In addition to the private equity investing aggressively in our space, banks have joined the party by offering credit to fund acquisitions. One particular roll-up has secured a $1 billion line of credit to support its market consolidation strategy.
It feels like we are a lifetime away from the roll-up binging of the 90s, fueled by huge amounts of debt that collapsed under the weight of the debt load (like Waste Management, Auto Nation and others). While we can say we have learned our lessons about over-aggressive leverage tactics, the seductive attractions of leverage never go away. In 2010, we saw a microcosm of this when WealthTrust, a wealth management roll-up, was crippled by its debt on the heels of the 2008 financial crisis and, ultimately, had to recapitalize.
“Recapitalize” is one of those artfully crafted words that sounds harmless but can actually leave more than a flesh wound. If the buying firm is unable to service its debt, the covenants in the note usually give the lender the right to trigger a refinance of the debts at materially worse terms (a “down round” of financing). This can result in severely diluting common shareholders and potentially forcing a conversion into a less valuable share class. Or, worse, it could wipe out their positions completely.
So, how do we understand how levered the buying firm is? It’s pretty straightforward. Dive into the balance sheet with these questions in mind:
- What amount and type of debt is the acquiring firm carrying?
- Run the standard ratios to see how leveraged it is. How do these ratios compare to your buyer’s competitors?
- Has the debt been used solely for acquisitions, or for other purposes?
- What are the repayment terms? What is the size of the debt service claim on the revenue stream over the next several years?
Also, is the buyer looking for a preferred position in your P&L as part of the transaction? This is the first tell there is leverage behind the scenes. Their preferred position means the buyer gets paid before management, which allows the buyer to lever this secured position into further leverage. This is what I call the Budweiser/Champagne model: If profitability is down, say 25 percent, the buyers with preferred position(s) are getting their checks as management is hit with 100 percent of the reduction in profitability.
Leverage, in the right hands, can be an incredibly effective tool. I would argue that its powers are typically harnessed for good. In fact, we at United Capital have access to debt facility.
We get the fact that money is cheap right now. But even cheap money has to be paid back. The size of that future obligation dictates the risk profile of the organization buying your firm. You need to have a clear grasp of what that obligation is before you sell your life’s work.