Growth of Family Offices in Private Equity

By EdgePoint

There are several types of buyers in M&A sell-side transactions. One group is strategic buyers who are companies that are in the industry of the seller, and could either be direct competitors or in an ancillary business that would be complementary with the seller’s business. A second common group is financial buyers, which are typically thought of as “private equity groups” or PEGs, which are a group of investment professionals with capital that typically purchase a portfolio of companies in which they own the majority of the equity, but the management teams actually run the day to day operations of the business.

PEGs actually come in many forms, but the most common is a traditional 10-year fund. 10-year funds are generally a group of investment professionals representing the PEG firm, which acts as the general partner, and they raise capital from limited partners (LPs) such as pension funds, endowments, asset managers, or high net worth individuals. They have a 10-year time horizon to put the committed capital to work and return those funds with profit to the LPs. During that time, they need to find privately held companies to purchase, buy them, grow them, and then sell them all within the prescribed 10-year fund timeframe (with some limited ability to extend). If the fund general partners are successful and make a return for their investors, they are able to raise additional successive funds, and the cycle continues. On average, funds may hold their investment companies for five years due to the timing pressure of returning capital and showing returns early enough to raise the subsequent funds. Because PEG firm professionals make their money from fees for managing and investing the committed capital plus a portion of the upside return on the investments that they make, PEG funds need to continue raising funds or their firm and income streams would end. This means that they have pressure to sell companies that have further growth potential to satisfy their fund timing or capital raising initiatives. Fund professionals lament about how difficult it is to find, chase, bid on, win, and close these investments in good growing companies, only to have to prematurely sell and start all over with a different company that may not have the upside of the one they were just forced to sell.

Because of the time pressure of working within a timed fund, many private equity professionals are choosing to go the “fundless” approach and either raise money on each transaction from LPs that know them from prior investments, or have an alternative source of capital that doesn’t necessarily have the same timing. Evergreen funds recycle the money that is returned to the LPs so that the investment pool doesn’t expire. Funds raised by groups of high net worth individuals may not have the timing pressure as a fund with pension or endowment investors.

Another source of capital that has emerged somewhat recently and been growing in popularity for many of these timing reasons is Family Offices participating in the private equity buyout arena. Family offices are private wealth management advisory firms that serve high-net-worth investors. Family offices can invest on their own or in conjunction with other family offices, usually through a separate “private equity” entity that is funded by the family capital. One big advantage to most family office buyout structures is that they have no specific “hold” period, which means they can hold an investment for as long as there is opportunity for growth and return on investment. Just because they have a theoretically unlimited hold period doesn’t mean that they will hold it forever. Family offices generally have private equity professionals and/or investment advisors running their private company investments and will look to take advantage of opportunistic transactions as well. What separates them from the funds is that they don’t have the pressure to exit prematurely when there is still strong growth in the forecast. They are often considered “patient capital” relative to traditional PEGs. This aspect is appealing to many sellers.

Whatever the source of capital, private equity represents a large and growing opportunity for business owners to partner with professionals experienced in growing businesses. They bring resources both in capital and strategically to the companies that they partner with, and allow the business owners to take risk capital off the table while staying involved in the business for as long as they would like to contribute, and allow them to step out of the company knowing their succession plan is being handled by equity-aligned partners who have helped in this transition many times before.

Common considerations for partnering with private equity when EdgePoint advises business owners include:

• The seller is able to cash out 80-100% in a transaction with an opportunity to reinvest equity alongside PEG (with a 3-5x their money expectation in 5 years – “second bite of the apple”)
• Private equity buyers provide the highest valuation in many auction processes
• As-Is and Where-is Transaction – Employee continuity and Company culture are maintained post-transaction (legacy maintained)
• Seller and/or executive management team can continue to operate the business with day-to-day control
• A private equity will form a board of directors comprised of relevant industry executives and business leaders to facilitate strategic growth and leverage relationships
• Because of the leveraged roll-over, owners can roll 10-20% of their proceeds to secure 20-49% of equity in the new entity
• A private equity transaction allows the Seller to dictate his or her own terms for continued employment with built-in succession help or retirement in the near term following the transaction
• Owners treated more like “senior partners” than employees post-transaction.

Family office backed private equity is strong and growing. A survey of 139 single-family offices from Grant Thornton found that 86% of those that already invest in private equity want to increase their commitments over the next three years. The survey found the median office has $276 million in investable assets, and the 109 offices that have invested in private equity since 2009 have allocated more than $8 billion in capital both in committed capital funds and direct investments. Slightly more than two-thirds invest in funds and just over half invest directly in Companies. Another 29% co-invest with funds directly, but alongside funds. Many family offices were funded by operating businesses that made the family wealthy, so there is a good fit and understanding of business owners. In some cases, there can by synergy or industry knowledge with the family office’s operating business as well.

Whatever the source of capital – committed capital funds or family office capital, private equity represents a flexible and potentially valuable transition option for business owners considering transition. Committed capital funds are abundant and eager to put capital to work and will often be the highest valuation even when in competition with strategic buyers, and can add strategic-like value post-transaction. Because of their longer hold timeframes, family offices provide the flexibility of longer term strategies and organic growth alongside a deep capital provider that may also have knowledge and experience in the industry. Both sources of capital offer a flexible and potentially lucrative transition option, without the perceived competitive issues that come with strategic buyers. This expansion of the buyer universe that has been occurring has contributed significantly to the robust and active sellers’ market that currently exists.

© Copyrighted by EdgePoint. Tom Zucker can be reached at 216-342-5858 or at tzucker@edgepoint.com

A Primer: Reps and Warranties Insurance

By Matt Keefe,
Managing Director

Once a business owner has come to grips with selling his or her business, and once the buyer and seller have agreed to the key terms, then the legal documentation and closing phase of the M&A process begins. Inevitably, the documentation and closing phase can be frustrating and stressful for both the buyer and seller and can cause deals to stall, or sometimes even die. One aspect of documentation that usually creates issues is the negotiation of the escrow amount related to potential breaches of Representations and Warranties, or more often referred to as “Reps & Warranties” (Reps & Warranties is a term to describe the assertions that a seller makes to a buyer in a sale.) Fortunately, there is a burgeoning insurance product that is significantly alleviating the hassles tied to breaches of Reps & Warranties.

What are typical breaches that would cause a buyer to file a claim and seek compensation? Oswald Insurance, one of the nation’s largest independent insurance brokerage firms, conducted an analysis to identify Reps and Warranties claims by breach type. The results of that analysis are set forth below:

Before Reps & Warranties insurance was available, a buyer of a business would offset a portion of the potential risk related to breaches by asking the seller to hold-back, or escrow, a percentage of the total transaction value. This created a well-defined process whereby the buyer could file a claim against the escrowed amount to recoup a portion of the purchase price if a material breach was found. Typically, the escrow represented 5-10% of the total purchase price and was in place for six to eighteen months.

That was how it happened before Reps & Warranties Insurance came along. Now, Reps & Warranties Insurance is being used in lieu of the indemnity agreements that require escrowed funds. While Reps & Warranties Insurance is not a standard practice in all M&A transactions, the insurance product is being utilize more and more…for good reason.

Reps and Warranties Insurance provides benefits to both buyers and sellers. For buyers, as Chris Jones, Managing Director and Founder of Align Capital Partners, states, “Reps & Warranties Insurance allows us to provide more cash to the seller at closing (making our bid more attractive) and significantly increases the efficiency of legal documentation.” Other benefits to buyers include potential for protection beyond the traditional indemnity period, ability to reduce collection concerns, and the opportunity to augment fraud protection.

Sellers also enjoy significant benefits from Reps & Warranties Insurance. First, like buyers, sellers can reduce legal costs by eliminating the negotiations over post-closing indemnity obligations. Second, and most importantly to sellers, Reps and Warranties Insurance eliminates the need for an escrow, therefore, maximizing the cash proceeds to the seller at closing.

Like any insurance product, there is a cost (premium) for the insurance and that cost is tied to the amount of coverage. The amount of coverage is determined by the deductible limit. For example, in a $100 million transaction, a 10% deductible policy provides $10 million of coverage. The premium can be purchased by the seller and/or the buyer. Premiums are priced based on coverage and are typically 2%-4% of the transaction value. Therefore, the cost of the $10 million of coverage may be $200,000 – $400,000

Since the inception of the Reps & Warranties insurance product, the speed at which a policy can be issued has increased significantly. It typically takes two weeks for a policy to be underwritten. This has also expanded the popularity of the solution

As M&A Advisors, we are always looking for tools to help expedite the process. EdgePoint has closed several recent transactions that employed R&W insurance and found, in all case, the benefits (for all parties) outweighed the cost. To learn more about how EdgePoint uses Reps & Warranties Insurance, or to learn more about EdgePoint’s M&A capabilities, please contact us at 800-217-7139.

© Copyrighted by Matt Keefe, Managing Director of EdgePoint Capital Advisors, merger & acquisition advisors. Matt can be reached at 216-342-5863 or on the web at www.edgepoint.com.

Impact of the Tax Cuts and Jobs Act on…

By EdgePoint

The tax reform signed into law December of 2017 includes lower federal tax rates and several new tax deductions that apply to both C-Corporations pass through entities, including LLCs and S-Corps. Along with those tax deductions come a new set of restrictions on other deductions such as the ability to deduct state and local tax (SALT) against federal income tax, limitations on deducting interest on business loan payments, among other miscellaneous complicated new rules affecting business taxation.

It is difficult to determine what the effect of these new rates, deductions and limitations will be on a business without examining the unique aspects of the individual company, including what business activity it conducts, its asset and wage base, and its ownership since the new rules were targeted to encourage certain types of business activities over others. How this may affect a business owner looking to sell his/her company is further complicated by the lower tax rates on C-Corps that still carry a double tax on the sale of assets, and the promise of lower taxes on pass through entities that seemingly bring the income tax rate closer to the capital gains rate mostly enjoyed on a sale of the business. With all the counterbalancing built into the new tax law, it is important to review some of the key points of the new tax law to determine how this may impact an owner’s decision to sell.

Corporations and pass through entities will all benefit by having lower actual tax rates. C-Corporations rates drop to 21% and the top individual federal rate of 39.6% goes to 37%, with higher thresholds that save an individual over $31,000 on the first million dollars of income without considering any deductions. Additionally, amounts for bonus depreciation are increased significantly, allowing companies to deduct both new and used equipment purchases. Finally, there is a pass-through income deduction of 20% on Qualified Business Income (QBI) under 199A that applies to businesses not in a specified service or trade company. This 199A pass through deduction reduces K-1 business income by up to 20%, but is limited by several factors including how much W-2 wages the company pays and the amount of its gross depreciable assets.

On the limitations side, the SALT deduction is limited to $10,000 and business loan interest is limited to approximately 30% of EBITDA and phases down to approximately 30% of EBIT in 2022, which will lower the ability to deduct interest further. The 199A pass through deduction of 20% on QBI in the highest tax bracket is limited by 50% of W-2 wages or 25% of Wages plus 2.5% of gross depreciable assets. Thus, the deduction benefits lower income companies that may have more wage or asset intensive businesses, and is either non-existent for some service businesses or reduced for eligible businesses that happen to have high margins that make a commensurate high return on assets or labor.

Entity choice will continue to matter to business owners as C-Corps may have a lower effective tax rate than pass through companies, but are still double taxed on the sale of its assets resulting in an approximate 37% effective rate in no-tax states to higher than 45% for mid-taxed states. This is still better than double tax rates as high as a combined 58% before the tax reform. As most of sale transactions are taxed as “asset transactions”, pass-through entities such as S-Corp and LLCs will continue to be the clear tax choice for those owners looking to sell their companies. This is in addition to the fact that pass through entities will create tax basis (AAA) for their owners on the after-tax income that is not distributed, unlike C-Corp owners who do not benefit in that way.

From a tax rate perspective, pass through entities that qualify for the 199A pass-through 20% deduction and are not limited by any of the wage or asset tests will bring their federal rate down from 37% to 29.6% by applying the 20% deduction to their business income. Even so, the loss of the state deduction in the SALT limitation will add close to 2% additional effective taxes on a mid-level tax state resulting in a 31.5% effective comparable rate. Although this is down from the 39.6% top rate prior to the reform, most higher profit businesses will not qualify for the full deduction, and the best-case scenario income tax rate is still significantly higher than the capital gains rate of 20% on the sale of the goodwill of a pass-through entity. Therefore, when you capitalize earnings on a multiple of EBITDA, which is higher than taxable net income – especially when reduced by Capex and working capital reinvestment, owners will find that they simply cannot “work a few more years” and make what they would in the capitalized sale transaction taxed at predominantly capital gains.

The M&A professionals at EdgePoint have been doing transactions through several major legislative tax changes, and although the change at the time may seem to affect a business owner’s decision to sell, it is our experience that taxes are only a part of the decision. In fact, tax changes generally have not played a major role in our clients’ decision to sell, except to the potential accelerating by a few months during a known tax increase period such as the expiration of the Bush tax cuts in 2012.

In our experience, business owners make the decision to sell when they feel they are ready to have the transition/succession discussion, the market cycle is favorable to them, and when their businesses are doing well. The tax cuts in the tax reform act of 2017 should add fuel to an already accelerating economy, and extend the market cycle to allow savvy business owners to take advantage of the current high valuations for their companies, while hopefully getting some tax relief in the process. That, we believe, will be the true impact of the new tax legislation.

© Copyrighted by EdgePoint. Tom Zucker can be reached at 216-342-5858 or at tzucker@edgepoint.com