September 15, 2022 •Michael Bannon
Many private equity managers looked to 2022 with bullish attitudes after the record-setting M&A boom of 2021. Investors, armed with plenty of dry powder and bolstered by low interest rates, chased ambitious deals.
But between a combination of inflation-fueled market volatility and tightening credit markets, the first half of the year proved precarious for both buyers and sellers. Valuations slumped, the cost of doing business rose, and private equity firms began to slow their activity and reevaluate portfolios.
Failed or turbulent deals for companies like Pearson, Nielson, Zendesk, and Citrix grabbed headlines. The fallout from these high-profile transactions left many middle-market business owners wondering if a private equity sale was still the right path for their own companies.
And they may be right to be worried. Middle-market private equity deal volume for the first half of 2022 dropped 26% from the same time last year. While mega-deals make the news, most private equity firms’ portfolios are made up of mid-sized investments – typically between $25 and $500 million.
What Kills a Private Equity Deal?
There are many reasons why deals never see the light of day, especially in an unpredictable market. Common causes of failure include:
- Valuation gaps
- Fluctuating interest rates
- Insufficient due diligence disclosure
- Loss of funding
For founder-led or family-owned companies, however, another deal-breaker often hits closer to home.
Although buyers and sellers are both invested in the success of a business, they are driven by differing priorities. While private equity firms are incentivized to deliver their investors competitive returns at any cost, business owners are often initially enticed by the promise of up-front liquidity and/or growth capital.
But as transactions progress (or shortly after completion), a selling shareholder’s goals may expand to include business continuity, security for their employees, and legacy preservation. That’s often when a disconnect emerges. Common private equity value-building tools, including staffing realignment, expense reduction, and strategic expansion, often result in significant changes, especially during times of economic uncertainty.
For some sellers, the realities of business optimization can be more jarring than they anticipated. Offers of premium pricing and assurances of sustained managerial control may help soften the blow. But for some business owners, that’s not enticement enough, especially among those shareholders seeking more than just a cash out.
What if a Private Equity Deal Falls Through?
A failed deal isn’t necessarily a dead end. The careful planning behind a well-conceived transaction process can be leveraged to recalibrate and consider alternate opportunities.
Undertake a strategic review.
Companies often benefit from taking a step back before diving into another deal. Aided by a deeper appreciation of market dynamics, stakeholders can reassess their goals, expectations, and desired timing. The process may still encourage a near-term transaction, but possibly with a broader solution set.
Reevaluate all options.
Beyond forging a new private equity partnership, companies may consider:
- Raising non-equity capital to fund expansion or a leveraged dividend
- Forging new corporate partnerships to drive targeted growth initiatives
- Engaging an investment bank or business broker to market a strategic sale
Another often overlooked option is an equity sale to an employee stock ownership trust. For companies with strong management teams, or shareholders that are more interested in taking some chips off the table, an ESOP formation may be an optimal next step. That’s especially true for owners who put a premium on business continuity.
Why are ESOPs Meaningful Private Equity Alternatives?
Like private equity, a leveraged ESOP is essentially a leveraged buyout. But the similarities end there.
Instead of an acquisition led by third-party investors, the buyer in an ESOP transaction is an employee trust representing employees’ interests. To finance the deal, the sponsor company secures financing on the trust’s behalf and uses pre-tax corporate cash flow to pay down the debt.
Sellers may receive less up-front cash in an ESOP transaction. However, a series of unique tax advantages often bridge potential gaps.
Shareholders can defer and potentially eliminate capital gains tax on sale proceeds.
Known as a 1042 rollover, this exclusive ESOP benefit stands in sharp contrast to a private equity exit. The latter generally carries a capital gains tax hit of at least 30% in most jurisdictions (combined federal and state).
Sponsor companies receive income tax deductions as well. The ESOP sale amount is deductible, and businesses that are 100% employee-owned can become tax-free entities, in perpetuity.
Employee ownership strategies offer flexibility to make future transactions.
Finally, implementing an ESOP doesn’t rule out the possibility of a future private equity or third-party sale. But in the event of an M&A exit, employee owners also receive sale proceeds in line with their allocated stock. That can turn what is typically a difficult outcome for loyal employees into a rewarding incentive.
Companies Should Know all Their M&A Options.
Even after a stalled or failed deal, there are instances where private equity remains the best option. However, when companies truly reach an impasse – either due to partnership issues, market fluctuations, or evolving goals – a pause, followed by a strategic reevaluation can be invaluable.
Patience and introspection often reveal new paths forward while reducing the risk of seller's remorse. Because even in the biggest transactions, it's possible for companies and selling shareholders to lose sight of what’s really important.