(Estimated reading time: 4 minutes 25 seconds)
The article in brief:
- In an acquisition, rollover equity can confer significant benefits, including keeping prior owners/management invested in the company’s success, bridging disagreements over the sale price, and reducing the sponsor’s cash outlay.
- In some cases, the complexity of calculating purchase price, especially for ASC 805 reporting, can be non-trivial.
- Several factors, including the rights and preferences of the rollover equity compared to the private equity sponsor’s shares and the sources of deal financing, have important implications for valuation.
In today’s M&A environment, transaction structures vary widely and often incorporate multiple financing components. Private equity (PE) firm-sponsored transactions often include a “rollover” of prior ownership into a newly-formed post-transaction company.
A Background Primer on Rollover Equity
Rollover equity is a common element of purchase consideration used by PE investors in a variety of deal types:
- Acquisition of a company intended to be held and grown organically;
- Acquisition of a company designed to be an initial platform for future acquisitions (a “platform investment”); and
- Acquisition within a roll-up or consolidation strategy in which additional “add-on” acquisitions are structured with rollover equity in the combined companies (platform/add-on structure).
There are several underlying benefits to both buyer and seller when entering into this type of transaction. PE investors often want to keep existing ownership and management teams invested in the company. Retained ownership interests (having “skin in the game”) are designed to keep buyer and seller aligned in terms of execution of the business strategy, ultimately maximizing the growth in equity value and returns to both the PE fund and the rollover equity holders through exit.
Rollover equity reduces the amount of cash needed by the PE firm to acquire a controlling stake in the target company and can bridge the gap in cases in which buyer and seller have a material delta in valuation. We also see more significant rollover percentages in cases where the target’s business may be subject to substantial risk factors. For example, if the target company has high customer concentration, or selling shareholders are highly involved in the day-to-day operations of the company, rollover equity may be one strategy utilized to help reduce risk and ensure a smooth transition.
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Purchase Price Considerations
Valuation issues, particularly in measuring appropriate purchase consideration for ASC 805, can range from simple to complex, driven mainly by capital structure and transaction funding sources.
In our view, specialists should not automatically default to common valuation adjustments (e.g., discounts for lack of marketability and control) simply because the rollover interest is not a controlling interest.
In these situations, actual buyer and seller considerations, at the time of the acquisition, must be taken into account for fair value purposes, as considerable diligence was likely undertaken in conjunction with the sale.
There are common rollover features that impact fair value, including the following:
- Senior or subordinate class or characteristics of rollover equity relative to sponsor equity;
- Percentage of target equity or assets rolled over and a percentage of the newly-formed company represented by the rollover;
- Pre-emptive rights;
- Tax or other dividends/distributions;
- Management rights/ board seats;
- Tag-along rights;
- Information rights; and
- New investments made by the PE funds (if add-on investment).
Retained ownership interests are designed to keep buyer and seller aligned in terms of execution of the business strategy, ultimately maximizing the growth in equity value and returns to both the PE fund and the rollover equity holders through exit.
Rollover – Single vs. Multiple Equity Classes
In a simple platform acquisition where the newly-formed portfolio company is capitalized with a single class of equity, discounts are typically not appropriate. Despite the rollover equity holders’ non-controlling investment in the company, in this type of transaction, buyers and sellers are aligned in terms of the expected holding period (typically four to seven years for a PE portfolio company). The PE firm’s control does not disadvantage the rollover shareholders, and it is assumed that the business will be operated with maximum efficiency to increase shareholder value. Rollover shareholders, mainly when the rollover is a material percentage of total equity, will often have tag-along rights, access to information, and board seats.
Regarding marketability, the PE investor is typically expecting a multi-year holding period until exit, which is generally necessary to deal with the leverage, return requirements, and execution of the business strategy. It can, therefore, be argued that the price paid by the PE firm reflects the inherent illiquidity of the investment, and no incremental discounts are needed.
While less frequent, it is not uncommon to see the rollover as a separate or subordinate class of equity. For example, the PE fund may invest in preferred stock while sellers roll into common stock. In these situations, it may be necessary to directly value the rollover equity using the pricing of the senior class as a basis to solve for the value of the rollover (using a “backsolve” technique). This is common when the rollover represents a separate class of junior equity. The value per-unit of the rollover equity is often adjusted down from the “face value” or the amount referenced in the transaction documents – where it frequently is assigned the same nominal price per-share as the senior PE fund equity – because the rollover is a junior class with subordinate payout characteristics.
Rollover in Platform Investments and Add-On Deals
In platform investments, the initial acquisition provides a foundation for building a larger business through add-on acquisitions. When an add-on acquisition includes a rollover equity component, the rollover represents equity in the combined company. If the buyer/platform finances the transaction without any new PE fund equity (i.e., with debt and rollover equity), there may not be a supportable basis for establishing the fair value of the rollover, regardless of the reference price utilized in the deal documents. In this case, a fundamentals-based valuation (DCF, market approach, etc.) is appropriate to measure the fair value of the combined total equity of platform and add-on (including any market participant synergies created by the acquisition). Depending on the capital structure of the combined company, additional procedures may be warranted to determine the value of the rollover security. In either case, conventional discount for lack of marketability (DLOM) techniques may be appropriate.
There are cases in which a platform will use cash (equity contributed by the PE fund) to finance a portion of the add-on. This may be sufficient for estimating the fair value of the rollover, assuming the combined company has a simple capital structure with a single class of equity.
Rollover equity has many benefits to both buyers and sellers when a private equity sponsor acquires a company from existing management. Nuances of the transaction financing and the new capital structure can have important implications for the valuation of the new securities and, ultimately, the fair value of total purchase consideration.
Rollover Equity for Private Equity Deals
Continue reading about valuation considerations for rollover equity in private equity platform acquisitions and add-on deals. In a prior article from Justin Johnson, he reviews issues related to mismatched securities and provides a robust discussion on solutions to consider.