Posted on: May 24th, 2018
Quasi Equity describes a form of capital with debt-like properties and equity-like functionality. This form of financing allows the issuer flexibility and value. The capital is less expensive than straight equity, yet provides virtually the same level of value add as a straight equity investment. Specifically, it can be mezzanine debt, venture debt, convertible debt, structured equity or preferred equity. It can be used for anything a company needs including expansion capital, acquisition capital or to recapitalize. One differentiator denoting quasi equity is the role that periodic interest payments and dividends play. Often a large percentage of total return for the quasi equity provider is provided through current interest and dividend payments.
Quasi Equity can be:
- Mezzanine loans or venture debt loans.
- Convertible debt
- Structured equity
- Preferred stock
- Rollover seller purchase price.
This reduces the level of non-current return required so that the instrument is less dilutive than straight equity. With straight equity, the investor realizes no current return and hence 100% of the return is provided on the back end through an exit. This makes straight equity quite expensive from an owner’s standpoint. Most straight equity investors target 20% per annum as a targeted return. To achieve this without any current return, they need to own massive amounts of shares, which is highly dilutive to a company. Quasi equity is generally considered as equity from an economic standpoint though it may be classified as debt on the balance sheet. Like equity, it is largely unsecured in the capital structure and is considered junior to any bank debt. Quasi equity evolved out of the need for more bespoke layering within transaction structures. With the emergence of non-sponsored equity groups, search funds and founder operated companies, the need for less dilutive, highly functional unsecured financing has arisen. These groups tend to invest smaller levels of cash equity and seek ways to stretch their capital across a larger transaction value. Quasi equity providers fill a very valuable role, as they provide deep levels of risk capital with attractive pricing and structural flexibility. Quasi equity can also be a seller note or a contingent payment structure in a deal, whereby the seller will receive additional payments in the future. It can also be considered purchase price equity. This refers to the discount from fair market value that a buyer negotiates from a seller. Quasi equity in short is a versatile concept that can refer to both capital invested in a deal or value left remaining in the deal by the seller to the benefit of the buyer.
How is Quasi Equity Structured in a Transaction?
Quasi equity utilizes the same type of valuation methodology as a mezzanine loan or private equity investment. The provider is valuing the capital through assessing the purchase price relative to the EBITDA of the Company. The capital is inserted as a layer of financing and the risk reward relationship is evaluated in a number of ways:
- Multiple of EBITDA- quasi equity is usually invested at a greater than 3 times multiple of cash flow. It is positioned under the loan which usually goes up to 3 or 4 times but in front of the true equity level.
- Growth potential – quasi equity providers are focused on growth and will invest at higher levels of risk if the company has a major growth catalyst in front of it.
- Amount of Debt- quasi equity is junior to any loans so the amount of debt is a factor of consideration when assessing the attractiveness of the deal.
- Exit Potential – quasi equity investors are keenly focused on the likelihood of the exit, and the likely acquirer in an exit. They shy away from situations where there is a low probability of an exit.
Quasi equity lacks the security and covenant provisions that lender enjoy. They are typically represented in a board position, and have the consent rights as to major corporate events.
Why is Quasi equity Valuable for My Deal
Most business acquirers want as much ownership in their acquisition as possible. Most buyers lack significant cash resources to fund a large percentage (>20%) of the purchase price. Yet they are not interested in purchasing the company if it means that their limited cash will only buy a minority percentage of the ownership.
Quasi Equity is most valuable for the following types of purchasers:
- Fund less sponsors.
- Search funds.
- Middle market companies.
Buyers like fund less sponsors, search funds and middle market companies all fall into this camp. They are entrepreneurially driven and do not want to work for someone else or be part of a company where they do not have total operating control. They might have respectable level of cash to invest, but need supplemental forms of capital to close the deal. Quasi equity is less expensive than straight equity, and allows the buyer to purchase the company without giving up control. Because of its lower return requirement (usually 12% to 15%), it is less dilutive than straight equity so you can use more of it to fill your sources of capital for the deal. Seller financing quasi equity is particularly attractive for an acquirer, as it usually carries a low interest rate and a flexible repayment term and maturity. Most seller notes carry an interest rate from 5% to 8% which makes this a particularly compelling form of quasi equity capital. Quasi Equity allows a buyer to do more with less of his own money. This applies to a situation where he is able to negotiate a favorable purchase price from a seller or where the seller keeps a small amount of equity in the deal post-closing. When this happens, and the price is lower or the amount of cash needed to close is lower, the lender is more flexible around the amount of cash the buyer puts in the deal.
Where do I find Quasi Equity for my deal?
If you are an entrepreneur, business owner or middle market company acquiring another company, you have to sift through various levels of funds to get to quasi equity providers. The most common quasi equity providers include mezzanine lenders, venture debt providers, structured equity and growth equity funds. The groups are institutional funds with a middle market focus. The key is to identify the right groups to focus on, through finding funds that focus on non- sponsored deals. Additionally, the funds must be non-control oriented which means that they will invest without the requirement of equity control. There are well over 800 of these types of funds across the United States and Europe. Most funds have robust web sites with their qualification criteria specifying deal size requirements and preferred industries. It is often highly beneficial for a buyer to work with a strong adviser who can streamline the process of getting to the best groups. The right adviser can add value to your deal process through optimizing the structure and gaining access to a wide number of lenders and investors.
How Will a Quasi Equity Provider Help Me post-Closing?
Once the initial deal is finalized, they are well positioned to provide continue value to your company. They can help you in a number of ways, both organizationally and strategically. These capital providers are incentivized to help grow the value of the company, because the bigger the equity value at an exit, the more valuable their shares or warrants are worth. They can do this through providing more financing post-closing for add on acquisitions.
They provide the following value post-closing
- Connections with sales prospects.
- Advice on business building.
- Add on financing for acquisitions.
If you are pursuing a roll up, and have other acquisitions to make, they can fund these deals for you provided the risk reward profile of the original deal in intact. They also have relationships with other companies that they can introduce you to, which may help for sales distribution or product synergy. Most quasi equity providers are very experienced and wise as to best management practices to create fast growth. They can help management road map growth strategies and organizational scale up to accommodate accelerated growth. Usually, private closely held companies become more professional and sophisticated through having a relationship with a quasi-equity provider. They require companies to have strong systems and reporting processes which forces a higher level of management professionalism on the company. This ultimately is a rewarding evolution for a company as it makes it more attractive and valuable company at the time of an exit, more likely to get a higher price.
What Types of Deals is Quasi Equity Best Suited For?
Quasi equity works best for deals with moderate purchase prices where the amount of loan funding accounts for 60% to 75% of the purchase price, leaving only 25% to 40% to be funded with equity or quasi equity. If the loan funding relative to the purchase price is closer to 50% or even less than 50%, it makes it challenging for the buyer and the quasi equity provider to make the deal work. Deal prices in a range of 5.0 times to 7.0 times are usually good candidates. If your purchase price is 8.0 times or higher, this approach is difficult to implement as the lending multiple usually flattens out at 4.0 times, leaving an additional 4 turns of purchase price to be funded by the acquirer’s cash and quasi equity.
Quasi equity is well suited for any type of deal including an acquisition, a management buy-out, or a recapitalization. A common thread to the use of quasi equity revolves around the asset light nature of the balance sheet of the target company. Companies with collateral heavy balance sheets can usually raise significant amount of asset based loans. Asset light balance sheet companies have a harder time raising large loan amounts, making them more suited to the use of quasi equity to close the purchase price gap in a transaction.
What are Some of Things to watch out for when using Quasi Equity?
Quasi equity providers, as minority shareholders, should be relatively passive participants within the governance structure of a company and not have rights disproportionate to their investment amount. In addition, you should make sure that the economic upside for the provider is straightforward and does not contain provisions that allow them to have extra upside relative to the other equity holders. Some structures, known as participating preferred, involve a 2 times return of the principal amount of the investment, with accrued dividends as well a pro rata share of the equity upside. This is tantamount to a double dip return on the principal which makes this very expensive for the issuer.
Things to watch out for:
- Complex return mechanisms for the provider.
- The right amount of equity upside.
- Disproportionate terms and protective provisions.
If a quasi-equity provider is getting a current return or a return of principal, these should be factored into their overall return calculations when solving for their share ownership. If a preferred structure has no current return and the principal is convertible into shares, then it should have more equity participation than a structure where the preferred stock receives a current pay dividend and a guaranteed return of principal. Similarly, mezzanine loans, which are a common form of quasi equity receive current interest payments and a contractual right of principal repayment. Due to this, they receive slim amounts of equity upside due to the fact that the majority of their return requirement is paid through the current interest mechanism.
Additionally, make sure that convertible share mechanisms result in the conversion into shares at market prices and not at significant premiums to the market price. Given the complexity of stock purchase agreements and warrant holders agreement, it can be a bit confusing to truly understand the price you are allowing the provider to convert into. You should always make sure that the price they convert into at a future date is equal to the fair market value of the shares at that time. There is no quicker way to get massively diluted than to misunderstand these subtle aspects of your arrangement with the provider.