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RIAs can turn stockpiled private equity cash to clients' advantage and into AUM

Clients who grimace at selling their business or standing pat may love a rising new option

Friday, July 29, 2011 – 2:16 PM by Elizabeth Ostrander, Guest Columnist
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Elizabeth Ostrander: Now PE firms are sitting on piles of cash raised in ’06-’08 that they must invest soon or return to their investors

Brooke’s Note: Most RIAs prefer to give no advice before giving bad advice. But this conservative approach can have a steep opportunity cost when a client comes knocking for counsel on the biggest financial decision of their lives – selling their company. Elizabeth Ostrander’s columns are invaluable ammunition for RIAs who don’t want to cede control to the Gucci-dressing folks at the investment bank.

I recently made the case for why financial advisors should initiate a dialogue with their clients about exit plans for their privately owned businesses. See: Five reasons for RIAs to think more like Goldman Sachs about businesses owned by clients.

For those of you who have begun those discussions, you’ve probably encountered a business owner who, although he or she likes the idea of generating liquidity and reducing the risk of having the majority of his or her wealth concentrated in this one asset, is not ready to sell.

Many owners are reluctant to sell outright because they feel strongly that they can still grow and improve their businesses. They may also not be ready to retire—they’ve spent their lives growing their businesses, and can’t imagine getting up in the morning and not running XYZ Inc.

A business-owner’s dilemma

We recently heard from a financial advisor we work with after he received a panicked call from his client. “Fred” is the owner of a business worth about $50 million. Fred’s son recently informed him that he does not wish to succeed him as owner and CEO.

Fred had always thought he’d sell the business to his son and take back a note for 100% of the purchase price. Fred was comfortable with this plan because he was confident his son knew the industry and business well and would thrive as the owner/CEO. Fred planned to stay active in the business in a consulting capacity for a number of years after his son took the reins and had no definite plan to ever “retire” from the business he built.

Given his age, 61, and without an alternate succession plan, Fred felt that his only alternative was an outright sale of the business to a third party. This would reduce his personal exposure to the business and generate liquidity.

But Fred faced the loss of his position, all of its accompanying perks and, most importantly, control and management of his business. He worried that if he sold the business outright and it wasn’t properly managed, he might watch his life’s work dissipate. Furthermore, Fred was confident that, with a capital infusion, he could take his company to the next level. But at his age Fred felt it wouldn’t be prudent for him to invest more of his capital in the business and personally guarantee additional bank loans.

Fred’s situation is not at all unusual and unfortunately this is how most business owners frame the issue – should I sell my business or not?

Monetizing one’s business is a huge event and a tremendously emotional one at that. More and more business owners are turning to their trusted financial advisor for guidance when contemplating this momentous transaction. Perhaps the most important thing financial advisors can do is help business owners understand that they do not have to frame the issue as an either/or proposition. Rather, there is a wide range of strategies that owners can consider when the goal is to monetize some or all of their private- business equity.

Most business owners are not aware of the many monetization alternatives that are available. By introducing their clients to these alternative strategies, and discussing how each option might impact their personal wealth planning goals, advisors can help their clients navigate arguably the most important financial decision in their lives.

A third way

One timely strategy advisors can suggest to begin a dialogue about exit strategies with their business-owning clients (or to continue the conversation after a client makes clear that he or she is not interested in selling outright) is leveraged recapitalization. Commonly referred to as a “recap,” a leveraged recapitalization is most appealing to middle-market business owners who are looking to take some, but not all, of their chips off the table. And it looks particularly attractive now due to our currently low capital gains rate, which many think will increase in the near future.

A recap is a restructuring of a company’s balance sheet, typically through a partnership with a private equity firm. The PE firm generally invests equity and provides or arranges debt with senior and mezzanine lenders. The owner exchanges his stock for cash and a portion of the newly capitalized entity.

This allows an owner to monetize up to 80% of his business but still stay involved in its operations. The owner maintains day-to-day operating responsibility for the business and retains his title, salary, benefits, and reputation in the community as a successful entrepreneur.

An owner can capitalize on the historically low capital gains tax rate, and get a second bite at the apple in 3-5 years when the PE firm and the owner have another monetization event in the form of an IPO, sale to another buyer, or another recapitalization. Furthermore, with the strong financial backing of a PE firm, the owner can watch his business reach its full potential.

Middle-market offices in play

This appealing strategy has only recently become more widely available to middle-market business owners. Prior to the financial crisis, recaps were typically the purview of large corporations and the PE firms that took them private.

Now PE firms are sitting on massive amounts of cash raised between 2006 and 2008 that they must invest soon or return to their investors, and the credit markets have not yet sufficiently recovered to support the large deals they had become accustomed to. Hence, PE firms are broadening their universe and eagerly pursuing middle-market companies. In fact, we get several calls from PE firms each week looking for middle-market companies in which to invest.

Of course, nothing in life is without a downside. Although the owner retains day-to-day operating responsibility, he or she does relinquish overall control of the company as the private equity firm makes all key strategic decisions. Also, the nature of the PE business is to monetize their investments, typically in 3-5 years, so their view is more short-term in nature.

Recap benefits

We recently introduced Fred to the idea of a recapitalization, and he loved it. The benefits are significant:

  • Significant amount of cash proceeds – $40 million in his case – are generated.
  • Proceeds are taxed at the long-term capital gain rate, which is currently at a low 15%.
  • Proceeds are used to diversify into other investments with Fred’s financial advisor overseeing this critically important process.
  • Fred retains a significant ownership stake ($10 million) with meaningful upside potential.
  • Fred remains motivated to grow the company and is backed by a strong financial partner, but there is diminished personal risk (no more personal bank guarantees).
  • Fred maintains his position and title as CEO with salary, benefits and other perks and maintains his reputation as a successful entrepreneur in the community.

One of many

The recap is just one timely strategy advisors can introduce their clients to who need or would like liquidity, but are not ready to sell their businesses outright. Advisors’ clients who own businesses are usually not aware of the wide range of monetization strategies available to them.

Who better than one’s trusted financial advisor to help guide a business owner through one of the most important – and emotionally trying – financial decisions of one’s life? It’s a natural extension of the wealth-management process for advisors to help clients determine which, if any, monetization strategy might make the most sense at a particular point in time in light of those clients’ overall financial and wealth planning objectives.

Once clients become aware of the many options they have, and are able to compare the risk/reward of staying entirely invested in their businesses versus diversifying into other asset classes, many realize they are able to achieve their long-term wealth planning goals sooner than they originally imagined.

An advisor who helps his client through this process has enhanced the value proposition delivered to the client and better positioned himself to capture the proceeds of the liquidity event, thereby increasing AUM. Even though most of an advisor’s business-owning clients will not wish to sell or monetize immediately, by beginning a dialogue with each of those clients, the advisor is creating a “lead list” of liquidity events and will likely be the person those clients turn to in the future when they are ready to monetize their businesses.

About the author: Elizabeth Ostrander is director of business development at Intelligent Edge Advisors, an M&A and investment banking boutique that works with financial advisors to plan, structure and execute liquidity events on behalf of their clients who own businesses.

Mentioned in this article:

Intelligent Edge Advisors
Mergers and Acquisition Firm
Top Executive: Thomas Boczar



August 17, 2011 — 12:47 AM

Just what I need as an RIA…..real estate !



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