Independent Sponsors: Structuring Deals in a Difficult Macro Environment
We've seen lower middle market private equity firms struggle in the current challenging macroeconomic environment with ultimately closing on a transaction under LOI. Sellers are getting cold feet about if 'now' is the right now. Interest rates and SOFR have doubled interest payments from where they were only a year ago. With debt and the cost of capital rising, lower middle market investors may struggle acquiring small businesses. Small companies are typically viewed as 'riskier' and lenders will provide debt at higher pricing for taking on that risk. Large and mega buyout deals have lenders more willing to provide 5-8x leverage, whereas a small company with <$10 million of EBITDA may receive lender indications of 2.5-4.5x leverage. Independent sponsors in particular must be creative in acquiring a small business as they do not have a traditional fund of pooled capital from investors, and thus must rely on raising capital and co-investors stepping up to close on transactions.
Here are some tips to closing on a transaction in the current challenging environment.
Seller Note: Seller notes are becoming more popular for buyers to close on a transaction. A seller note typically charges a fixed percentage (i.e. 5-8%) and allows for an investor to close on a deal without that cash in-hand upfront. If a buyer is acquiring a business for $100 million, the seller may provide a $20 million seller note to provide additional financing at close and be paid back during the hold period. While the seller would likely prefer the cash upfront, they may be willing to help fill the funding gap to ensure the deal closes.
Seller Rollover: More and more deals are being closed today with a 60/40 or 51/49 equity split between the buy and current owner. Depending on the firm's strategy, many private equity firms may look to acquire 70-80% of the business through its own equity, co-investors, and debt. Given the rise interest rates and challenging debt markets, private equity firms and independent sponsors particularly need to become more creative in its sources & uses. Increasing the seller rollover amount not only develops a higher certainty to close, but also creates strong alignment of interest with the current founder. The seller benefits from the future upside and 'next bite of the apple' by rolling into the transaction and can help to fill any potential equity gaps. It is also more tax efficient to rollover an existing investment.
Structured Preferred Equity: If the seller is unable or unwilling to provide additional notes or rollover, many independent sponsors are turning to structured equity. There are a wide variety of forms in which this investment can take place from convertible, or participating preferred equity, to PIK notes, almost acting like a mezzanine debt instrument. Preferred equity often includes a set % PIK rate (i.e. 8%) which accrues throughout the life of the investment. Preferred equity or structured equity sits above common equity (typically seller rollover or other subordinate investors) and helps protect against downside risks. While preferred equity doesn't help with filling any funding holes at closing, it does help mitigate future risks by being higher up in the cap table. PIK notes are an attractive instrument today by helping the business maintain its cash and 'PIKing' throughout the investment to be paid out at a future date.
Minimizing Debt: In a very challenging interest rate environment, smart investors are minimizing the amount of debt utilized at closing. Typical senior debt that previously costed 5-6% all-in is now costing small businesses 8-10%. Mezzanine debt has historically been provided at 10-12% rates and is now costing 14-16%. Many small businesses do not have the scale and free cash flow generation to meet these outsized interest rate payments. Our advice is to work with lenders that you know. New lenders may surprise you with challenging debt covenants and little cushion, higher upfront fees or amortization, and become unfriendly in the event the business struggles operationally. It is important for independent sponsors in particular to develop strong relationships with a handful of lenders who can step up when needed to close on transactions.