It’s no secret that private equity firms use debt aggressively to create leverage and increase the returns on their investments. However, much less attention is given to another hidden way that private equity firms create leverage in its legal structure and most clients are surprised to find real, quantifiable, leverage in the terms and conditions of seller rollover investments.
As background, virtually every private equity firm offers sellers an opportunity to reinvest their proceeds into the platform and participate in the famed “second bite of the apple.” These rollover investments can be extremely attractive to some sellers, providing them with significantly better short term returns than would otherwise be available to them. Private equity firms prefer these structures because it allows them to keep the sellers invested in the asset so they are much less likely to have to go out and replace a management team and it reduces the amount of equity they need to invest. In order to keep that management team invested, these rollover investments are therefore almost always subject to a series of calls in the platform LLC agreement which are often tied to the sellers continued employment with the platform.
For example, in the most generous of these rollover deals, the sellers might be bought out at “fair market value” in the event of any “good leaver” situations. Sounds fair, but almost every private equity platform includes some form of multiple arbitrage as part of its strategy. If their target investments are businesses being purchased at a multiple of 6.0x with an EBITDA of $10M, that multiple will jump to 9.0x once a business has $50M in EBITDA. By using the 6.0x multiple for “fair market value” repurchases (or in some cases by simply refunding the investment), the private equity investors enjoy the entire “size multiple” and therefore juice their returns.
Other deals might not even offer sellers fair market value in a buyout – they may just return to the sellers the initial value of the investment. In that case, the rollover investment provides even more leverage than debt because the investment was interest free.
These issues can be especially fraught in the situation where a majority seller has a stated intention to retire in the near future and “pass the baton” to a new generation of management. Depending on what side of the table you are on, the justifications for placing repurchase restrictions on that rollover investment go away or there is a great opportunity to further leverage your investment.
Nathan Viehl is a partner in Thompson Coburn's Corporate practice group.
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