Recapitalization is a strategy that companies use during an M&A transaction to make the deal more attractive. Recapitalization essentially involves exchanging one type of financing for another – debt for equity, or equity for debt. For example, a company issuing debt to buy back its equity shares would be an example of a recapitalization.
Recapitalization can be used by either the acquiring company or the target company. Common situations include the acquiring company needing to raise additional capital in order to finance the acquisition, or when the target company needs to restructure its debt or obligations in order to make the acquisition more attractive.
Overall, recapitalization is used to align the capital structure of the companies involved in the M&A transaction and increase financial flexibility that supports the integration of the two companies.
Let’s have a look at a few commonly used recapitalization strategies in further detail.
In a leveraged recapitalization, the company replaces part of its equity with additional debt, thereby changing its capital structure. One form of leveraged recapitalization might be a company issuing bonds to raise money while in the midst of an M&A transaction where it is the acquirer.
A situation in which a company may resort to leveraged recapitalization is if its share price declines. A declining share price will make the acquisition less feasible or attractive to the shareholders of the target company. As such, the acquiring company may issue debt securities to fund buying back its outstanding shares in the market. By reducing the number of outstanding shares, the target company expects to increase its earnings per share and share price, thereby placing the company in a stronger position as it acquires the target company, notes the Corporate Finance Institute.
A leveraged buyout is a type of leveraged recapitalization that involves a target company purchased by an acquirer that utilizes a significant amount of debt to meet the cost of acquisition. In this scenario, the acquiring company’s cash flows are used as collateral to secure and repay the debt obligations.
During this type of transaction, the acquiring company’s balance sheet is loaded with additional debt used to purchase the target company. Subsequently, the capital structure of the target company is changed, as the debt-to-equity ratio grows significantly under this type of buyout.
LBOs are also commonly known as hostile takeovers because the management of the targeted company may not want the deal to go through. Leveraged buyouts tend to occur when interest rates are low, thereby reducing the cost of borrowing; they are also popular when an acquiring company feels that the target company is underperforming and is undervalued, according to Investopedia.
In an equity recapitalization, a reverse situation to leveraged recapitalization or leveraged buyout occurs. A target company issues new equity shares in order to raise money to be used to buy back the company’s debt securities. The goal, of course, is to reduce the company’s debt and make its debt-to-equity ratio more attractive for an acquiring company.
Higher debt levels increase a company’s risk level, potentially lowering its credit rating and making the company less attractive a target to investors.
Reasons for Recapitalization
There are several reasons that motivate companies to recapitalize, in order to make themselves more agile as they enter an M&A transaction.
1. Stock Price Falls Dramatically
A substantial decline in a company’s stock price is one reason for the management of an acquiring company to consider recapitalization. To prevent further declines, the company will issue debt to repurchase its shares, and the supply-demand forces will, hopefully, push the stock price up.
2. Reduce the Financial Burden
The excess of debt over equity can result in high interest payments for a company positioning itself as an M&A target. In this case, the target company’s goal is to change its capital structure by issuing new equity and repurchasing part of its debt, thereby making it more attractive a target for an acquirer.
3. Prevent a Hostile Takeover
Recapitalization can be used as a reverse strategy to prevent a hostile takeover by another company. The management of the target company may issue additional debt to make the company less attractive to potential acquirers.
4. Reorganization During Bankruptcy
Companies facing the threat of bankruptcy or companies that have already filed for bankruptcy can use recapitalization as a part of their reorganization strategy. A successful recapitalization can help an insolvent company survive the process of bankruptcy, satisfying such parties as the bankruptcy court, creditors, and investors. If successful, the company adopts a new capital structure that can help it continue its operations and avoid liquidation, and possibly position itself as a takeover target.
How to Use Caplinked’s Virtual Data Room for Successful M&A Transactions
As projects and transactions become more complex and are handled by distributed teams during a transaction, security but also accessibility are critical for large volumes of highly-sensitive data.
Companies should consider using a virtual data room (VDR) to host these documents in the cloud in order to assure speedy due diligence. With rights management, permissioning, tracking, and other advanced features, transactions could be delayed without it. Such delays can affect transaction prices, especially in volatile markets.
Organizations should consider an enterprise document security solution like Caplinked, which has years of experience working with corporate, financial, and legal teams and providing VDRs for transactions and ventures of all sizes.
Jake Wengroff writes about technology and financial services. A former technology reporter for CBS Radio, Jake covers such topics as security, mobility, e-commerce, and IoT.
Corporate Finance Institute – Recapitalization
Investopedia – 10 Most Famous Leveraged Buyouts