BRIDGING THE Gap

At a time of decreased deal flow and mismatched valuation expectations, investors are using creative tools to provide capital to companies or extend the life of their funds

BY ANASTASIA DONDE

With various stressors weighing on the investment industry, deal flow for traditional platform buyouts has declined and valuation expectations have also fallen. Rising interest rates and inflation, the collapse of several regional banks, and declining equity values have all changed the game for M&A practitioners. Some are waiting on the sidelines while market conditions improve, while others are employing specialty investment strategies to bridge the pricing gap or agree to terms when there is a valuation mismatch.

Some of these tools—like preferred equity or mezzanine funding—are used to help companies in need of capital for growth or add-on acquisitions while traditional debt or equity financing is unavailable. Other strategies like earnouts, seller notes and ratchets get tapped to close a deal when there is disagreement on valuation or performance metrics between the buyer and seller. Net asset value (NAV) lending and continuation funds, meanwhile, are becoming popular ways for private equity funds and portfolio companies to extend their runway before an exit.

These instruments are often costly and create complex capital structures or throw the priority in which lenders and investors get repaid out of order. But investors say they’re still useful options at a time when access to traditional equity and debt capital is challenging. We explore some of these strategies in detail below.

Earnouts And Seller Notes

A common issue these days is disagreements on valuation between buyers and sellers. Sellers expect high valuations based on comps from previous years, but with rising interest rates and reduced access to debt financing, buyers are less inclined to pay high multiples. When sellers base multiples on projected EBITDA or revenue numbers, buyers are often unconvinced high growth is possible in the current market. One way they’ve managed to agree on terms is by structuring earnout or seller note agreements.

In this situation, a sponsor will buy the company for a lower valuation than the seller wants, but it will structure an agreement to pay the founders more money if they hit their projected growth targets in the next year or two, explains Brian

Crosby, managing partner at Traub Capital. His firm recently closed a deal for a consumer business, where Traub Capital structured an earnout agreement with the company. The earnout can be made as a cash payment to the founder or as a seller note—a loan that the seller provides to the buyer for deferred payments over time.

“We added a second unique component to the earnout, where the seller note will be subordinate to the equity coming into the business,” says Crosby. He adds that this structure makes lenders more comfortable, since they’d prefer that cash flow or new money coming into the business be used to reinvest in the company or pay down debt. “That’s why we made it a piece of seller paper,” Crosby says, noting that the company still has a conservative capital structure with 3x leverage. Traub Capital has used seller notes in three out of four deals in its new fund.

“You have to make sure you clearly define the earnout, and what has to be achieved and by when,” Crosby cautions. “You have to make sure there is no discrepancy in understanding what the goals are.”

Ratchets

Another way for buyers and sellers to come to terms on valuation is by using a ratchet agreement. Unlike earnouts, which reward founders for hitting predefined financial goals, ratchets can create either a reward or a penalty for missing targets. “Essentially, it ties a piece of the deal price to future performance but allows for both sides to be incentivized by potential equity upside,” says Bobby Sheth, managing director at Salt Creek Capital.

“Say the company has a prediction for a future growth rate for revenue or EBITDA and really believes in that number,” Sheth says, and that the sponsor buys 70% of the business with the founder retaining a 30% stake. “If what you’re saying is true, then [the founder’s] ownership stays the same. If not, we ratchet the founder’s stake down to 15%, for example,” he explains. “It’s a way to let them bet on themselves.”

Sheth notes this approach usually works better with sizable, mature companies with at least $10 million in EBITDA. “It locks in a purchase price. If they hit their growth targets, then I’m paying this multiple. If not, I’m paying them a lower EV

(enterprise value),” he says. Salt Creek usually gives a company one or two years to achieve its growth targets.

Sheth’s firm used this arrangement with a specialty chemicals business, wherein Salt Creek’s minority position would become a majority stake if the company missed its numbers. “We’re typically majority owners, so we said, ‘If you don’t hit your numbers in year one or year two, our position would go to 60% ownership,’” Sheth says. The firm is currently looking at several other situations to factor in ratchets in buyout agreements.

Mezzanine

Investors sometimes use mezzanine financing, a type of junior debt, as an alternative to equity or debt financing. Mezz acts as a high-yield loan that typically is less dilutive or expensive than equity but costlier than other types of debt. The loan is usually secured by a second lien on the assets of the company. Although it’s priced like junior debt, it sits between equity and senior debt in the capital stack.

Anne Vazquez, a general partner at NewSpring Capital who focuses on the firm’s mezzanine strategy, says her firm has been very busy assessing new investment opportunities. Companies are interested in mezz that can be used for a leveraged buyout, debt restructuring, refinancing or growth capital. “When working directly with companies, there is an education component. No one wakes up one day and says they want expensive mezz debt,” Vazquez says. But the option is there for businesses that otherwise would be limited to dilutive equity, given the tight credit markets and slower M&A activity. “If you believe in the equity story and the company is growing, mezz can be a compelling growth lever for your business,” she says.

NewSpring recently invested in an electronics manufacturer that needed funding to support a strategic acquisition, where both the buyer and the target had experienced strong growth. The capital structure put 3x leverage on the company with 1x of that in mezz. “Now their focus will be on growth while integrating, and we can be the patient capital to help facilitate that growth,” Vazquez says. The deal closed in early July.

In some cases, implementing a mezzanine debt structure with a preferred equity component might work best so that leverage doesn’t go up as much, Vazquez says. To remain conservative in its underwriting, NewSpring recently worked on a capital structure that provided a $10 million growth investment, $8 million of which went to mezzanine and $2 million to preferred equity. That structure ensures the company isn’t over-levered, which could hinder its growth plans.

Preferred Equity

Like mezzanine, preferred equity also sits between the senior debt and equity of a company’s capital structure. It involves new equity interest in a company that technically falls in the junior debt category but has priority over common equity interests when it comes to paying out dividends.

Matt Shafer, head of direct private equity at Northleaf Capital Partners, says preferred equity is an option in this market, where interest expense can eat away at even strong companies’ cash flow. “The big issue is that the cost of debt increased enormously over the last two years,” Shafer says. “There are really good companies out there where leverage was arranged under different circumstances. The earnings and performance haven’t gone down, but it’s harder to find money to grow.”

That reality has created the need for alternative capital solutions that can be used to help a business grow, as in the case of a healthcare business that received preferred equity from Northleaf in March. A portfolio company of a brand-name sponsor that had double digit revenue growth, the business was healthy, according to Shafer. Yet high interest expenses were hindering its ability to pursue M&A. “There was everything good about that situation except that the company had too much debt to continue the acquisition growth strategy,” he says.

A benefit of preferred equity is that it does not put pressure on the cash flow of the business, Shafer notes. “But it’s cheaper than equity from the private equity fund that owns the company.” If the company’s existing sponsor has remaining LP capital, it usually wants to use it for other purposes, such as new deals. “Using someone else’s money that’s a little bit cheaper makes sense,” Shafer says. Preferred equity can also be a way to distribute capital to investors. Northleaf recently looked at a tech services company where proceeds would be used for a dividend recap to return some money to LPs.

Continuation Funds And Nav Lending

Another way to return capital to LPs while giving sponsored companies more runway before an exit is through continuation funds.

While not a new concept, continuation funds have garnered more acceptance from the LP community in the last year or two. For funds that are nearing the end of their life cycle but need some time before exiting one or two final companies, continuation funds offer liquidity to some investors while rolling other LPs or new ones into a new fund that will house just one or two portfolio companies.

Northleaf’s Shafer says his firm’s secondaries business was an early adopter of continuation funds, and has invested in them since 2012. The investor community has become more open to this vehicle lately, especially since it usually means access to portfolio companies at lower valuations and favorable economics, with lower fund management fees and a tiered carry structure. “LPs have become more accepting, though they viewed it as a negative 10 years ago,” Shafer says. He adds that

RAFAEL CASTRO Partner, Hark Capital

they recognize the structure could be better than selling assets amid unfavorable market conditions.

NAV lending is another option for fund managers that want to extend the runway for a handful of remaining companies. A NAV loan is backed by the unrealized value of the private equity fund. Like continuation funds, NAV loans have been around for years but have garnered more acceptance recently as market conditions became choppier.

Compared with a continuation fund, a NAV loan is a simpler, more focused solution that can be completed in four to six weeks, according to Rafael Castro, partner at Hark Capital, a NAV loan provider. “The difference between a NAV loan and a continuation fund is like the difference between a Band-Aid and surgery,” he says. On the other hand, if the GP needs a greater amount of capital and some of the existing investors want to realize their stakes while others want to “roll,” the continuation fund could make more sense.

Before providing a NAV loan, Hark Capital looks at the remaining assets in the portfolio and determines the loan-to-value ratio of its loan relative to the value of the portfolio. When performing the analysis, the firm likes to see diversification: at least four or five companies that are “viable names” with a defensible strategy.

Castro thinks about downside protection in terms of both coverage and diversification. If there are several good names in the portfolio, one potential write-off among several good performers will still allow the NAV lender to be repaid upon exits of other portfolio companies. “We can be particularly helpful in situations where the alternative cost of capital is equity. If you compare our cost of capital to the real economic cost of bringing in dilutive equity, I think we’re an attractive option,” Castro says.

As a case study, last year Hark Capital lent $50 million to a $400 million fund that needed capital to pay off a senior debt facility at one company and finance add-on acquisitions at another. The remaining assets in the fund were diversified across multiple portfolio companies and industries, including industrials, business services and consumer, Castro says.

When it comes to fund finance solutions, Castro and Shafer think NAV lending and continuation funds could become a permanent fixture of the investment landscape. Whereas in the past, using a continuation fund or a NAV loan could be seen as negative or signal that the remaining assets were impaired, now it means something different. The assets are likely healthy but need more runway because of high interest rates and lower valuation expectations.

“A few years ago, maybe there was a little bit of a stigma among GPs driven by a misunderstanding of [NAV loans]. Now we’re starting to see that thaw. We’re starting to see more people in private equity embrace this as a solution,” says Castro.

Continuation funds have also gained more acceptance in recent years because of market conditions and new governance aspects. The Institutional Limited Partners Association published new guidelines on continuation funds in the summer.

“It went from being the assets that didn’t work being sold at very mediocre prices to being the assets that did work being sold at very good prices,” says Shafer. “The outcome to limited partners who chose to sell into these deals became a positive outcome.” //