The Verit View – April 2016
The Verit View is that, for many founders, selling a minority stake is a crucial step in both their middle market company’s long-term capital plan and in the owner’s estate plan. And a financing market turned cool to minority investing shouldn’t upset those plans.
Purchases by private equity funds of minority stakes in the U.S. and globally have been on the decline, according to Dealogic. The number of minority investments made by private equity firms globally last year, 649, was the lowest in more than decade, and aggregate global dollar volume was far below 2014 and below the peak years of the prior decade. Activity in the U.S. was also down, with the number of private equity purchases of minority stakes, 296, well off the pace of the last three years. And Dealogic reports that the downward trend continued during 2016’s first quarter.
Some contributing factors:
–Private equity funds globally have more than $1 trillion in capital and commitments, known as dry powder, and thus are under pressure to put those funds to use. Buying entire companies puts the most capital to work the quickest and leverages a firm’s investment in due diligence.
–Private equity fund managers often prefer outright control of target companies, as opposed to the uncertainties of being a minority shareholder.
–Especially in the middle market arena, many private equity funds are looking to acquire platform companies and then rapidly add on related acquisitions; buying a series of minority stakes is an unwieldy method for such a consolidation play.
But owners of middle market companies often have different goals. As a company matures and a founder contemplates eventual retirement, he/she often desires to “take a little something off the table” to diversify an estate long concentrated in a single asset. This can dovetail with a company’s need for additional capital to support internal growth and acquisitions. And quite importantly, these same owners are far from being ready to exit entirely; they have big plans to keep building the company they founded and are often in their prime as managers.
The good news is that, in Verit’s recent experience, there are alternatives to private equity. An abundance of reasonably priced capital supports traditional mezzanine funds that remain active and interested in taking meaningful positions in well-run, financially sound middle market companies.
Perhaps best-suited to a minority stake – with the potential to buy the entirety of a middle market company – are your company’s workers, through an employee stock ownership plan, or ESOP.
Many of the nation’s largest ESOPs started as a minority holder and over time acquired additional stakes to eventually become 100%-employee owned. Examples worth your study include Hisco, a highly successful industrial distributor; Schweitzer Engineering, a maker of sophisticated componentsfor the power industry; Central States Manufacturing, a building products supplier specializing in high-touch service; and S&C Electric, another highly-regarded supplier to utilities and power companies. In each case, the company was sold in steps.
Verit Advisors has deep relationships in the ESOP lending community and our recent experience is that abundant capital is available to fund partial financial exits by founder/owners of well-positioned middle market companies.
For those seeking a partial exit, an ESOP as minority owner holds these advantages:
–The founder can retain control and governance, which includes some safeguards for ESOP owners (the employees), is workable and reasonable.
–Those selling stock in a C-Corporation can defer the capital gains taxes, potentially forever, by investing the proceeds in qualifying securities such as stocks and some bonds, under federal tax laws designed to encourage employee ownership. This means that after-tax proceeds can actually be higher than selling to a private equity fund or other buyer for cash. In some high-tax states, combined federal and state capital gains can take a 33% bite out of cash proceeds.
Private equity fund managers have perfectly good reasons for veering away from their industry’s former focus on buying minority stakes in companies. But that doesn’t mean that founders and owners of quality middle market companies should forgo taking on minority partners, as part of their corporate and personal financial plans. Verit’s view is that looking beyond currently available private equity alternatives will enable business owner to realize this important transition strategy.