Time to Revisit the Recapitalization

As the summer doldrums end and we head into the 4th Quarter of 2009 with few signs of significant near-term improvement in the economy as it impacts private, middle-market companies, maybe it is time for company owners to reconsider a recapitalization.

Our January ‘09 blog entry introduced the concept of what the financial community calls recapitalizations – a financing mechanism that enables business owners to take some money out of the business thus diversifying personal assets, to take on a financial partner who can help sustain the business through what I believe are the more difficult times still ahead, and possibly to provide capital for acquisitions of weaker competitors, all to enable the company to come out of this recession larger and stronger and in a better position to sell at a higher valuation as the economy improves. Recapitalization financing can also be used to replace expiring senior debt.

Many of our middle-market company clients and their advisors responded to the recapitalization concept presented in January with the polite acknowledgement that it was interesting but with the decision to wait for “a quarter or two” until the economy improved and then consider going to market to sell the company at higher valuations. Well, three quarters have almost now passed since then, the economy continues to slide, and middle-market company valuations are still heading lower. According to a recent W.Y. Campbell & Company report, real GDP declined at a 1% annual rate during Q2 ’09, a reduced decline from Q1 ’09. And according to the same W.Y. Campbell report middle-market transaction multiples fell in Q2 ’09 to 4.9x EBITDA down from 5.7x EBITDA in Q1 ’09 and from 7.2x EBITDA for all of 2008.

All signs point to bank debt being increasingly expensive and difficult to obtain. Many business term loans put in place over the past 3 to 4 years are coming due and business owners will be hard pressed to replace those loans with similarly structured bank debt. Notwithstanding the money many banks have received from federal government stimulus and economic recovery programs, banks are struggling, with the <em>Wall Street Journal</em> reporting that there are 416 banks on the FDIC’s At-Risk List (<em>WSJ</em>, August 28, 2009). The <em>WSJ</em> article reported that in Q2 ’09 defaults on commercial and industrial loans more than doubled from a year earlier; credit-card losses climbed to a record 9.95%; banks are sitting on $332 billion of loans more than 90 days past due, the highest level since the FDIC started collecting the data 26 years ago; banks are holding more than $34 billion in repossessed real estate; and even as banks modify billions of dollars of mortgages, their pools of foreclosed properties keep growing, for Q2 ’09 up 12% from Q1 ’09 and up 72% form the previous year – the highest level since 1993.

On top of all this, some predict that the core unemployment rate will reach 12% or 13% and the federal government’s uncontrolled fiscal policy threatens the sustainability of any potential recovery with higher inflation and the devaluation of the dollar. None of this gives any indication that the middle-market business environment is improving or that bank debt will become more available in the near term or until the banks work through these growing problems.

On the positive side, private equity and subordinated debt funds are still flush with capital, some estimate about $600+ billion. However, the lack of leveraged financing and discounted multiples applied to deteriorating earnings has expanded the gap between buyer and seller valuation expectations making buyouts all but impossible. As a result of the dearth of buyouts occurring in the middle-market, those investors are more creative and flexible than I have seen them in the past in order to invest their funds. They are willing to provide capital for both majority AND minority recapitalizations, enabling business owners to maintain both operating and financial control. Private equity and sub debt funds invest in management teams; their business model is not to run businesses. And the good fund investors add value beyond the capital they provide, helping improve corporate governance and financial reporting, opening new distribution channels, assisting with acquisitions, etc., all to help create value for the company, investors and business owners.

At Wood Warren we understand the issues middle-market business owners face and we know the private capital markets – the investors and lenders to private, middle-market companies. We would welcome the opportunity to assist analyzing the financing alternatives, to undertake a process to find the right investor or lender, and to facilitate transactions that will help middle-market companies survive and thrive in these challenging times.