Why a private debt structure makes sense in replacement capital deals

News: Insight & Opinion | 30 May 2023

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Replacement capital transactions typically see private equity firms purchase a stake in a company from existing shareholders as part of a shareholder re-organisation. Managing Partner, Claire Madden explains how using private debt instead of bank debt in these deals can benefit all parties. 

With another election looming in 2024, and still no clarity from any of the political parties around what changes they may or may not make to capital gains tax (CGT), Entrepreneurs’ Relief (ER) and Business Asset Disposal Relief, demand from owners of successful businesses to de-risk and realise a portion of the gains they’ve built up remains strong. Releasing some of the capital they’ve got tied up in the company by bringing a private equity firm on board to buy out a part of their shareholding – or to buy out other passive or retiring shareholders entirely – is called a ‘replacement capital’ deal. But how should this kind of transaction best be structured? 

How can replacement capital help business owners? 

For business owners considering cashing out some or all of their shareholding, the usual route is to enter into a full private equity-backed management buyout (MBO) process. The provision of capital to undertake that transaction is typically where private equity comes in alongside a tranche of third-party bank debt. This option may result in owners giving up ultimate control of their company by handing over a majority stake. However, there’s another solution – and one that may be more suitable for the management team involved and that also works well for the incoming investors. 

That solution is for the private equity firm to provide the company with private debt instead of bank debt, and to take only a small equity stake in the business attached to the loan note – well below the equity percentage taken in a traditional MBO deal. Providing the company with debt in this way makes it possible for value to flow out to shareholders who require it. And it allows those staying in the business to roll their proceeds into equity in the new deal so that they retain overall control and maximise the benefit they receive from any growth they deliver from this point on. 

How does a private debt structure work in replacement capital deals and why is it attractive? 

Private debt-funded replacement capital deals can be priced very keenly, leaving more equity in the hands of management teams and business owners than in a traditional buy-out, while creating an attractive risk/reward profile from an investor’s point of view. 

Replacement capital: benefits for investors 

Removing senior bank debt from the equation gives greater priority to investors (and management teams) in the returns hierarchy. Investors provide a first-ranking loan to the business, with a small equity ‘kicker’ (of, say, 10-25%) attached. In terms of recovery capitalisation, the business only needs to be sold for the value of the debt instrument in order for investors to get their money back. In essence, they trade some of the equity upside in return for de-risking the overall investment.  

Moreover, structuring a deal this way typically means that investors are effectively ‘in the money’ from day one in terms of their equity stake. On top of the returns from their prior-ranking loan note, they will participate in the equity upside once the initial debt instrument has been paid off. So, if we invest £5m of debt into a business we believe is worth £10m, with a 20% equity stake attached, then that equity is worth £1m straight away – clearly, a very pleasing position for an investor to be in. 

Replacement capital: benefits for business owners/management teams 

Business owners and managers rolling over their value get to keep a much higher share of the equity in the business than they would in a traditional MBO (80% in the example above, compared to less than 50% normally). That’s a very appealing prospect for individuals who have plenty of faith in the strength and future potential of their business and are keen to stay on board to drive it forward.  

It means that they will reap a much greater proportion of any value they add to the business. As such, they are often happy to trade sitting behind the investors’ prior-ranking loan facility in order to retain more of that equity upside for themselves and their team. Control is another important factor: in this way they will have unlocked gains from their business without selling up entirely or ceding control to an investor who has a majority equity stake. 

This type of structure also allows more flexibility because, since the investors who provide the debt also have an interest in the equity, they are likely to take a more pragmatic, longer-term view if the company hits any bumps in the road than a bank would do. 

Unearthing a hidden marketplace 

Demand is definitely there for a solution to the problem of how to lock in business value entrepreneurs have created at today’s CGT rates without having to sell up or buy out all shareholders. However, this is a largely undiscovered marketplace, ripe for unearthing. Private equity firms running buyout funds cannot take advantage of this structure, so either specialist fund models are required, or it lends itself very well to investment firms like us who can take a deal-by-deal approach and can be creative about how to meet the needs of individual businesses. 

The reality is that some situations are better suited to a private debt investment like this than a traditional MBO structure. Not only that: we are finding that more and more business owners and management teams are not just prepared to consider it – in many cases they would actually prefer to structure deals this way. Only a few dedicated providers currently exist but as more emerge, and once advisers become more aware of this option, the market will undoubtedly grow, as an innovative alternative to the standard private equity route. Why let it remain hidden away?