A recapitalization, or more commonly referred to as, “recap” represents a significant change to a company’s debt and equity ratios to finance its overall operations and growth. In essence, a recap represents the exchange of one type of financing for another, debt for equity or equity for debt. Recapitalizations come in a variety of forms, are executed in multiple ways, and offer an array of strategic maneuvers. From reducing debt burden to allowing for reorganization and continued operations, a recapitalization can be a genuine lifesaver for many businesses. However, a recap is not for everyone and we discuss below the situations in which recapitalizations are the best move for a business and when to avoid them.
Types of Recapitalizations
Recaps are popular in today’s M&A marketplace as an alternative to a traditional sale. There are many different types of recaps and reasons why a company would pursue them. The leveraged recapitalization is when a company supplants a portion of its equity with debt, which inherently changes the capital structure. A common goal for a leveraged recap is to raise funds by issuing debt securities to buyback unpaid shares. The company aims to increase its value per share by decreasing the number of shares outstanding.
A leveraged buyout (LBO) is a form of leveraged recapitalization originating from a third party. Here, the business is acquired by a 3rd party using debt financing and the target’s cash flows are typically used to repay the debt obligations.
In some cases, businesses can pay off debt securities through money raised by issuing new equity shares through an equity recap. This reduces debt by issuing new equity shares and using those new funds to pay off all of or a portion of its debt obligations.
Reasons for Recapitalizing
1. Significant Decrease in Stock Price
Companies recap to bolster the supply-and-demand ratio in order to combat a significant decrease in its stock price. The company issues debt in order to repurchase shares, which lowers supply and theoretically should drive up share price.
2. Modify Debt Ratios
Companies with a poor debt-to-equity ratio frequently face an increasingly deeper financial hole and often run up against debt covenants. To address this, businesses recapitalize to adjust their capital structure ratios. They issue new equity and pay off portions of outstanding debt.
3. Prevent Hostile Takeovers
While many financial strategies are executed to enhance the attractiveness of a business, recaps are also used to make a business less attractive. If the target company perceives a potential hostile takeover by another company, the target can rack up debt to dissuade a takeover in a scorched earth strategy.
4. Bankruptcy Reorganization
Companies on the brink of and during bankruptcy will recapitalize to stabilize the business. It is a reorganization strategy used by insolvent companies to prevent liquidation and continue operations during the bankruptcy process. With proper guidance, the new capital structure achieved by executing a recap can salvage business operations and retain jobs.
5. Support Growth Initiatives
While many companies recap to pay down debt, some use recapitalizations to fund expansion of the business. Companies frequently recapitalize with investors when they emerge from a downturn. Often, the investors deliver more than just capital by bringing operational and industry expertise to the table.
Private Equity Recaps in Healthcare Services
Impacts from the broader economic downturn in 2020 and those specifically within the healthcare sector, caused downward pressure and declines for many companies. Firms pivoted to cushion the blow and/or access new revenue channels that for many, proved lucrative. As a class, healthcare services companies are now experiencing growth from the declines of the previous year (we will discuss this in more detail later). Bolstering the year-over-year growth, are new service channels created from COVID that generate additional revenue streams. Yet, these new revenue streams require more time, management, and capital resources (which may already be strained from last year’s dynamics). This scenario is just one of many where PE recaps can provide a great benefit to sellers because they offer a liquidity event now (de-risking the owner’s investment in the business). If structured correctly, the recap can also provide the seller with significantly more gains than a traditional sale as the newly allied PE expertise and the broader economic recovery, propel the business past previous performance levels.
Figure 2 – https://news.bloomberglaw.com/bloomberg-law-analysis/analysis-7
When PE recaps are consummated, it’s important for the seller to identify any and all synergies. As an entrepreneur/founder, the thought of selling a portion of your company to another entity can be an anathema. Founders and entrepreneurs sacrifice blood, sweat, and tears to build their company and the misconception that entity would be telling them, ‘what to do’ is a terrible idea. Culture and structure are key components to any PE recap. For these types of transactions to succeed, it’s imperative that the buyer brings more to the ‘marriage’ than just money. PE firms can bring expertise in so many ways: sector focus, competitive advantages, market access, operational, organizational, financial, etc. For example, PE firms often improve buying power through economies of scale and can reduce an owner’s cost of goods. Sometimes, PE firms double or triple the value of the business after the recap closes. If you are going to walk down the aisle with a buyer, best be sure they are the ‘complete package’.
The COVID-19 recession was the first recession during which health spending decreased1. Reductions in elective care, restrictions in senior living and social distancing requirements had a range of impacts on companies in the second quarter of 2020. By the year end, much of the spending returned but not to prior 2019 levels. Consequently, many companies experienced a V-shaped recovery, and some are still yet to recover to pre-COVID levels. Owners of businesses that experienced a decline in 2020, are now seeking to de-risk while also capturing future growth as the company and economy continue to recover. For many entrepreneurs/founders, the business is not only their source of income, it is also their retirement plan. Striking a balance between risk and growth is of critical importance for these individuals.
PE recaps offer tremendous opportunity for healthcare services businesses if the right partner is pinpointed and a deal is structured equitably. Identifying a PE firm that repeatedly demonstrated success within the seller’s sector is only the beginning. Owners must compare several potential PE partners on the basis of a wide range of contributions, including: synergies, opportunities, management style, corporate culture, competitive advantage, growth plans, access to capital, risk tolerance, transaction structure, valuation, etc. Executing a PE recap is a uniquely complex transaction that is best completed with the help of an M&A advisory firm. When a seller completes a PE recap, they are ‘marrying’ the buyer for a period of time and needs to be sure both parties are meant for each other!
Figure 3 – https://news.bloomberglaw.com/bloomberg-law-analysis/analysis-7
Recapitalizations are a popular method for restructuring companies. There are a variety of types to choose from and reasons why a company would pursue a recap. In the private sector, founders frequently have a majority of their savings and retirement tied up in their business. For many of these founders, the PE model offers a method to de-risk their position while at the same time, offering an opportunity to net more cash as the business grows in the future. However, it is imperative that the seller finds the right PE partner. Healthcare services sellers are reporting record inquiries from PE buyers and transactions have surged nearly 50% between 2016 and 2021. In a strong sellers market, its easy to get swept up in the feverish activity and make a poor decision choosing the wrong group to sell to. Recapitalizing a business is an incredible opportunity for an independent owner to achieve generational wealth. Sellers can realize 2-3x more value through this strategy than if they sold 100% of their business in a single transaction. The upper range will only be achieved through comparing several different PE firms and structuring the recap properly and equitably.
This is Article #2 of a multi-part series. Please click here to read Article #1 – Selling to Private Equity – A Healthcare Sellers Perspective
1. Cynthia Cox, Krutika Amin, Rabah Kamal. How have health spending and utilization changed during the coronavirus pandemic?, Peterson-KFF, (March 2021)