Partner up with the seller: Preserve and Grow Capital!

For the last 2-3 quarters, we have been experiencing the greatest psychological recovery in the recent history of economics and frankly, it’s hard to pinpoint the “Real Why”. While the stock market has improved to the benefit of some, the majority of Americans continue the struggle to meet their daily needs (for as expected, job recovery is slow). Recent market activity has been surreal; however, if you looked into the dreadful realities of bankruptcy proceedings during the last few years, last month’s “Flash Crash” in equities markets should probably have been expected. Moreover, “amend to extend” loans have surfaced, seemingly pushing the inevitable off well into the future.

Unfortunately, the fact remains that access to capital continues to be tight and typical private equity firms have heaped tens of billions of debt onto companies acquired from 2004 to the end of 2007—debt that is likely difficult to service, and certainly not cheap, which ultimately begs the question whether a traditional PE firm can afford such an increase in debt (or so called financial engineering). Therefore, we expect to see lots of opportunities in the middle market, certainly in the lower middle market; however, the real difficulties lie in determining how realistic the valuations of certain companies are. Valuations for bankrupt companies are often well below the ultimate auction rates of assets for many reasons. However, unreliable and yet attractive valuations could potentially open the window to big bargains; although there still exist enormous hazards if the buyer really does not know the business and its operational complexities, the opportunities are there for the picking.

It’s critical that PE firms look carefully into protecting the principle investment (downside) as the basic guarantee, without compromising the upside for all parties involved. This “win-win” approach could be achieved through implementing a creative structure for a deal. If the PE investor understands the business and its assets, it would still make a lot sense to go for straight equity deals. An industry focused, specialty PE firm could potentially move into growth/late-stage investments where growth capital is critical for a company’s success. In these cases, industry specialization will not allow a firm to negotiate better with the market, but will also provide a perspective that enables deeper understanding of market variability, condition, the visibility of a company within the market, and general day to day operations from a business perspective. For example: one could choose a convertible structure to get the coupon for 2-4 years, then convert them into equity at a pre-decided price and include an exit structure (with a built-in clause for claw-back, earn-out, etc., if the company does not perform as promised by management/owner/i-banker; … structuring is always specific to the business and market peculiarity of the deal) under which the PE fund’s stake is bought out by the promoters (or investment banker/ placement agent) or other investors. A structured deal could be a valuable tool when a PE investor is not comfortable with a sell-side investment banker’s projection on revenue and returns. The fact is that there are many ways to get things done so long as all parties take a “partnership approach” and a PE investor has deep understanding of a business and its operating domain!

Dealing with a PE investor who has deep understanding of a domain and its business operations allows a seller to get the well deserved full value of a business, to get the deal done quickly and to sustain a long-term relationship with all parties involved.