Recapitalization for Business Growth
Roger Strode, partner in National Healthcare Practice with Foley Lardner says that recapitalizations are transactions that are very common these days and they are very common in the private equity industry.
According to Strode, current recapitalizations are popular with urgent care companies, ambulatory surgery companies, pain medicine, diagnostic and interventional radiology, some of the hospital based practices like anesthesiology, radiology. Strode says all of these areas are interested in recapitalization for growth.
Strode says the definition of a recapitalization is, the re-financing of a business oftentimes by non-physician investors.
“With a recap, what usually happens is a fairly well funded strategic or financial investor will come in, will buy anywhere from 60 to 90 percent of the business and will cash out the owners anywhere from the extent of 60 to 90 percent of their equity and pay them cash for the business. The owners will roll over a portion of their equity into the new company that will be the growth vehicle,” Strode says.
“What you often have is a company that has grown very quickly or has grown to the point where it has quite a bit of value to it. The owners are sitting on a lot of built in equity, but they don’t really have the ability to monetize the equity. They want to grow bigger, they want to grow more, but they really don’t have the necessary cash to fund the growth on their own. There is oftentimes a desire by those owners too, to take a little money off of the table to cash in some of the equity growth that is inherent in the practice.”
According to Strode there are three main benefits for a company to enter into a recapitalization deal.
Benefit number one is that owners gain the ability to get cash off of the table as well as maintain a certain portion of equity in the new company, Strode says.
Jack Eskenazi, managing partner at Healthcare Advisory Partners says that typically in a recapitalization where a private equity group is investing and taking a control position in a platform company, management usually stays.
“There are some occasions where a private equity group has already developed a relationship with a very strong executive and that executive is going to lead a platform investment. But, even in that case, they are going to be typically looking for strong management in an acquisition candidate and looking to incentivize strong management to stay. So, typically in a recapitalization the goal is to retain management,” Eskenazi says.
“Also, when talking about an acquisition candidate, there could be two relevant parties that may be the same people or may be different people. One is management who is running the company, the other is ownership, who owns the company. Oftentimes if its’ the same person or people and the private equity group does a recapitalization, then they are going to try to incentivize the management that has been responsible for the success of the company to date. They are going to get them to stay by allowing them to retain equity, and so, if ownership is management, then they are probably going to retain, plus or minus 20 percent of the equity of the new company. If not the same, and the private equity investor wants to retain management, they might be incentivized with a smaller percentage, at a negotiable rate.”
Strode says benefit number two, is that you have got an investor now that is well capitalized and has the ability to fund the company through debt guarantees, go out and grow the business.
Benefit number three is that you then get the synergies behind some very savvy financial or strategic investors, and often times physician executives who understand the business and understand the industry.
When it comes to risk, Strode says you really have to consider it from either side.
“On the buy side, risks are always those around fraud abuse and program violations. Those are oftentimes big risks because, depending upon the business that you are buying, these private equity firms are very careful and you have got to do enough diligence to make sure that you are not buying into a problem. Generally, the main provider stays in place, provider numbers stay in place, contracts with Medicare and Medicaid stay in place and if there have been program violations, whether they are fraudulent or simply negligent or accidental, those violations follow you. They can very easily suck up a lot of your value if you buy into a problem,” Strode says.
Andrew Hertzmark, managing partner at Generation Partners is an advocate for companies performing due diligence on themselves prior to entering a deal.
“At the end of the day, every company has some warts and the worst thing you could do is try to hide those warts and hope the investor doesn’t find them. The purpose of doing diligence on yourself is multifold. One, the management and the company needs to make sure that they are prepared for all of the questions and have the materials before the questions are asked. They are not caught off guard and try to change the wheels while the car is in motion,” Hertzmark says.
When it comes to the actual due diligence performed in the recapitalization Eskenazi says that it is not necessarily a longer process.
“I would say in the case of a recapitalization, whether it’s a strategic operator acquiring a company, or a private equity group investing, honestly, the due diligence is very similar. I think the acquisition criteria might be slightly different in that a private equity group is relying much more on the management team of the target company to continue the successful growth of the company. Whereas in a more traditional strategic acquisition, quite honestly, there could be pretty significant reliance on the management team, but of course in a strategic acquisition, the management team of the buyer is going to take the ultimate responsibility for the operation,” Eskenazi says.
Strode explains that on the doctor’s side, the risks are that you get into business with someone who just doesn’t suit you.
“You get caught up in the immediate money, and you really don’t understand that fundamentally, you have sold control of your business. You can listen to the discussion when you are in the buying process; it’s a mutual admiration society. This is because there are a lot of people making money at that point, a lot of people getting the businesses they want to get into and sometimes the physicians don’t necessarily think down the road that “This is my life now. I no longer control this business that I built from the ground up and grew myself.” It is no longer just your baby, you now share the baby,” Strode says.
Hertzmark says that the best way to face a recapitalization is to look at it as a marriage.
“So, most important and the biggest challenge is for the two parties to make sure that they spend enough time getting to know each other before the transaction is consummated. The biggest risk that we have found is the investor doesn’t do enough diligence on the type of person that they are partnering with. More often than not the management team and the owner doesn’t do enough diligence on the investment partner they are bringing on,” Hertzmark says.
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