A recapitalisation (recap) is one of many potential ways that a private equity firm can exit an investment (see this post for an overview of exit strategies). It involves a business borrowing money to fund a repurchase of equity from an investor that wants to exit. A recap is usually marketed as a way for an owner/manager to continue running the business if they do not want to sell when the private equity firm does.

There are a few points I’d like to make about recaps:

1. A recap is unlikely if the firm owns all/most of the business. If the investor owns most of the business, then it is unlikely the bank will lend enough to buy the entire equity stake. The only way this would work would be if the expected sale multiple was the same or lower than the lending multiple. That is, if the bank would lend 3x earnings and the investor only wanted 3x earnings for their stake. But, this would be highly unlikely.
2. A recap will rarely involve the natural buyer. The buyer in a recap is the business itself and one would imagine that the most natural buyer of a business wouldn’t be the business itself. The natural buyer is the buyer that can rationally pay the most for the business due to synergies, opportunities and other areas of value uplift. This is why sellers most commonly seek to sell to the most natural buyer, because in theory they can pay more.
3. A recap represents increased risks and costs. Even though we’ve learnt that capital structure shouldn’t influence our valuations, in reality, the remaining owners of a recapitalised business will incur increased risks and costs due to increased debt. This can only negatively affect the price a rational buyer is able to pay. The counter argument to this is that gearing also represents the potential for increased value creation, so in some ways it offsets risk, but in reality the risk is still there.

Overall, I’d say that a recap would represent a less than ideal outcome. It may be necessary when a private equity firm must exit, but it would rarely be the ideal plan prior to the initial investment. This is simply for the fact that a recap doesn’t represent the most natural buyer and hence it wouldn’t represent the highest possible price. For this reason, I would say that a recap isn’t a compelling exit strategy and is only a saving grace in unfavourable circumstances.

I hope I’ve mentioned it before… private equity is firstly about risk mitigation and secondly about earnings growth. This is why private equity firms rarely invest cash as ordinary equity; they want the extra protection that comes with preference equity. One of the most common points of contention though, is the use of coupons on preference equity (or interest payments on convertible notes). Vendors often feel that private equity firms shouldn’t get the benefits of a debt while enjoying the upside of equity.

Preference coupon payments mitigate risk by returning cash to the private equity investor sooner. The returned money can’t be lost and it is worth more than money returned at exit (time value of money). But, this is hardly consolation for the vendor who is stuck with ordinary equity and no guaranteed periodic payments.

By saying what I’m about to say, I’m probably going to feel the full wrath and scorn of the private equity industry, but c’est la vie. I believe a coupon is only fair if:

1. it is intended to offset an abnormally high top-line valuation; and/or 
2. there is a mechanism in place to compensate management on the upside.

An example scenario is if the private equity firm values the business at $X, but the vendor wants to set a precedent for future investments at $X+Y. The private equity firm could agree to the $X+Y valuation by offsetting the uptick by a preference coupon payment. 

You may note that I’m being a little hypocritical. In a recent post, I lauded the strategic value of the private equity offering and suggested it was worth more than any upfront valuation by a trade buyer. However, there needs to be balance. Those of you too aggressive with coupons should probably weigh the value of these coupons against the opportunity cost of lost deals. You can try to justify your coupons a million different ways, but at the end of the day, if it doesn’t feel right for management, then the deal won’t proceed.

An issue that often arises when bedding down transaction documents is what happens to a variation in net assets at the time of settlement. That is, what if the vendors siphon money from the business at the last minute by selling stock, PP&E or just taking cash straight from the bank?

Private equity firms generally value businesses on their forecast maintainable earnings. So, in theory, they should only be concerned with whether the business has the assets needed to support the forecast maintainable earnings. In practice though, this is a very subjective measure and private equity firms don’t like the idea of vendors using such tactics to shift value; it’s a matter of saving face.

A remedy is to apply a dollar-for-dollar adjustment to the purchase price based on any variation to an agreed net asset figure. But creating an additional source of purchase price uptick creates an additional channel for price manipulation. So, in typical private equity style, the preference is to limit the adjustment to the downside (and not reimburse the vendors for any net asset change on the upside). But, as you can imagine, owners rarely welcome this.

For the sake of fairness, I believe the best solution is to ensure there’s an effective earn-out condition attached to the deal (to align interests at least in the first year) and include a downside dollar-for-dollar net asset adjustment with a lower trigger (that allows the business to operate as usual). If the vendors sell assets from the business at the last minute, they risk lower earnings in the current year and hence a reduction in their earn-out. Even in this case, the downside net asset adjustment trigger will limit them. This is a relatively complex solution, but possibly the fairest.

Contrary to popular opinion, private equity firms are interested in risk mitigation first and value creation second. The structure of most private equity deals reflects this. In aggregate, the components of the deal should protect the private equity firm on the downside and incentivise the management team on the upside. This typically suits the risk profiles and expectations of each party. 

Consequently, unlike venture capital, a private equity deal is more than just money for stake; there’s some sauce involved too. The following points discuss some of the components of a private equity deal that lead to the aforementioned risk and return profiles:

1. Clawback (or ratchet): a clawback involves a condition whereby the private equity firm’s stake in the business increases (and the management’s stake decreases) if the business doesn’t meet certain earnings targets. The purpose of the clawback is to protect the investor against downturns in earnings. Inherently, this is a protection mechanism for the private equity firm. 
2. Incentive scheme (or ESOP): an incentive scheme, or employee stock ownership plan, balances the effect of a clawback. It provides incentives to management to reach certain earnings targets (or a particular exit price). It often only partly offsets the effect of a clawback, meaning that the net effect is favour of the private equity firm. Inherently, this is an incentive mechanism for the management team.
3. Earn-out: this is a condition whereby a portion of the purchase price is deferred and conditional upon predetermined targets. While deals involving expansion capital use clawbacks, complete buyouts of a business use earn-outs (therefore, earn-outs are usually mutually exclusive to clawbacks). The purpose of the earn-out (just like the clawback) is to protect the private equity firm from downside volatility in earnings and from any unintended consequences to misinformation. Inherently, this is a protection mechanism for the private equity firm.  
4. Management Fees: these fees are paid upfront and/or periodically to the private equity firm in return for help to grow the business. They can range from reasonable to exorbitant, depending on the perceived value of the firm and the fragility of the deal and management team. Management fees are another way the private equity firms can realise a return on their investment prior to exiting. Inherently, this is a protection mechanism for the private equity firm.  
5. Coupon or interest payments: although the term “private equity” suggests the invested capital exists as equity, some firms prefer to invest in hybrid securities such as convertible notes (which include an equity component). The benefit to the firm is they receive the upside of equity with the protection of regular interest or coupon payments. This can seem perverse to potential investees, but it can also facilitate higher valuations. Inherently, this is a protection mechanism for the private equity firm.  
6. Preference subordination: private equity firms prefer to invest in preferred stock so in the case of failure, they rank ahead of ordinary shareholders. A coupon payment is often included, but even without a coupon the subordination mitigates some risk for the investor.  Inherently, this is a protection mechanism for the private equity firm.  

There are many other components and conditions to a typical private equity deal, but these are the primary tools used to manipulate the risk and return profile of the deal. They’re not always divisive in nature; they can simply make an otherwise risky deal viable.

Best regards,

the Private Equiteer