During times of financial turbulence, a business may require restructuring. A company with a high debt-to-equity ratio may re-purchase its shares from the open market, increase its price, and improve its equity ratio. Companies trying to avoid hostile takeovers or wanting to derail acquisition often issue more debt to reduce their appeal to buyers.
Companies that want to reduce their financial obligations may also benefit from recapitalization. By paying off their debt and reducing their debt-to-equity ratio, these companies reduce their financial obligations, which allows them to disburse more of their profit to company shareholders.
Recapitalization: Definition and Process
The process of reorganizing a company’s debt and equity to stabilize its capital structure is known as recapitalization. Recapitalization refers to restructuring various forms of capital, such as debt, equity, and preferred stock. A company may want to switch from funding based on debt to equity or vice versa, or a company may want to buy all its outstanding shares by issuing new debt as decided by its board of directors.
Major reasons for recapitalization include:
- A decline in stock prices
- To get rid of the financial burden
- To prevent a hostile takeover
- Reorganization strategy during bankruptcy.
To settle affairs and avoid going out of business during bankruptcy, companies undergo recapitalization with high leverage to pay all their debt-based obligations by raising capital by issuing new shares of stock.
A company may also opt for recapitalization when offering an exit strategy to its venture capitalists or private equity partners.
The company’s majority shareholders monitor the recapitalization process to ensure that it doesn’t affect the price and volatility of the company’s stock. As a result, the process can positively or negatively affect the company’s financial structure.
Types of Recapitalization
- Leveraged recapitalization
- Leveraged buyout
- Equity recapitalization
Leveraged recapitalization, also known as a leveraged recap, is a financial transaction in which a portion of the company’s existing equity is replaced by a package of debt securities having both senior bank debt and subordinated debt. To put this simply, a company borrows money to buy back previously issued shares to reduce the equity from the company’s capital structure.
Leveraged recapitalization aids in preparing a company for its growth period. It is popular when interest rates are low because it allows companies to pay off debt or equity at affordable prices.
Leveraged recapitalization is publicly traded and has little effect on shareholders. Therefore, shareholders favor leveraged recapitalizations.
Private equity firms prefer leveraged recapitalization for early exit of investment or as a finance source. This kind of recapitalization often restricts where the company sells assets that are not a good fit. It allows the company to reduce its debt. The only drawback of leveraged recapitalization is that it may drive the company to lose its focus and become vulnerable to recession and unexpected shocks.
The acquisition of a company using significant borrowed money to meet the acquisition cost is known as a leveraged buyout. In this type of transaction, a company is purchased through a combination of stock and debt, and its potential cash flow serves as collateral for securities and loan repayments. In a leveraged buyout, the financial structure of the target company changes with the change in the debt-to-equity ratio.
A leveraged buyout is often part of a consolidation strategy. It is usually done to control competition, enter new markets, and diversify the company’s products and services. A leveraged buyout is one of the best strategies for business owners who want to make money at the end of their professional term.
Usually, a leveraged buyout has a ratio of 90 percent debt to 10 percent equity. After borrowing money for the acquisition, the acquired company issues bonds against the combined assets of the target and acquiring company. This opens the target company’s assets as collateral against the acquiring company. Leveraged buyouts are used to make a public company private or sell a portion of an existing business. They are also used to transfer ownership in small businesses.
For an acquiring company, the relevant questions focus on how much money is needed, how much is available, and what type of payment structure and personal verification is required. The target companies must have a dependable cash flow, reliable and robust management, and a good exit strategy for the acquirer to realize gains.
Equity recapitalization is a technique used by private equity groups and investors whereby business owners sell a part of the business and retain some equity to benefit from its future growth. The process involves raising new funds by withdrawing part of their authorized ordinary stock. Equity recapitalization allows business owners to retain equity a second time while investors sell the company.
The great benefit of equity recapitalization is that the company is infused with new money and business partners to help it grow. In addition, instead of repaying the loan, their investment is repaid with interest and future auctions.
Equity recapitalization affords the business owner a smoother succession plan because the investor intends to improve the company’s management, resulting in less responsibility for the owner. It also releases the company’s owner from carrying personal guarantees for its debt. In addition to benefiting the owner, equity recapitalization allows management teams to participate in company ownership even if they do not have the necessary resources. Private investors seeking management support may offer senior executives the opportunity to participate in the company’s stock through purchasing or receiving cash.
The process by which a government or state takes control of a particular company or sector is known as nationalization. There is no compensation for seized assets, income, and the loss of net worth of the company.
When a large company’s economy faces collapse, it is usually taken under state control. The government invests in private companies using this strategy by purchasing a large portion of the company’s shares. The TARP program, which the US government used to keep the country’s banks operating during the 2008 financial crisis, is a typical example of government action. However, this strategy is not used to transform a large business. Instead, nationalization leads to the re-use of funds.
Businesses in developing countries are nationalization targets. Privatization of government-run operations and their transfer into the private business sector mostly happens in developing companies.
Companies functioning in foreign countries are at risk because they receive no compensation for their seized assets. Counties with unstable political leadership and unstable economies are more likely to proceed with Nationalization.
Nationalization helps companies redirect revenues to the country’s government instead of the private sector. The primary focus is to export funds, resulting in no benefit for the host country.
Not Just a Last-Ditch Attempt
Business owners must rethink their strategies when looking at their long-term goals. Many companies require liquidity, but their owners are not ready to sell the business and relinquish control. Recapitalization allows them to retain control of their businesses and reduce debt by selling a portion of the company to a private investor or group. This allows owners to diversify their holdings with capital infusion and maintain ownership.
Recapitalization may be a vital part of value creation, allowing business owners to scale their companies or prepare their exit strategies. Seek the advice of professionals who can assist in determining whether your company might benefit from recapitalization.
Business owners face many challenges in deciding and implementing strategies. Value Scout offers resources that will fit your business’ future. Contact our experts today to build a secure future for yourself.