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Keeping Your Balance: Taking a second bite of the apple

Mark J. Kovaleski

Mark J. Kovaleski

Mengel, Metzger, Barr & Co. LLP is a long time member of BDO USA, LLP, a U.S professional services firm providing assurance, tax, financial advisory and consulting services to a wide range of publicly traded and privately held businesses. BDO Capital Advisors, LLC is an affiliated company providing middle market investment banking focusing on four product areas: mergers and acquisitions advisory, corporate finance capital raising, special situations advisory and board advisory.

I recently had a chance to sit down with BDO Capital’s managing director, Valentina Midura, to discuss leveraged recapitalizations. She recently published an article on the subject. The following are excerpts from her article.

What is a leveraged recapitalization?

A leveraged recapitalization is a transaction where a private equity firm uses outside debt together with its own capital to buy a controlling interest, typically 70 to 80 percent, of the ownership of a privately held company. Shareholders are able to create liquidity for themselves and diversify their investment portfolio through the transaction while at the same time maintaining economic ownership in “their” company. The residual ownership interest also allows the seller to share in the upside and growth of the company monetized through a future sale or liquidity event via a “second bite of the apple.”

A leveraged recapitalization not only provides privately held businesses with an alternative to an outright strategic sale but it can also be used to address multiple objectives faced by small business owners and diverse shareholder needs including:

• Allowing for the buyout of all or a select shareholder with differing objectives;

• Facilitating the transfer of the business to the next generation;

• Funding tax liabilities associated with family succession; and

• Attracting capital to fund future growth

Not every business is a viable leveraged recapitalization (recap) candidate. The primary requirement is the ability to utilize debt, including asset-based and/or cash flow-based financing to fund the transaction. Businesses considering a leveraged recapitalization should have a consistent and predictable stream of cash flows.

Secondly, the transaction requires that the selling shareholder(s) be willing to use some of their sales proceeds to buy back equity of the “new” corporation and assume the risk associated with this equity stake. Additionally, this deal structure requires that the selling shareholders or existing management team continue with the new corporation for some pre-defined period of time in order to run the company until the second bite of the apple or subsequent liquidity event.

Business characteristics that may determine the suitability of a company’s candidacy for a recap include:

• History of positive and predictable cash flows;

• Evidence of a strong management team;

• A defensible market position;

• The ability to increase market share through organic growth and/or acquisitions; and

• Positive market dynamics — participation in a fragmented industry and/or the ability to enter untapped markets

Benefits of a leveraged recapitalization

Beyond the benefits of providing liquidity to the selling shareholder and diversifying wealth for a private business owner, a major benefit of this transaction type lies in the opportunity to share in the future success of the company. The cumulative proceeds seen in the original transaction and those monies received through the second bite of the apple provided incremental value to the business owner when compared with those proceeds realized through the one sales event to a strategic buyer. In addition, the owner was also able to continue working while providing for the security of his employees and future of his management team.

Private equity firms

The typical equity investor that transacts a leveraged recapitalization will seek a majority ownership stake in the target company. However, it is important to note that the PE firm is very much investing in the existing management team, which they will rely upon to continue to run the company and maintain its day-to-day operational control. In fact, many investors use their required level of involvement, or lack thereof, as an important measure of their success in their investment.

Although the existing management team will continue to run the business, a number of cultural changes will likely occur upon the consummation of this type of transaction. In all likelihood, a new board of directors will be constituted, there may be an increased focus on profitability and both organic and acquisition related growth will become a priority. Finally, there will be “outsider” involvement in “material” operational and strategic decisions affecting the company.

Depending upon the sophistication level of the business, and its owners and management team, some or all of these changes may be material or inconsequential. To some businesses it may offer skill sets not resident with the existing management team allowing the company to accelerate its growth.

However, consistent with almost all leveraged recapitalizations, the PE firm will lend assistance in helping to define a merger and acquisition plan and assist in sourcing, negotiating and consummating future deals. While helping to facilitate growth and enhance profitability, PE firms also help evaluate potential exit strategies, which may include a sale to a strategic party, another leveraged recapitalization or an IPO.

BDO Capital Advisors, LLC has a strong working knowledge of leveraged recapitalizations. This fact is evidenced by a transaction where we sold SolarWinds, Inc., a technology firm in the network management industry, to Bain Capital Ventures and Insight Venture Partners. As part of the leveraged recapitalization, SolarWinds’ management team retained a meaningful yet minority position in the economic ownership of Newco. The management and investors grew SolarWinds and later determined that an IPO was the most viable exit strategy for the owner.

On May 24, 2009, SolarWinds, Inc. went public on the NYSE, one of only seven public offerings during the first half of 2009. Based on the initial trading day price, the company’s market value was approximately $1.2 billion, which equated to a very robust return for both the investors and shareholders of the company — a true success story.

Mark J. Kovaleski, CPA, is a partner with Mengel, Metzger, Barr & Co. LLP. He can be reached at