Coming Back To Earth

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

________________________________________________

The glow has begun to abate and I am back in the loving embrace of my immediate nuclear family again.

And away from that drunken sot of a brother of . Away from his fistful of aluminum bottles and his near-magical affinity for attracting state troopers at the exact wrong time.

It was great to check the Superbowl box off the bucket list, however, especially given the “down to the wire” exigency of the finale, though I think my stomach could cope better with a blowout (on either team’s part).  It was also excellent to do it with family, too… with a guy I’d been going to Giant games with since we were little kids.  I’m only disappointed that babies kept two brothers away and Vegas the third, because I think Dad would have liked all of us to be together in these seats I found.  Seats that were so eerily close to where we all used to sit in the old stadium… where Dad used to sit.

I had a hellacious day at work today because I’ve really got no time to be taking even weekends off, never mind the odd Superbowl Monday I used for travel and “recovery” yesterday.  But things are hopping right now, thanks to this current odd mixture of liquidity and nervousness.   A lot of shareholders are taking the money and running these days, deciding discretion is the better part of valor.

But Ben keeps the presses moist and full of fresh green paper, because after all this is an Election Year.  And a year when the Giants are Superbowl Champs.

It’s only February, but this really is shaping up to be a magical year already, no?

______________________

No position changes today.  I might even add tomorrow if the dollar continues to break down, however.  My March Madness pick is the previously mentioned AUX gold stock, btw.  I hope you will join The PPT to participate.

My best to you all, and thanks for your patience and indulgence.

On The Important Matter of Equity Recapitalizations

(Not to be boring, but I figured I’d repost this with the second chart included, showing the exit values)____________________________________________________________________________________

I figured I’d take an excursion outside the normal realm of stock advice to discuss a subject in a less liquid arena – that of private, closely held company mergers and acquisitions.  While publicly traded company M&A is certainly a key component in our every day trading analysis, many of you may not realize that the vast bulk of M&A transactions take place every day in what is generically called “the middle market” of smaller, private companies that comprise the backbone of our economy.  Increasingly, middle market entrepreneurs are discovering that the equity recapitalization is a great way to achieve liquidity without completely stepping away from the business they love. 

 

Demographics are driving much of the M&A market today, with many baby boomers entering what we in the business call “the gray zone” of their careers, typically beginning in their early fifties.  Most successful entrepreneurs have put their very lives into their businesses – working sometimes seven days a week and very long hours for a period of twenty five to thirty years to build them.   By their early fifties many owners come to the realization that a) they are vesting the majority of their net worth in a single, illiquid concentrated asset and b) they are not going to live forever.   Therefore, a combination of conservatism and a desire for estate planning will drive even the most dedicated of entrepreneurs to contemplate liquidity through sale of his/her company. 

 

In the past, when an owner chose to sell his company, the universe of buyers was largely restricted to “strategic acquirors” — a euphemism for his direct or indirect competitors.   Today, thanks to the success of pioneers in the world of financial purchasers like Henry Kravis of KKR and Ted Forstmann of Forstmann Little, “the financial buyer” alternative has become a driving force in the world of private M&A.  My colleagues and I have estimated there are now as many as 5,000 private equity vehicles extant, in the form of specific venture and private equity funds, family offices, special purpose pools, and even “one off” executives-for-hire.   Thanks to this well developed private capital market, equity recapitalizations have replaced 100% buyouts as the most attractive alternative to the liquidity seeking entrepreneur. 

 

The equity recapitalization is attractive because it allows the entrepreneur to take a large amount of his equity risk off the table, while retaining a material part of his company as an investment going forward.   This alternative is naturally most attractive to those owners who seek to stay with their company for some period after a liquidity transaction.   Because private equity capital usually requires that an acquisition’s management team be retained (as they do not, as a rule, like to operate their portfolio companies), this form of transaction is among their most desired as well.   Not only do they retain the management that has created the company and made it so attractive to purchase, but they keep management incented via the shared risk of a continuing equity investment. 

 

Let me lay it out in a simple example (see below).    An entrepreneur seeks to sell his company, and through a negotiated auction process (JakeGint assisted, one hopes) arrives at an agreed upon purchase price with a private equity firm of his choosing.    On the day of close, the assets of the company are sold to a “Newco” structure established by the private equity firm for $100 million.  Newco will then be “recapitalized” with a new balance sheet that will be leveraged according to the agreed upon comfort of both parties.  In my example, I use a 40% equity and 60% debt structure (this ratio will vary according to the riskiness of the company, it’s history, prospects, and the state of the debt markets).     

 

As the debt will be funded by the private equity providers’ partners (usually a combination of bank and/or mezzanine funds), only the 40% — or $40 million—in equity is required to complete this financing.   In my example I posit that the selling owners will wish to retain 30% of the company going forward.  They must therefore take from their selling proceeds ($100mm after tax) 30% of $40 mm, or $12 million to fund their retained equity in the company.    Even after taxes, they have reduced their net worth exposure to around 20% of the ongoing company, while retaining 30% and a partner who will most likely seek to maximize that asset through additional acquisitions, growth, etc.  

 

Recapitalization Illustration

 

(dollars in millions)

 

 

 

 

 

(Assumption: Company sold for 5x Cash flow of $20 mm)

 

 

 

 

 

 

 

 

Equity

Debt

Original Company Sale Price

 $   100.0

 $ 100.0

 $           -  

Capital Gains Taxes

        20.0

 

 

Net to Owners

 $   80.00

 

 

 

 

 

 

 

 

 

 

Equity

Debt

Newco Recapitalization

 $ 100.00

 $   40.0

 $        60.0

Equity Group Investment

70%

      28.0

 

Selling Owner’s Invesment

30%

      12.0

 

 

 

 

 

 

Selling owner’s Net Gain

 $     68.0

 

 

 

 

 

 

 

             

This method not only allows our entrepreneur to continue with his company, along with an equity (and board) interest in the enterprise, but it also allows the selling owner to take what is in effect “a second bite at the apple.”   This is because within three to seven years (typically) that private equity firm will be seeking to either “recap” company again (via debt incursion and dividend to equity holders), or to sell out to a strategic or financial buyer completely.   Keep in mind that if all the company does is pay down the debt incurred before selling itself again and sells at the same price as “the first bite,” the owners will have nearly tripled their original investment ($12mm becomes $30mm).   If the company manages to grow organically in that period, more is the better (again see the examples given of exit prices and IRR’s).  

“Second Bite”  Closing Sale Illustration

 

 

 

 

 

 

 

 

(Assumption: Company sells again for 5x cash flow)

 

 

 

 

 

 

 

Scenario 1:

Cash flow constant, Debt paid off in year 5

 

 

 

 

 

 

 

Year 5 CF

 $     20.0

 

Proceeds to:

 

CF Mult

          5.0

x

PE firm

Owners

 

Sale price

 $   100.0

 

 $      70.0

 $     30.0

 

5 Year IRR

 

 

20.1%

20.1%

 

 

 

 

 

 

 

Scenario 2:

Cash flow increases 5% per year,  Debt paid off in year 5

 

 

 

 

 

 

Year 5 CF

 $     25.5

 

Proceeds to:

 

CF Mult

          5.0

x

PE firm

Owners

 

Sale price

 $   127.6

 

 $      89.3

 $     38.3

 

5 Year IRR

 

 

26.1%

26.1%

 

 

 

 

 

 

 

Scenario 3:

CF increases 5% per year,  Debt paid off in year 5, 6x Mult.

 

 

 

 

 

 

Year 5 CF

 $     32.2

 

Proceeds to:

 

CF Mult

          6.0

x

PE firm

Owners

 

Sale price

 $   193.3

 

 $    135.3

 $     58.0

 

5 Year IRR

 

 

37.0%

37.0%

 

 

 

 

 

 

 

 

You can see, therefore, why a hard driving boomer who is perhaps not quite ready to lay down his hammer, but who is seeking the risk modification a certain amount of liquidity brings to one’s later years, might see the equity recapitalization as the perfect solution to his portfolio concerns.   From both an emotional and financial standpoint, it’s an excellent fit.

________________________________________________________________________________ 

 

 

 

Coming Back To Earth

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

________________________________________________

The glow has begun to abate and I am back in the loving embrace of my immediate nuclear family again.

And away from that drunken sot of a brother of . Away from his fistful of aluminum bottles and his near-magical affinity for attracting state troopers at the exact wrong time.

It was great to check the Superbowl box off the bucket list, however, especially given the “down to the wire” exigency of the finale, though I think my stomach could cope better with a blowout (on either team’s part).  It was also excellent to do it with family, too… with a guy I’d been going to Giant games with since we were little kids.  I’m only disappointed that babies kept two brothers away and Vegas the third, because I think Dad would have liked all of us to be together in these seats I found.  Seats that were so eerily close to where we all used to sit in the old stadium… where Dad used to sit.

I had a hellacious day at work today because I’ve really got no time to be taking even weekends off, never mind the odd Superbowl Monday I used for travel and “recovery” yesterday.  But things are hopping right now, thanks to this current odd mixture of liquidity and nervousness.   A lot of shareholders are taking the money and running these days, deciding discretion is the better part of valor.

But Ben keeps the presses moist and full of fresh green paper, because after all this is an Election Year.  And a year when the Giants are Superbowl Champs.

It’s only February, but this really is shaping up to be a magical year already, no?

______________________

No position changes today.  I might even add tomorrow if the dollar continues to break down, however.  My March Madness pick is the previously mentioned AUX gold stock, btw.  I hope you will join The PPT to participate.

My best to you all, and thanks for your patience and indulgence.

On The Important Matter of Equity Recapitalizations

(Not to be boring, but I figured I’d repost this with the second chart included, showing the exit values)____________________________________________________________________________________

I figured I’d take an excursion outside the normal realm of stock advice to discuss a subject in a less liquid arena – that of private, closely held company mergers and acquisitions.  While publicly traded company M&A is certainly a key component in our every day trading analysis, many of you may not realize that the vast bulk of M&A transactions take place every day in what is generically called “the middle market” of smaller, private companies that comprise the backbone of our economy.  Increasingly, middle market entrepreneurs are discovering that the equity recapitalization is a great way to achieve liquidity without completely stepping away from the business they love. 

 

Demographics are driving much of the M&A market today, with many baby boomers entering what we in the business call “the gray zone” of their careers, typically beginning in their early fifties.  Most successful entrepreneurs have put their very lives into their businesses – working sometimes seven days a week and very long hours for a period of twenty five to thirty years to build them.   By their early fifties many owners come to the realization that a) they are vesting the majority of their net worth in a single, illiquid concentrated asset and b) they are not going to live forever.   Therefore, a combination of conservatism and a desire for estate planning will drive even the most dedicated of entrepreneurs to contemplate liquidity through sale of his/her company. 

 

In the past, when an owner chose to sell his company, the universe of buyers was largely restricted to “strategic acquirors” — a euphemism for his direct or indirect competitors.   Today, thanks to the success of pioneers in the world of financial purchasers like Henry Kravis of KKR and Ted Forstmann of Forstmann Little, “the financial buyer” alternative has become a driving force in the world of private M&A.  My colleagues and I have estimated there are now as many as 5,000 private equity vehicles extant, in the form of specific venture and private equity funds, family offices, special purpose pools, and even “one off” executives-for-hire.   Thanks to this well developed private capital market, equity recapitalizations have replaced 100% buyouts as the most attractive alternative to the liquidity seeking entrepreneur. 

 

The equity recapitalization is attractive because it allows the entrepreneur to take a large amount of his equity risk off the table, while retaining a material part of his company as an investment going forward.   This alternative is naturally most attractive to those owners who seek to stay with their company for some period after a liquidity transaction.   Because private equity capital usually requires that an acquisition’s management team be retained (as they do not, as a rule, like to operate their portfolio companies), this form of transaction is among their most desired as well.   Not only do they retain the management that has created the company and made it so attractive to purchase, but they keep management incented via the shared risk of a continuing equity investment. 

 

Let me lay it out in a simple example (see below).    An entrepreneur seeks to sell his company, and through a negotiated auction process (JakeGint assisted, one hopes) arrives at an agreed upon purchase price with a private equity firm of his choosing.    On the day of close, the assets of the company are sold to a “Newco” structure established by the private equity firm for $100 million.  Newco will then be “recapitalized” with a new balance sheet that will be leveraged according to the agreed upon comfort of both parties.  In my example, I use a 40% equity and 60% debt structure (this ratio will vary according to the riskiness of the company, it’s history, prospects, and the state of the debt markets).     

 

As the debt will be funded by the private equity providers’ partners (usually a combination of bank and/or mezzanine funds), only the 40% — or $40 million—in equity is required to complete this financing.   In my example I posit that the selling owners will wish to retain 30% of the company going forward.  They must therefore take from their selling proceeds ($100mm after tax) 30% of $40 mm, or $12 million to fund their retained equity in the company.    Even after taxes, they have reduced their net worth exposure to around 20% of the ongoing company, while retaining 30% and a partner who will most likely seek to maximize that asset through additional acquisitions, growth, etc.  

 

Recapitalization Illustration

 

(dollars in millions)

 

 

 

 

 

(Assumption: Company sold for 5x Cash flow of $20 mm)

 

 

 

 

 

 

 

 

Equity

Debt

Original Company Sale Price

 $   100.0

 $ 100.0

 $           -  

Capital Gains Taxes

        20.0

 

 

Net to Owners

 $   80.00

 

 

 

 

 

 

 

 

 

 

Equity

Debt

Newco Recapitalization

 $ 100.00

 $   40.0

 $        60.0

Equity Group Investment

70%

      28.0

 

Selling Owner’s Invesment

30%

      12.0

 

 

 

 

 

 

Selling owner’s Net Gain

 $     68.0

 

 

 

 

 

 

 

             

This method not only allows our entrepreneur to continue with his company, along with an equity (and board) interest in the enterprise, but it also allows the selling owner to take what is in effect “a second bite at the apple.”   This is because within three to seven years (typically) that private equity firm will be seeking to either “recap” company again (via debt incursion and dividend to equity holders), or to sell out to a strategic or financial buyer completely.   Keep in mind that if all the company does is pay down the debt incurred before selling itself again and sells at the same price as “the first bite,” the owners will have nearly tripled their original investment ($12mm becomes $30mm).   If the company manages to grow organically in that period, more is the better (again see the examples given of exit prices and IRR’s).  

“Second Bite”  Closing Sale Illustration

 

 

 

 

 

 

 

 

(Assumption: Company sells again for 5x cash flow)

 

 

 

 

 

 

 

Scenario 1:

Cash flow constant, Debt paid off in year 5

 

 

 

 

 

 

 

Year 5 CF

 $     20.0

 

Proceeds to:

 

CF Mult

          5.0

x

PE firm

Owners

 

Sale price

 $   100.0

 

 $      70.0

 $     30.0

 

5 Year IRR

 

 

20.1%

20.1%

 

 

 

 

 

 

 

Scenario 2:

Cash flow increases 5% per year,  Debt paid off in year 5

 

 

 

 

 

 

Year 5 CF

 $     25.5

 

Proceeds to:

 

CF Mult

          5.0

x

PE firm

Owners

 

Sale price

 $   127.6

 

 $      89.3

 $     38.3

 

5 Year IRR

 

 

26.1%

26.1%

 

 

 

 

 

 

 

Scenario 3:

CF increases 5% per year,  Debt paid off in year 5, 6x Mult.

 

 

 

 

 

 

Year 5 CF

 $     32.2

 

Proceeds to:

 

CF Mult

          6.0

x

PE firm

Owners

 

Sale price

 $   193.3

 

 $    135.3

 $     58.0

 

5 Year IRR

 

 

37.0%

37.0%

 

 

 

 

 

 

 

 

You can see, therefore, why a hard driving boomer who is perhaps not quite ready to lay down his hammer, but who is seeking the risk modification a certain amount of liquidity brings to one’s later years, might see the equity recapitalization as the perfect solution to his portfolio concerns.   From both an emotional and financial standpoint, it’s an excellent fit.

________________________________________________________________________________