Leveraging the Second Bite of Apple – Corporate Law and Company Law

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It’s no secret that private equity firms use debt aggressively to create leverage and increase returns on their investments. However, much less attention is paid to another hidden way in which private equity firms create leverage in their legal structure and most clients are surprised to find real and quantifiable leverage in the terms and terms of the seller’s rolling investments.

As a backdrop, virtually all private equity firms offer sellers the opportunity to reinvest their profits into the platform and participate in the famous “second bite of apple”. These rolling investments can be extremely attractive to some sellers by offering short-term returns that are significantly higher than would otherwise be available to them. Private equity firms prefer these structures because it allows them to keep the sellers invested in the asset, so they are much less likely to have to replace a management team and it reduces the amount of equity that they need. they have to invest. In order to maintain the investment of this management team, these rolling investments are therefore almost always subject to a series of appeals in the LLC platform agreement which are often related to the maintenance of the employment of the sellers with the platform.

For example, in the most generous of these rollover transactions, sellers could be bought out at “fair market value” in the event of a “head start” situation. Sounds fair, but almost all private equity platforms include some form of multiple arbitrage as part of their strategy. If their target investments are businesses bought at a multiple of 6.0x with an EBITDA of $10 million, that multiple will increase to 9.0x once a business has an EBITDA of $50 million. By using the 6.0x multiple for redemptions at “fair market value” (or in some cases simply redeeming the investment), private equity investors benefit from the full “size multiple” and optimize their yields as well.

Other transactions may not even provide sellers with fair market value on a buyout – they may simply return sellers the initial value of the investment. In this case, the rolling investment offers even more leverage than the debt because the investment was interest-free.

These issues can be particularly difficult in the situation where a majority seller has the stated intention of retiring in the near future and “passing the baton” to a new generation of leaders. Depending on which side of the table you are on, the rationales for placing redemption restrictions on this rolling investment disappear or there is a great opportunity to get more out of your investment.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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