Privately-held companies face unique challenges in terms of raising capital. When they have a need for cash to grow their business, it can be difficult to raise the capital without giving up control over operations.
As a solution to that quandary, privately-held companies can seek to access capital by selling a minority equity stake to an outside investor, which allows them to maintain majority ownership of their business.
The need for this type of equity financing may arise in a variety of situations, including (but is not limited to) the following:
- The desire to raise capital to grow the business—either to expand into new geographies, buy equipment, launch new products or services, or to conduct M&A;
- The need to finance the buy-out of certain existing equity holders;
- Restructuring the company’s balance sheet to reduce financial leverage or improve its liquidity position; or
- Providing liquidity to existing shareholders for estate planning or other reasons
According to Rob Tyndall, Managing Director with Fifth Third Securities, “A recapitalization is often a mission critical catalyst that accelerates company success and speeds achievement of owners’ goals. But it is not one-size fits all. Company leaders need to make thoughtful, informed decisions, especially in this environment of greater uncertainty.”
Minority recaps can be complex structures, or they can be relatively simple sales of a minority equity stake. The central objective of these deals is to address any capital needs identified by the company while also optimizing the capital structure itself and its cost.
The key concern involves the leverage of the company following the transaction: existing equity holders will want to minimize the sale of equity—it is a more expensive form of finance than debt—but without incurring so much debt that it makes the company less financially able to react to downturns. A highly leveraged company might also see its debt financing costs increase as creditors see it as a riskier proposition.
Successful minority recaps balance the desire to minimize dilution of equity ownership through the use of senior, subordinated and mezzanine debt structures with creating a robust balance sheet that can withstand the financial stresses of a full business cycle.
Equity owners wary of dilution from minority recaps can also consider the flexibility that junior capital and new equity offer shareholders and operators. A prudent mix of debt and minority equity in a recap has the potential to complement the company’s growth objectives, boost the tax efficiency of the company, and, ultimately, enhance return on equity.
The sale of minority equity stakes can also bring new partners to provide strategic expertise for the next phase of the company’s growth. This benefit cannot be understated as many private equity firms (PE firms) can bring significant resources to bear for the companies in which they invest both from an operational efficiency standpoint (sharing best practices or vendor access from across their portfolio of investments) and in supporting strategic growth through M&A (helping to identify, analyze, and execute acquisitions).
The need to optimize balance sheets means that, by definition, minority recaps are very tailored transactions and vary depending on the company’s specific characteristics and strategic goals. Typically, these transactions consider the full balance sheet including senior debt and junior or mezzanine debt, if applicable. Today, convertible equity structures are popular, for public companies in particular, as they provide equity participation if the company performs as expected but protects in a downside scenario by providing the investor with liquidity preference if needed.
A central part of optimizing the efficiency of the new capital structure can simply be consolidating existing debt structures and making sure the cost of this funding is minimized. Lenders can lower the cost of funding to companies by offering a suitable mix of asset-based credit, collateralized by company assets such as receivables and equipment, and cash-flow based term loans based upon historical and expected company cash flows.
Junior or Mezzanine Debt
The creation of a new debt and equity structure, which incorporates junior or “mezzanine” capital, can also be used to fulfill the desired capital requirements to deliver the specific objective of the company.
A company whose goal is to use cash flow to invest or to pay off existing debt may want to consider junior capital financing because this structure tends to be longer-term and doesn’t amortize. These characteristics may increase cash flow available for operations and investment during the term of the junior capital.
Additionally, junior capital investors tend to be more flexible and tailor their investments to a company's particular financial situation and objectives. Unlike senior lenders, junior capital investors are focused on both the credit worthiness of a borrower as well as the overall value of the enterprise, which allows them to be more flexible on coupon structure, tenor and terms. However, this flexibility for the borrower comes at a cost. Junior debt is more expensive than senior debt, given that it is subordinate to senior debt in the case of corporate insolvency and therefore higher risk in a downside scenario.
While equity grows organically within a business and reflected on the balance sheet, it is an accounting measure and not necessarily a true measure of a company’s “market” equity value. The ability to bring in “fresh” equity from an outside investor can be an attractive avenue to access additional capital, reset a company’s balance sheet and establish the market value of the company at that time. Raising equity or equity-like capital is an expensive financing alternative—with ownership dilution and potentially preferred dividends as the price.
Many PE firms see the current market as an opportunity to put large amounts of cash to work. However, whatever the market dynamics, it is always the case that PE investors are notoriously price-sensitive, as a key component to their investment models relies on entry pricing. The counterpoint to this is the historically significant amount of capital PE firms have available to invest—they cannot afford to not invest and have thus become more flexible on their investment structures and return requirements.
For example, historically, most PE firms typically pursued only controlling investments, but today more PE firms are looking to minority investments in an effort to differentiate themselves as these firms compete for new deals.
According to Jeff Thieman, Managing Director and Head of Financial Sponsors Group with Fifth Third Securities, “Private equity funds are more eager than ever to invest in good companies. Investors are more flexible than ever to offer tailored capital structures adapted for a post-pandemic environment. This includes a greater focus on minority investments that are less dilutive to existing shareholders.”
The Key: A Consistent Approach
While every deal is very different, companies should look for financial advisors that take a consistent approach to every transaction by focusing on the enduring relationships that the bank has developed with both corporates and—specifically within the area of minority recaps—with PE firms.
Minority recaps require expertise, flexibility and speed. All parties need to work quickly to tailor and execute on the minority recap so the company can quickly refocus on delivering on its business strategy for the benefit of its newly-structured shareholder base.
“A successful capital raise process is often guided by a trusted investment bank, who provides professional advice, market-based feedback, and effective execution resources. This results in a capital structure that is optimized for business performance and needs of shareholders,” said Tyndall.
Contact your Fifth Third Bank Relationship Manager, or Rob Tyndall (Robert.Tyndall@53.com) or Jeff Thieman (Jeff.Thieman@53.com) with Fifth Third Securities to help identify the best recapitalization solution for you.