Each quarter Meridian Capital publishes its Middle Market M&A Snapshot that focuses on key trends in Middle Market M&A. The Q3 2015 Newsletter addresses new developments in the debt and equity markets and discusses the merits of a minority recapitalization.
In 2015, private equity firms, strategics, and subordinated debt lenders continue to have significant un-invested capital that they wish to deploy. Given the competitive marketplace, equity and debt investors have increased their appetites for “alternatives investments”. The favorable market dynamics have driven an upswing in M&A activity and are providing business owners with attractive alternative liquidity options. In the right situation, a minority recapitalization can be a powerful tool for shareholders to benefit from strong valuations, readjust the capitalization table, and provide capital for further growth.
Minority Recapitalizations Can Be A Powerful Tool For Shareholders
Macroeconomic Trends and Monetary Policy
In the first half of 2015, the major domestic economic indicators – inflation, unemployment, consumer spending, and the price of oil – all moved in a positive direction. Economists are projecting accelerated domestic GDP growth of 2-3% for both 2015 and 2016. However, the global economy remains lackluster with central banks outside of the United States responding with a massive use of quantitative easing, leading international interest rates to plummet. In Europe, the possibility of Greece exiting the eurozone has caused yields on many sovereign bonds with a 9-year or shorter duration to turn negative for the first time. The low interest rate environment continues to encourage investors who are seeking yield to move up the risk curve and target alternative investment assets.
More Flexibility, More Leverage, More Options
Investors are piling into high yield bonds, leveraged loans, second lien, and mezzanine debt causing yields on those assets to drop. The competitive dynamics favor borrowers who are now able to obtain financing at lower rates with more friendly terms, increased leverage, and less stringent covenants. The capital markets have been buoyed by BDCs, CLOs, and traditional institutional investors’ increased appetite for leveraged loans and their desire to move down the capital stack to find higher yielding assets.
Simultaneously, private equity firms are facing an increasingly competitive marketplace and, at times, are challenged to find quality investments to deploy capital. Private equity firms are turning to creative deal structures and are increasingly receptive to minority investments in quality companies. The current market dynamics present an attractive opportunity for entrepreneurs who are seeking near-term liquidity without sacrificing majority control or future equity upside.
The Nuts & Bolts of Minority Recapitalizations
In minority recapitalizations, a business owner converts a portion of the company’s equity into liquidity for shareholders or growth capital while continuing to maintain a majority ownership position. The company raises debt typically with the support of a private equity or subordinated debt sponsor eliminating the requirement that the business owner personally guarantee the financing. The debt and equity proceeds are used to purchase shares from the existing shareholders at a market valuation. The resulting capital structure leaves the existing shareholder with a controlling interest in the business. An example is shown below.
The key benefits of a minority recapitalization include: (i) increased access to capital to support growth, (ii) increased ability for shareholders to diversify wealth, (iii) likely removal of personal guarantee on debt, (iv) ability to take chips off of the table at a strong market valuation, (v) alignment of personal and business risk tolerance, (vi) access to operational experience.
Maintaining Control and Liquidity
A minority recapitalization is a great solution for business owners who want to diversify and de-risk their portfolios by taking chips off the table while retaining equity and allowing the potential for a “second bite of the apple” during a future M&A event.
It can also be employed by shareholder groups who have diverging short and long term interests. For example, a minority recap can provide one shareholder with liquidity at a market price while the remaining shareholders maintain, or even increase, their equity position. This can be particularly beneficial for buyouts of inactive shareholders or for management buyouts. Meridian Capital can help determine if a minority recapitalization is the right structure for your situation and, if so, help facilitate the transaction.
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