Due to the hard work and perseverance of the sponsor and the management team, the portfolio company has done well with EBITDA growing, for example, from $15.0 million at the time of purchase to $20.0 million. Equally important, the company’s debt load has shrunk considerably from its original 4.0x total leverage (or $60 million) down to a modest 0.75x (or $15.0 million).
But rather than sell the company or pursue a dividend recap, the sponsor finds a perfect add-on acquisition. In this example, the add-on has EBITDA of $15.0 million so, with synergies, the combined company’s EBITDA should approach $40.0 million. Unfortunately the price for the target is a whopping 8.0x, or $120.0 million, but the synergies make it well worthwhile for the sponsor.
So the private equity firm calls the incumbent lenders and asks to borrow the full $120.0 million purchase price. The sponsor explains that, even before synergies but after refinancing the existing debt of its current portfolio company ($15.0 million) and paying fees ($5.0 million), the total debt multiple before taking synergies into account will be a modest 4.0x, well within prevailing market multiples.
And then, just as things seem to be going smoothly, the lender gets back on the phone and says “so how much cash equity are you putting into the deal?”
The sponsor is not sure he heard right because its existing portfolio company that’s being contributed to the deal, even when applying a conservative enterprise value multiple (say 7.0x) that’s lower than the target’s, is still valued at $140.0 million with $125.0 million in equity value. Isn’t this enough of a commitment to the deal? On a combined basis, equity as a percent of total capitalization is over 45%, also well within prevailing market conditions. But the lender is obstinate and insists that, without new cash equity coming into the deal, he isn’t interested in playing.
While not every lender feels this way, we’ve been surprised to see quite a few who do believe that, despite a portfolio company’s large equity value, cash is still king and an additional cash investment is necessary to demonstrate a sponsor’s continuing commitment to the deal. Interestingly we’re not sure how a lender would have reacted if the sponsor had re-levered the company, taken out some cash as part of a dividend recap, and then re-invested the proceeds in the add-on deal.
We are not particularly fond of these lenders’ logic and believe that the large equity stake created within the existing portfolio company is an ample commitment to the deal and is really no different than cash. However, lenders often cite two concerns when bringing up their “cash” argument.
First, since most lenders are enterprise value lenders, they are always concerned that there is insufficient equity below them to cushion a decrease in value. Having the sponsor contribute cash makes the lender much more comfortable because an additional cash investment creates a larger cushion. We would argue that, absent a disagreement on valuation, the equity value created and contributed by the portfolio company is no different than cash equity. So long as this total equity meets the minimum market requirement, it should be a sufficient buffer for any lender.
But more importantly, lenders cite that the need for a sponsor to invest additional cash demonstrates they have “skin in the game” in case a problem arises. But doesn’t a commitment of an existing portfolio company’s equity value created by a sponsor show the same commitment as a cash investment? The private equity firm could have sold the company and reaped the cash but instead is agreeing to put it at risk in this new transaction. Certainly committing the hard earned equity value, although not monetized, should show the same level of commitment and should, therefore, be treated as cash.
As more sponsors seek to create value, add-on acquisitions will increase in popularity. We hope lenders will conclude that the equity value created and contributed by PEGs is just as valuable as cash.
Ron Kahn is a managing director at Lincoln International.