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July 16, 2020
Minority equity deals are becoming increasingly common as specific factors impacting capital supply and company ownership make them a more viable and attractive option. The dynamics of the COVID-19 environment echo some factors of the 2008 economic cycle—giving business owners a renewed appreciation for personal and business risk. For those considering taking some chips off the table, a minority equity structure can be a compelling alternative to a majority sale to a private equity firm or full sale to a strategic buyer at what may be considered a depressed valuation. Likewise, given the challenged leveraged buyout debt markets, private equity firms see non-control equity deals as a market reality and a more attractive (if not the only) means to put their capital to work in the near-term.
A few key undercurrents are driving these mindset shifts, and there are good business cases, on the parts of both investors and company owners, to participate in minority transactions.
Bank financing is challenging to arrange in the current environment, making the traditional LBO a more difficult deal to complete than it would have been six months ago. Banks are seeing pain in their portfolios and are subsequently tightening controls. Debt underwriters are less willing to accept addbacks or make material adjustments to EBITDA.
Aside from debt finance, we are in a choppy market where volatility is more prevalent, and buyers are more hesitant. In order to get to valuations that were typical before the pandemic, they are incorporating more creative structures—such as deferred consideration, seller notes, or earnouts—to create pathways for sellers to eventually make as much as they would have if they sold their businesses in 2019.
Private equity firms are sitting on exorbitant amounts of dry powder, and tight debt markets can’t be used as an excuse not to put capital to work. In the absence of control deals, they are creating minority structures that incorporate a clear path to exit. These are not silent or passive investments. They are meaningful minority stakes—between 25 and 49%—with active board representation and other similar aspects of a control private equity partnership.
Firms who were not historically looking at minority deals are now open to a much more flexible approach. Some are even taking it a step further by publicizing specific products whereby they can position themselves as minority investors to companies in the lower middle market. As more private equity firms become willing to make minority investments, the capital supply and demand balance will shift, driving minority discounts down and making this alternative even more attractive to business owners.
Sellers have an understandable concern about taking chips off the table in a down market. Minority capital is useful in these situations—where there is a disconnect in valuation expectations and market conditions.
Many owners who held on through 2008 are looking at the current market dynamics and repricing risk. The uncertainty of the future makes some cash-in-hand today and a chance at another bite at the apple down the road more attractive, especially when you can maintain control as you work alongside a partner to build your company’s scale and value.
Some of our clients are in strong financial positions but are watching their competitors struggle. Bringing on minority capital to execute an acquisition strategy can put companies in a better position when they are ready for a full exit. Even if a minority equity financing dilutes them in the near-term, employing that capital to acquire and materially grow revenue and profitability can often create more equity value long-term.
For example, we are working with a digital transformation consulting firm that is doing quite well despite global economic headwinds, and they are seeing opportunities to buy smaller competitors at attractive valuations. This has turbocharged their desire for a significant minority transaction in order to pursue acquisitions and organic growth, which will ultimately position them stronger coming out of this environment.
These decisions are heavily nuanced by sector. Some industries are benefitting from COVID-19’s effects and experiencing an uptick in business, but it remains unclear as to whether those increases are sustainable. In these cases, we are seeing minority transactions emerge with structures in place that give the investor downside protection while simultaneously giving the company owner upside opportunity. Uncertainty of future revenue does not have to mean “no deal.”
As is the case with a majority private equity deal, selecting the right partner based on the specific value-add they can provide is among the most important considerations for business owners pursuing a minority equity deal. For instance, a business owner may be looking for a partner with expertise in acquisitions and integrations, new market/international expansions, new product development, elevation of human capital/executive team, or specific customer access.
In particular, a financing partner that has sector expertise will be particularly adept at understanding growth drivers, trends, and opportunities, along with a deep understanding of competitive intelligence, and can bring key industry relationships to bear. The result of a minority equity deal with the right partner can be highly transformational and compelling, with incremental value creation that results in the business owner’s actual dollar equity value—even taking into account the equity dilution—being well above what it would have been without the equity partner.
This market is evolving rapidly, and buyers, investors, and sellers are adjusting their expectations on the fly. Our team is committed to keeping a pulse on the nuances of the industries we serve and would be happy to share additional insights with you. Please don’t hesitate to reach out to discuss these or other considerations.
Continuing with our “What’s Now? What’s Next?” series, we’re highlighting our team’s insights within two promising sub-verticals of industries facing broader challenges. Click the stories to read more:
Our team is staying plugged into the impacts and success strategies for each of the industries and sub-verticals we serve as the economic environment shifts amid COVID-19. We would be happy to discuss the above or other trends with you.
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