In search of creative exits

While private equity firms are actively looking to source new transactions, they are also mindful that they need to exit from existing portfolio companies to show returns which will support raising new funds. The market of the last four years has not been as conducive to traditional exits as the private equity funds who made investments in 2006, 2007 and early 2008 and prior, anticipated, in part, because of the unanticipated down markets of the last several years. Creative exit strategies will not be able to turn disaster into a homerun, but they could turn a problematic exit into a workable exit.

Faced with the market challenges, private equity firms are exploring non-traditional realization events such as sales to employee stock option plans (ESOPs), Master Limited Partnerships (“MLPs”), and non-traditional acquirers, and recapitalizations. Traditionally, ESOPs have been the option of last resort.

 
However, private equity funds are beginning to explore situations where ESOPs could be used to facilitate management buyouts. While the administrative and regulatory costs and potential liabilities associated with ESOPs are often viewed as burdensome, in the right circumstance, the tax benefits of the structure will far outweigh any burden and can facilitate an exit opportunity for a fund when a traditional exit may not be available. An ESOP that owns an S corporation can also avoid tax at the entity level which provides the ability to deduct principal and interest on debt used to purchase the shares of ESOP that acquires the business.

There is also a renewed and heightened interest in MLPs.  Private equity funds not in the traditional infrastructure and energy sectors historically had very little interest in, or knowledge of MLPs. Recently, because of the market valuations for MLPs, the smaller size IPOs for MLPs compared to traditional IPOs, and the broader interpretations by the IRS and practitioners of the definition of “qualifying income”, more private equity firms are looking at portfolio companies to see if all or a portion of their business could be spun off as an MLP.

Masood Sohaili

Again, there are tax advantages to the MLP structure, including elimination of tax at the entity level, which is significant, and providing depreciation and other tax benefits traditionally associated with real estate partnerships (which is less significant). While such structure may result in a more limited investor base and additional administration and regulatory burdens, the rewards, and the opportunities to exit in a non-traditional manner, are resulting in private equity funds giving MLPs more than a passing glance.

In addition, from the demand side additional players are looking at portfolio companies that have not developed in a manner consistent with the original acquisition or IPO thesis, that could be used to seed a roll-up strategy or that are in need of additional capital that cannot be deployed by existing owners for one reason or another. Such players include other private equity firms focused on distressed opportunities, as well as small public companies looking to aggregate portfolio companies.  Sovereigns, family offices, domestic and foreign pension funds have also become more sophisticated investors and have a greater appetite for higher yields that often involve more diligence and sophisticated structuring.
Recapitalizations, especially using high yield and mezzanine financing options, are also continuing at a rapid pace in order to allow private equity funds to show a realization event, even when a sale is not available.

Whenever markets are less fungible or commoditized there are opportunities to make a difference in the outcome using market knowledge and creativity.  Just as the private equity funds explored different industries and expanded their investment thesis in order to source deals, in a competitive market, private equity firms should also actively investigate and explore the current market conditions to take advantage of inefficiencies and opportunities provided in the current market, to help facilitate positive exits for their existing portfolio companies.

Based in Los Angeles, Masood Sohaili is a partner in law firm DLA Piper's corporate and finance group.