sale/leaseback transactions

8/14/2019 Sale/leaseback Transactions

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Understanding Real Estate &Private Equity Roles in

Sale/Leaseback Transactions

By: Jonathan W. Hipp


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The Basic Private Equity Business Model

Deal Sourcing

Transaction Due DiligencePricing / Structuring

Post Transaction PortfolioCompany Management

Portfolio Company Exit

Continuous Process

6 weeks 6 months

18 months 9 years

6 weeks ContinuousProcess


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Deal Sourcing Basics

Targeted Deal Sources:

Targeted Calling Efforts

Industry Research / Due Diligence Existing Co-Investors

Professional Service Advisors

Seeded Start-Up Opportunities

Potential Deal Sources:

Investment Bankers

Business Brokers Real Estate Brokers

Attorneys


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Due Diligence Basics

Facets Of Due Diligence: Financial

Management Team Key Company Stakeholders Industry Undisclosed Liabilities

Due Diligence Tools: Proof to Cash Book Cash Tax Boots on the Ground

Due Diligence Philosophy: Triangulate to the Truth


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Investment Criteria

Service Businesses with good profit and cash flow margins

Proven Business Model: Revenues $20+ million. Enterprise value of $20+ million. Currently profitable - at a minimum profitable at the

operating level. Proven Management: Complete, competent, battle tested Both industry specific & general management experience

Team has a significant ownership post closing Operational / Tactical / Quantitative focus vs. Big Picture

or Visionary


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Investment Criteria - continued

Recurring Revenue Model: Contractual Recurring Revenue

High Customer Retention Rates Growth: Is there growth opportunity? Does it have a History of Sustained Growth?

High Margins: Gross margins & EBITDA Indicative of a well-run business with sustainable

competitive advantage.

Systems & Controls: Can the Company Produce Accurate and Timely

Operational and Financial Data.


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Investment Criteria - continued

Return On Invested Capital (ROIC): Is it high (+20%) and canit be sustained? Does the Companys business model andgrowth plans support the additional deployment of capital at a

high ROIC?

Strategic Competitive Advantage: Has the Companydifferentiated itself from the competition? What are the threats &

opportunities? Multiple Expansion: Do current industry conditions or

transaction pricing lend itself to multiple expansion?

Potential Return: Is the Company capable of producing 3x 5x invested capital over a 3 5 year period?

Last Man Standing Test: Is this a business you would be

comfortable owning personally, forever?


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No Love for Dirt, Sticks,

Bricks or Steel

Main Reason: Usually Holds Hostage a

Lot Of Capital in aLow(er) Return Asset Class

The Private Equity View of Real Estate

Private Equity & Real EstateThe View from the Private Equity Side of the Table


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Question: How do you get an asset class (Real Estate) thatproduces annual returns in the 8% to 12% per year to produce

private equity type returns 25% to 35% per year?

Answer: You Dont!

Solution: Dispose of lower return assets & reallocate capitaltoward higher return assets. A $10 description for this exerciseis Capital Allocation.

This solution is applicable to select private equity folks /transactions as well as select business owners with desirablereal estate and high return growth opportunities.



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Store A

Store A Sans Real Estate

Revenue $520,000 $520,000

Rent $52,000 (C)

EBITDA (A) $120,000 $68,000 (D)

Investment

Land $185,000

Building $265,000

Equipment $50,000 $50,000

Total Investment (B) $500,000 $50,000

Estimated ROIC (A/B) 24.00% 136.00%

Notes:

Assumed Real Estate Disposition

- Rent @ 10% of Unit Revenue $52,000

- Priced At An 8% Cap Rate 8.00%

Gross Transaction Proceeds $650,000

Est. Net Transaction Proceeds $455,000 (E)

(C): Assumes rent factor @ 10% of Revenue sold at an 8% Cap Rate

(D): Post Closing EBITDA $120,000 less $52,000 rent

(E): Assumes 30% effective tax rate.

The Return on Invested

Capital (ROIC) for Store Aincreases from 24% to 136%once real estate is sold

Transaction proceeds of$455,000 can be deployed toopen new locations orreallocated toward other high

return pursuits.

An Example of Capital Reallocation:



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What if a business owner simply wants to cash out or sell & has nointerest in reinvesting in his/her business?

Disaggregating the real estate from the business and selling it in aseparate process still may make sense: Split Sale.

Most financial buyers will not ascribe a Market Value to real estatethat tags along in a business sale. At most 1.0X to 2.0X additionalturns of EBITDA are given by the Financial Buyer.

Splitting the real estate and selling via a sale-leaseback transactionto a 1031 Buyer or real estate investor may do a better job of

maximizing seller proceeds.

You are effectively pulling rent from EBITDA but selling it to adifferent investor (a real estate investor) for a higher multiple.



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Selling a Typical Business:Multiple range with real estate increased from 3X 5X to 5X 7Xas real estate assets are sold along with the Business.

Revenue $5,000,000 $5,000,000 $5,000,000

EBITDA $1,000,000 $1,000,000 $1,000,000

Exit Multiple 5.00 6.00 7.00

Business Value W/ Real Estate $5,000,000 $6,000,000 $7,000,000



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Transaction #1 Sell the real estate.

A 10% rent factor & 8.5% caprate is assumed for the realestate sale.

Transaction #2

Sell the business.

The business multiple range isreduced from 5.0X - 7.0X to3.0X 5.0X to account for the

absence of real estate fromthe Business Sale.

The Split Sale Methodologyyields more proceeds to seller.

Revenue $5,000,000 $5,000,000 $5,000,000

EBITDA $1,000,000 $1,000,000 $1,000,000


Business Value W/ Real Estate (X) $5,000,000 $6,000,000 $7,000,000

Transaction #1 - Real Estate Sale

Rent $500,000 $500,000 $500,000

Cap Rate 8.50% 8.50% 8.50%

Real Estate Value (X) $5,882,353 $5,882,353 $5,882,353

Transaction #2 - Business Sale

Revenue $5,000,000 $5,000,000 $5,000,000

Rent $500,000 $500,000 $500,000

EBITDA $500,000 $500,000 $500,000


Business Value $1,500,000 $2,000,000 $2,500,000

Total Value Of Enterprise =

Business + Real Estate Values (Y) $7,382,353 $7,882,353 $8,382,353

Imputed Value Of Split Sale

(Y-X) $2,382,353 $1,882,353 $1,382,353



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Other Possible Benefits of Sale Leaseback Funding: Accretion: A sale-leaseback transaction maybe mildly accretive for the

business in the near term. Example Sale-leaseback proceeds where used to retire debt.

The reduction in debt service exceeded initial rent by $80,000 /year. Using a business valuation of 3.0X 5.0X EBITDA, thisincremental cash flow increases the enterprise value of the

business by $240K $400K. As a Funding Source: Sale-leaseback cash may be a cheaper and

more stable source of financing: Initial Lease Payments maybe < Debt Service

Rent Increases every 5 years vs. Monthly for variable rate bankdebt

Leaseback financing (Lease) usually has less reporting & operatingrestrictions than bank debt.

In troubled times a real estate investor maybe easier to work with thana bank.



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Selling the real estate in a sale-leaseback transaction doesnot necessarily mean the business needs to be sold. Nor

does it mean all cash proceeds need to be reinvested into thebusiness. As long as the Seller continues to have significantvalue or stake in the underlying business, proceeds from thereal estate sale can be used for a variety of recapitalization

activities.

Provide Liquidity to the Owner Chips Off the Table Cash Out an Inactive Partner Make the business more affordable for the next Generation of family members or tier of management



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Real Estate Disposition Highlight Reel:

One transaction enabled a Company to pay off 1/2 of outstandingindebtedness and distribute all invested capital back to investors.

A second transaction enabled a Company to pay off all outstandingindebtedness and created an additional $1,000,000 to $1,600,000 of

equity value for investors.

A third transaction allowed a Company to retire 100% of outstandingindebtedness, increase cash from operations by $600,000 per

annum and raise a $5,000,000 funding commitment for new unitdevelopment.



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The Realities of the Sale Leaseback Transaction:It is Not All Sunshine & Lollipops

Sale Leaseback transaction is not for all business / realestate owners.

Using the Split Sale Leaseback transaction takes muchlonger to exit a Company.

There are many transaction derailers to frustrate the

process.



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Questionable Sale Leaseback Candidates:

Real Estate that would be a Challenging Investment regardless of the Tenant:

Environmental Issues Title Issues In Need of Significant Capital Improvements to Remain Serviceable Currently Clouded by Litigation Easements Need to be Renegotiated

Businesses with Volatile Revenue & Cash Flow

Businesses with Variable & Large Maintenance CAPX Requirements

Businesses with Large Working Capital or Seasonal Working Capital Needs

Businesses that have Employed Too Much Leverage

Businesses that are Not Well Run/Run to the Detriment of Other Stakeholders

Businesses in Industries/Markets that are Undergoing Significant Changes



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A Split Sale Leaseback / Business Sale takes much longer toexecute. In a strong market expect the real estate disposition totake an extra 90 days. In a struggling market, it could take a fullyear. Not all Stakeholders will find this acceptable.

Potential Transaction Hazards:

Bank Covenants

Bank Prepayment Penalties

Syndicated Bank Loans

Franchisor(s) Rights /Agreements

Special Permits / Licenses That

Tack To The Real Estate

Bank Yield Maintenance Provisions

Hedging Arrangements

Uncooperative Minority Investors

Inexperienced Professional Advisors Accountant / Legal / Tax



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Sale Leaseback Issues A Personal Perspective:

Working a transaction with syndicated debt can bechallenging.

Focus on projected net after tax proceeds not gross

proceeds. Get in front of issues with line employees and other

stakeholders.



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Sale Leaseback Issues Business Owner Post ClosingConsiderations:

Fewer Fixed Assets = Less Debt Capacity Lease must be structured to guarantee long term access to site hosting

business activity. Landlord #1 maybe low maintenance but subsequent

landlord(s) could have agendas. ROFR in lease preferred construct for

dealing with this. If Sales Leaseback is used as a debt refinancing tool, at some point lease

expense will surpass debt service will the host business support this added

cash outflow?

Maintain flexibility to exit business with favorable lease assignment language. Sale Leaseback tenant guarantee(s) inhibit business owners ability to have

complete access to funds in asset sale. There is an continuing contingent

obligation.

May limit exit opportunities with marginally capitalized business buyers



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Sale Leaseback Factors Critical to Success:

Clear and Realistic Client Expectations:

Value / Transaction proceedsTime to close

Experienced legal, accounting & tax counsel engaged at the front end.

Pre-Packaged & up-to-date due diligence. Costs more on the front end but ina strong market saves time

Form legal documents (PSA & Lease) that balance seller/buyer interests: Helps with portfolio sale(s)

Assists with identifying serious buyers Keeps ongoing legal fees to a minimum Helps preserve seller sanity



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Sale Leaseback Factors Critical to Success:

Last, but not Least:

Competent Transaction Advisors

from Start to Closing!



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How to Contact Us

If you would like feedback regarding a transaction of interest or if you comeacross a transaction that might be of interest, please feel free to contact me:

Jonathan W. Hipp

President/CEO

11150 Sunset Hills Road | Suite 300 | Reston, VA 20190

T: (703) 787- 4714 | F: (703) 787- 4783

[email protected]

We will act quickly to provide you feedback. Every transaction is treated withthe highest level of confidentiality.

THANK YOU!!

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