It’s All About the Leverage – Increasing Rollover Participant’s Equity Share
The previous post in this rollover series provided an overview of the benefits of rollover equity when selling a business. In this post, we consider further the power of leverage in such a buyout whereby current owners can increase their equity stake in the acquiring entity beyond their initial rollover cash contribution.
Increasing Upside Potential for Sellers
Consider again the example from the previous post of three equal partners selling their business to a private equity buyer for $30 million, with a 10% rollover equity component ($3 million). Further consider this buyer is funding 50% of the $30 million purchase price with debt (a mixture of senior and mezzanine financing) and the remaining $15 million in cash, which includes the sellers’ $3 million cash / rollover equity contribution.
As the chart below illustrates, the selling partners rollover equity is thus leveraged in the same manner as the equity contributed by the private equity buyer, and as a result the selling partners would own 20% of the post-closing equity (not 10%) because the equity value at closing was reduced by the debt used to facilitate this leveraged buyout. Put another way, the selling partners’ $3 million rollover equity contribution constitutes 3/15 or 20% of the $15 million equity used to fund the acquisition, which may significantly boost the sellers’ return potential on the deal. Rollover participants should be mindful in this regard to review carefully the post-acquisition pro forma balance sheet of the acquiring company in order to understand and confirm their equity stake, taking into consideration the amount of acquisition debt.
| Leveraged Buyout Structure with Seller Rollover Equity
($ millions) |
|
| Debt | |
| Bank debt | $10,000 |
| Subordinated debt | $5,000 |
| Total debt | $15,000 |
| Equity | |
| Rollover equity | $3,000 |
| New equity | $12,000 |
| Total equity | $15,000 |
| Total Deal $30,000 | |
More Leverage = More Equity
Almost all acquisitions by private equity firms are leveraged buyouts, and the greater the leverage, the greater the share of rollover participant’s equity. As a result, as leverage on the deal increases, so increases the rollover equity participants share of the sale proceeds upon a successful exit. Indeed, it is not uncommon in this regard for the return on the rollover participant’s interest in the second sale to be more valuable than the initial buyout. Looking again at the chart above, if the acquiring company is later sold to a strategic buyer for $80 million, the rollover equity participants would receive a $16 million return (20% of $80 million) on their initial $3 million. Compare this to a return of $9.6 million to the rollover equity participants if the private equity buyer only funded the initial acquisition with $5 million in debt, with this lower debt leverage providing the rollover equity participant with 12% (not 20%) of the post-closing equity.
The greater the leverage, however, also means the greater the risk. Most significantly, the debt used to finance a leveraged buyout will have to be repaid before rollover participants see such a return on the second sale. Although the capital and expertise provided by the new private equity co-owners should accelerate growth and increase the cash flows used to service this debt, adverse events such as recession, increased competition or weak management may nonetheless lead to difficulties in meeting the company’s debt obligations. These and other seller risks will be the subject of the next post in this rollover equity series.
