Michael Mufson sees two prominent concerns among those who want to sell their business.
“When they call us, they have two questions: What am I worth? How long's it going to take?” says the managing director at Mufson Howe Hunter & Co.
In his remarks about recapitalization at the inaugural Dealmakers Conference in Philadelphia, Mufson highlighted what he sees as a disconnect between an owner’s initial understanding of a recap and the reality.
“Conceptually, they understand they’re getting a lot of funds out of it — there’s a lot of cash — but the whole process, once you start meeting with the investors, and the Q&A is happening, and they’re talking about the culture and the type of investing, then it gets real.”
Recapitalization, he says, is about understanding your company’s actual value in the market and finding the right investor who buys in with terms that make sense for the owner-turned-employee. Here’s Mufson’s take on recapitalization.
Determining value
Mufson says that recaps represent somewhere around 75 percent of the transactions that are taking place in the market today with private equity. These are liquidity transactions whereby the privately held company will seek an institutional investor, typically a private equity group, which will invest in the company at fair market value and own from 51 to 80 percent of the business. The balance of the equity is considered rollover equity by the sellers.
Generally, Mufson says a good candidate for a recap is a good candidate for any investment — a company that can confidently be projected to grow 3.5 to 5 percent organically and 10 percent through acquisition. Investors are looking to get at least three times the investment over five to six years.
Additionally, investors typically target privately held businesses that are not in a hyper growth area but that have a good growth story — anywhere from 3 to 10 percent per annum growth, with high gross margins, low or no customer concentration, a good management team and good information systems. Companies have the best chance of getting a good multiple if they’re also positioned to make acquisitions or grow organically.
What the company will fetch in the marketplace is also contingent on its size. Mufson says that at the end of the first quarter 2019, the average of all transactions was about 11x EBITDA. But, he says, there's a big spread when it comes to multiples. Bigger companies get bigger multiples because there’s more to leverage. A company that is getting an 11 multiple, for example, is a little shy of six times total debt to EBITDA. And a company that’s $50 million or less is maybe three, three and a quarter total debt to EBITDA.
However, those valuations are also a product of the current market, in which valuations are historically high. If there’s a market-shaking announcement or development, Mufson says prices would soon drop.
Fair partner
Mufson says there are two styles of investing. In one, a private equity firm will “attach to the knees and ankles” — it will put in a dollar and the owner puts in a dollar. In this situation, the seller will own one-fifth of the business and the firm four-fifths.
In the other type of investment, private equity firms will put a preferred above that, and their dollars will have preference and a dividend; they then share after return of capital. That dividend is usually somewhere between 8 and 12 percent.
“That isn’t as good as the former,” Mufson says. “So you really want to be careful about the culture of the private equity group. Now there are times when it’s warranted — if the valuation is crazy and the private equity investor pitched a deal, found some due diligence issues, doesn't want to retrade and will say, ‘I’ll stay with the deal that I gave you, but I’m going to take a preferred position with a return.’ But you want to pick a partner who’s going to take the attitude that it’s pretty egalitarian — if it’s good for me, it’s good for you.”
Mufson says that seldom do you see less than a 20 percent rollover by the management team. The average is usually around 30 to 33 percent, with the range being 49 percent down to 20 percent of the company that is owned by the seller post transaction.
Time is never your friend
While sellers are enjoying a market with high valuations, Mufson cautions that cycles don’t last forever.
“We know that we’ll go into downdraft at some point in time,” he says. “We have a saying that we probably repeat in our shop twice a day: Time is never your friend. So if you need to do something, start, get it done, because we don't have reliable Ouija board. The markets are strong, the fundamentals are good — as long as commercial banks, the debt funds and the market as a proxy stay strong, because people do use the market valuations generally and for the psychological side of it. But if a company needs to do a liquidity event for family planning, because of an illness, because an uncle or cousin doesn't want to be in the business, the recap is a perfect vehicle.”
