firms as an important dynamic in consolidating industries. This supply-side force would be idle, however, without the demand for recapitalizations as a means of satisfying owner objectives. Entrepreneurs can derive meaningful enjoyment and pride out of owning and controlling a business, yet most who founded and nurture a business are driven by a desire for substantial wealth. At some point, too much wealth can become tied up in the business. This often is realized when an abrupt health or other family issue occurs, personal interests change and/or estate planning underscores net worth concentration in a single, illiquid asset.
A recapitalization (ie, distribution of cash to shareholders through a refinancing) is an attractive option for owners seeking increased liquidity and risk diversification as well as preservation of many of the non-financial attributes of private ownership. The benefits can include the opportunity to receive as much as 90% of the company’s value in cash; retain a substantial equity position; retain operating autonomy; provide an orderly transition to the next generation of management; enjoy the tax benefits of the recapitalized entity; and tap into the resources and experience of a strong equity partner with whom to share the risks (and upside) in the future value of the company. Unlike a strategic sale, a recapitalization avoids disclosure of sensitive and confidential information to possible competitors, as well as potential employee concerns about a new employer.
The Characteristics of a Recapitalization
A recapitalization can be structured in many ways and should be tailored to meet specific shareholder objectives. It can range from the sale of a minority of shares for partial liquidity, to a full sale of all shares, to a mix that satisfies shareholders with divergent desires (eg, passive or family shareholders). Most PE firms prefer that those important to the business retain a meaningful amount of equity (often through a successor company newly formed for tax advantages). This demonstrates commitment and keeps interests aligned as equity partners. In conjunction with providing shareholder liquidity, add-itional capital can be infused to fund growth and initiatives to which current shareholders may have been hesitant to commit.
As simply illustrated in Table 1, the critical variables in a recapitalization are valuation and the amount and structure of the capital raised and the use of proceeds (distribution vs infusion). Debt financing alone can fund a recapitalization, but this often requires personal guarantees—thereby diluting one of the key incentives. When a PE firm backs the capital structure, the amount and terms of debt generally are far superior and exclude personal guarantees. Lever-age substantially increases the proceeds without further diluting equity. Many private business owners are debt averse; yet for an owner confident in the business’ growth, a prudently leveraged capital structure can maximize liquidity, minimize equity dilution and substantially increase return on re-tained equity and stock options. Part of the rationale behind a recapitalization is to have substantial protection against the disaster scenario in which the value of the business is severely impaired along with the owner’s net worth.
The Characters Behind a Recapitalization
Most recapitalizations are led by PE firms, which invest pools of privately raised capital (ie, funds). A PE firm is highly motivated to monitor, support and provide incentives to a company’s management in pursuit of maximizing value in its funds. Some PE firms have extensive contacts and deep industry experience across many similar companies and can provide a broad perspective to identify strategic opportunities. For example, Paragon Medical has closed eight strategic acquisitions after partnering with Seidler Equity and AIG Altaris. After partnering with Arsenal Capital, Leis Medical recently acquired MedicineLodge and then formed iMDs.
Notwithstanding, most PE firms confine their involvement to big-picture matters, leaving day-to-day operational decisions to management. Because it takes significant time and expense to identify and partner with an attractive company with solid management, most PE firms are not looking for a quick “flip” or near-term sell but would prefer its investment to generate a high return over a longer period. Usually, the PE firm and company management decide together on the ideal time and manner in which to maximize shareholder value, as their interests are closely aligned after a recapitalization.
For example, an IPO triggered the liquidity realization for Olympus Partners, which acquired a majority interest in Symmetry Medical in 2000 and then supported its major acquisition (Mettis) in 2003. KRG Capital liquidated its investment in consolidator Accellent through a recapitalization to a consortium of PE firms. Charter Oak exited Stealth Medical through a recapitalization sponsored by Churchill Capital. Churchill combined Stealth with Unique Instruments to form what is now Orchid Orthopedic Solutions, which subsequently made three strategic acquisitions.
A PE firm’s return on investment, however, is inversely related to its price of entry; thus, it will strive to secure the deal at the lowest price. Nevertheless, good PE firms value and safeguard their reputations, as success is short-lived if they are known to treat owners and management unfairly. Each PE firm has a unique approach, specific areas and industries of focus and expertise, and different investment criteria. Of the thousands of PE firms, perhaps only a few are ideally suited to a given business’ characteristics and shareholder objectives.
To optimize the terms of a recapitalization, an owner must be extremely well prepared and proactive rather than merely receptive and responsive. It is best to qualify carefully and negotiate with several PE firms at the culmination of a confidential, auction-like process involving only those firms suitable for the opportunity. Once the field has been winnowed and the negotiated terms are sufficiently similar, the final selection should be based on select qualitative attributes.
David Reilly is a managing director of Cronus Partners LLC, an investment banking firm that specializes in mergers and acquisitions, private placements and financial advisory services. He leads the firm’s healthcare practice and can be reached at (203) 642-0200 or DReilly@CronusPartners.com.
Author’s Note: Nothing contained in this article is to be considered the rendering of financial, investment or professional advice for specific circumstances. Readers are responsible for obtaining such advice from professional advisors and are encouraged to do so.
