When the exit window closes, price the minority

The desk has been asked to reopen four company sales that were paused between March and August. In three of the four the gap between the indicative range of a year ago and the best current bid was between 30 and 40 per cent. No owner accepts that gap while the business is performing, and none of these businesses is failing. What has changed is the cost of acquisition finance, not the quality of the asset. The consequence is a market in which the whole company will not trade and a part of it will.

A structured minority solves a specific problem. It gives the owner cash without agreeing a price for the entire business at the bottom of a cycle, and it gives the investor a return that does not depend on an exit inside three years. The instruments that have cleared this autumn share a shape: preferred capital for between 15 and 30 per cent of the equity, a cash or accrued coupon between 7 and 9 per cent, a liquidation preference of one times, and a conversion ratchet that improves the position of the investor if a sale is delayed beyond a stated date.

The coupon receives most of the negotiation and deserves the least. What decides whether a minority is worth holding is the set of rights attached to it. Four matter. The first is a seat with defined reserved matters rather than an observer role. The second is a redemption right that is enforceable in the jurisdiction of the company and not merely stated in a shareholders agreement. The third is information: monthly management accounts within fifteen business days, and the right to appoint a valuer at the cost of the investor. The fourth is a tag right that survives a change of control of the holding company as well as of the operating business.

Owners resist the ratchet, and the resistance is reasonable when the mechanism is written badly. A ratchet that increases the investor share every year regardless of performance converts a partner into a creditor with equity upside. We draft ratchets that trigger on a single event, usually the absence of a liquidity event by a fixed date, and that cap the additional share. In the three transactions the desk completed this half, the capped ratchet added between 2.5 and 4 percentage points to the holding of the investor if no sale occurs within 42 months. That is a price for waiting rather than a penalty for operating.

Valuation in these transactions is set by the entry multiple on trailing earnings and by nothing else, because there is no market clearing price to reference. The desk applies the same four tests it applies to a control position. Is the advantage structural: a regional specialist with regulatory registrations qualifies, a business whose margin came from a supply shortage does not. Can it be converted and on what timetable: the redemption right and the ratchet are the answer. The third test asks whether this is the best available use of the proceeds. The fourth asks what loss we are prepared to accept, which for a minority means the loss of the whole position without control of the remedy.

This market will not last. When the cost of acquisition finance settles, whole companies will trade again and structured minorities will look expensive to the owners who issued them. That is the right outcome. A minority written in a closed window is a bridge between two valuations, and the documents should say so plainly. The transactions that will age badly are the ones written as permanent partnerships while carrying terms that make sense only across eighteen months.

Published 2022-11-15 by the Investment Banking division. Research is prepared for eligible counterparties and does not constitute advice.