Div Recap or Partial Equity Sale?

Hello all,

I am advising my friend on what he should do with his business. He came to me because the IBs he met with want such massive fees. So I told him I would see how I can help him. The business is in the healthcare/clinic space. He has grown the company to profitability and has healthy margins and strong EBITDA. I calculated the EV to be around ~$15-20m. He wants to "take some chips off the table". However, all the PE firms we are meeting with keep low balling him and saying "we don't pay the highest multiple because we can offer so much value as partners". So, I thought maybe we could explore a div recap? That way he won't have to give up any equity. I am not super familiar with div recaps but I assume I just need to reach out to private credit shops and see what interest there is? I understadnd they will just offer debt at a multiple of EBITDA? The business can definitely take on more debt and sustain more interest payments. I just don't know what option is best for the long haul of the business. What do I need to look at? How the debt will affect WACC? Like I am just not sure all the consequences of a div recap in comparison to a partial equity sale. Any thoughts on how I should look at this would be appreciated!

 
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The issue you're going to run into this far into the lower middle market is lenders' comfort with use of proceeds. The biggest wart here is that it's a non-sponsored business.

If you were financing growth or an acquisition, there's enough lenders who will have no problem with lending to a founder-owned company. 

If you're simply transferring money to your own pocket, most lenders will at least blink if not pass.

It can be done, I'm not saying it's impossible, I'm saying that lenders underwrite the downside scenario rather than the upside. A minority equity investor has no problem putting money in a founder's pocket because the incentives are aligned for future growth. Disagree with it all you want, but a lender (especially the less institutionalized ones that you'll encounter trying to do a ticket size below $5m) is not enthusiastic about paying you fun money. This is amplified if the business was bootstrapped from internal cash flows and not financed through founder equity investment (actual cash in the door).

Personally, I disagree with this logic and find it disrespectful, devaluing sweat equity is nonsensical. Unfortunately in my experience in situations very similar to this one, however, it's the norm.

To get around this, see if you can find a local family office to come into the business at the price you want. Once you've gotten third-party validation of the valuation, you can pursue the dividend recap much more easily. Ultimately, you may have to accept an equity investment at a price you don't love (and minimize the percentage sold) in order to do what you really want to.

I am permanently behind on PMs, it's not personal.
 

I would add to the comment above to really do your diligence on the “value add.” Some firms will have provisions attached to their security that effectively give them veto rights on most major decisions of the company. Your friend should really think through how the partnership would work and how it would impact their growth plan. It is tougher in this environment, but I have seen local banks in the past give modest leverage (1-2x) in these situations, so your friend could do a small dividend and then try to take excess cash flow out of the business for a few years if it is not needed for growth. This might get them the amount they want just over a 3-4 year period vs. all upfront.

 

I do advisory work with a family-owned business in exactly the same segment as you're describing. A bit larger, but same ballpark. They own other businesses in other industries as well. We've done dividend recaps on their businesses multiple times.

While I agree that, at face value, lenders' tendency will be to turn away from issuing debt for purposes of owners cash extraction, I'd say it's very case specific.

In our case, the business has financed a lot of medical equipment and real estate with the same few banks for decades. The banks are quite comfortable based on their history with the borrowers, their track record of growth, etc. As long as you're not too aggressive, I think it's doable (although expensive in today's environment - goes without saying, but sometimes when it comes down to it, and you're paying 7%+ term loan to get cash out for lifestyle, owners decide they maybe don't need the proceeds that bad).

Putting together a quick package for the lenders will go a long way. Doesn't need to be a crazy IB level CIM, just 7-10 pages, describe the business, market, owners, projections, etc.

In our case, as long as we're below 3.0x debt / EBITDA, banks were pretty easy going.

Feel free to PM if you want to chat.

 

Also - this is my anecdotal experience but I find PEs really don't pay up when you're at that $25M - $30M EV. They might give you 6x-7x. If your friend doesn't mind running the business, I'd get the 2.0x dividend recap, keep running it for 5 years, do it again, or exit at that time when the business has grown and he can benefit from a better multiple. There's also tax efficiencies from the dividend recap.

Obviously situation dependent but something to think about.

 

Have dealt with these situations in this size range. 
 

Not sure what your friend is getting quoted on fees, but I think he will be better served actually running a process if he has fully decided to take chips off the table. 
 

Finding a lender to do div recap in this size segment is going to be tough. He can hustle and talk to many banks until he finds the one, but that will come at a significant time and energy cost to connect with all of them and supply due diligence materials. I assume he is pretty busy running and growing the business to do this. 
 

Best course of action seems to be to run a growth equity process and size up the deal by taking some primary capital as well - so you can get bigger fish in the bidding pool and create competition. If in the multi-site clinic space, he can use the extra capital to do an acquisition while throwing some secondary proceeds for himself. The presence of a sponsor and scaling up of the business through acquisition will then open a much easier path to div recaps or a second equity sale in 2-3 years. 
Happy to chat if you want to DM. 

Ugh the FBI still quotes the Dow... -Matt Levine
 

Just a point on this, assuming the premise is the owner doesn't want to hire an investment bank / broker to run a process due to fees...  I think running an equity process will be much more time consuming than trying to find a lender for a dividend recap. My experience has also been that at that size, finding a legit sponsor for a minority will be super tough.

If you sell 20% - 40%, assuming no leverage, you're asking someone for a $4M - $8M equity check. Maybe better going through a combination of HNW and family office? Don't know what you've been seeing?

 

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