Understanding Real Estate &
   Private Equity Roles in
Sale/Leaseback Transactions




        By: Jonathan W. Hipp
The Basic Private Equity Business Model

    Deal Sourcing                 Continuous Process

    Transaction Due Diligen...
Deal Sourcing Basics
    Targeted Deal Sources:
        Targeted Calling Efforts
        Industry Research / Due Diligence...
Due Diligence Basics
    Facets Of Due Diligence:
         Financial
         Management Team
         Key Company Stakeho...
Investment Criteria
    Service Businesses with good profit and cash flow margins
    Proven Business Model:
      → Reven...
Investment Criteria - continued
    Recurring Revenue Model:
     → Contractual Recurring Revenue
     → High Customer Ret...
Investment Criteria - continued
    Return On Invested Capital (ROIC): Is it high (+20%) and can
    it be sustained? Does...
Private Equity & Real Estate
      The View from the Private Equity Side of the Table


    The Private Equity View of Rea...
Private Equity & Real Estate
           The View from the Private Equity Side of the Table

    Question: How do you get a...
Private Equity & Real Estate
            The View from the Private Equity Side of the Table
     An Example of Capital Rea...
Private Equity & Real Estate
           The View from the Private Equity Side of the Table

     What if a business owner ...
Private Equity & Real Estate
           The View from the Private Equity Side of the Table

     Selling a Typical Busines...
Private Equity & Real Estate
               The View from the Private Equity Side of the Table
                           ...
Private Equity & Real Estate
           The View from the Private Equity Side of the Table

     Other Possible Benefits o...
Private Equity & Real Estate
            The View from the Private Equity Side of the Table

     Selling the real estate ...
Private Equity & Real Estate
            The View from the Private Equity Side of the Table

     Real Estate Disposition ...
Private Equity & Real Estate
           The View from the Private Equity Side of the Table

     The Realities of the Sale...
Private Equity & Real Estate
             The View from the Private Equity Side of the Table

     Questionable Sale Lease...
Private Equity & Real Estate
             The View from the Private Equity Side of the Table

     A Split Sale Leaseback ...
Private Equity & Real Estate
           The View from the Private Equity Side of the Table

     Sale Leaseback Issues – A...
Private Equity & Real Estate
            The View from the Private Equity Side of the Table

     Sale Leaseback Issues – ...
Private Equity & Real Estate
             The View from the Private Equity Side of the Table

     Sale Leaseback – Factor...
Private Equity & Real Estate
           The View from the Private Equity Side of the Table

     Sale Leaseback – Factors ...
How to Contact Us
     If you would like feedback regarding a transaction of interest or if you come
     across a transac...
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Sale/leasebacks

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Understanding Real Estate &
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Sale/leasebacks

  1. 1. Understanding Real Estate & Private Equity Roles in Sale/Leaseback Transactions By: Jonathan W. Hipp
  2. 2. The Basic Private Equity Business Model Deal Sourcing Continuous Process Transaction Due Diligence 6 weeks – 6 months Pricing / Structuring Post Transaction Portfolio 18 months – 9 years Company Management Portfolio Company Exit 6 weeks – Continuous Process 2
  3. 3. 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 3
  4. 4. 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 4
  5. 5. 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 5
  6. 6. 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. 6
  7. 7. Investment Criteria - continued Return On Invested Capital (ROIC): Is it high (+20%) and can it be sustained? Does the Company’s business model and growth plans support the additional deployment of capital at a high ROIC? Strategic Competitive Advantage: Has the Company differentiated 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? 7
  8. 8. Private Equity & Real Estate The View from the Private Equity Side of the Table The Private Equity View of Real Estate No Love for Dirt, Sticks, Bricks or Steel Main Reason: Usually Holds Hostage a Lot Of Capital in a Low(er) Return Asset Class 8
  9. 9. Private Equity & Real Estate The View from the Private Equity Side of the Table Question: How do you get an asset class (Real Estate) that produces annual returns in the 8% to 12% per year to produce private equity type returns 25% to 35% per year? Answer: You Don’t! Solution: Dispose of lower return assets & reallocate capital toward higher return assets. A $10 description for this exercise is Capital Allocation. This solution is applicable to select private equity folks / transactions as well as select business owners with desirable real estate and high return growth opportunities. 9
  10. 10. Private Equity & Real Estate The View from the Private Equity Side of the Table An Example of Capital Reallocation: Store A Store A Sans Real Estate The Return on Invested Revenue $520,000 $520,000 Capital (ROIC) for Store A Rent $52,000 (C) increases from 24% to 136% EBITDA (A) $120,000 $68,000 (D) once real estate is sold Investment Land $185,000 Building $265,000 Transaction proceeds of Equipment $50,000 $50,000 Total Investment (B) $500,000 $50,000 $455,000 can be deployed to Estimated ROIC (A/B) 24.00% 136.00% open new locations or Notes: reallocated toward other high Assumed Real Estate Disposition return pursuits. - 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. 10
  11. 11. Private Equity & Real Estate The View from the Private Equity Side of the Table What if a business owner simply wants to cash out or sell & has no interest in reinvesting in his/her business? Disaggregating the real estate from the business and selling it in a separate process still may make sense: Split Sale. Most financial buyers will not ascribe a “Market Value” to real estate that tags along in a business sale. At most 1.0X to 2.0X additional turns of EBITDA are given by the Financial Buyer. Splitting the real estate and selling via a sale-leaseback transaction to 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 a different investor (a real estate investor) for a higher multiple. 11
  12. 12. Private Equity & Real Estate The View from the Private Equity Side of the Table Selling a Typical Business: Multiple range with real estate increased from 3X – 5X to 5X – 7X as 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 12
  13. 13. Private Equity & Real Estate The View from the Private Equity Side of the Table Revenue $5,000,000 $5,000,000 $5,000,000 Transaction #1 – EBITDA $1,000,000 $1,000,000 $1,000,000 Sell the real estate. Exit Multiple 5.00 6.00 7.00 A 10% rent factor & 8.5% cap Business Value W/ Real Estate (X) $5,000,000 $6,000,000 $7,000,000 rate is assumed for the real Transaction #1 - Real Estate Sale estate sale. Rent $500,000 $500,000 $500,000 Cap Rate 8.50% 8.50% 8.50% Transaction #2 – Sell the business. Real Estate Value (X) $5,882,353 $5,882,353 $5,882,353 Transaction #2 - Business Sale The business multiple range is Revenue $5,000,000 $5,000,000 $5,000,000 reduced from 5.0X - 7.0X to Rent $500,000 $500,000 $500,000 3.0X – 5.0X to account for the EBITDA $500,000 $500,000 $500,000 absence of real estate from the Business Sale. Exit Multiple 3.00 4.00 5.00 Business Value $1,500,000 $2,000,000 $2,500,000 The Split Sale – Methodology Total Value Of Enterprise = yields more proceeds to seller. 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 13
  14. 14. Private Equity & Real Estate The View from the Private Equity Side of the Table 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, this incremental 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 bank debt Leaseback financing (Lease) usually has less reporting & operating restrictions than bank debt. In troubled times a real estate investor maybe easier to work with than a bank. 14
  15. 15. Private Equity & Real Estate The View from the Private Equity Side of the Table Selling the real estate in a sale-leaseback transaction does not necessarily mean the business needs to be sold. Nor does it mean all cash proceeds need to be reinvested into the business. As long as the Seller continues to have significant value or stake in the underlying business, proceeds from the real 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 15
  16. 16. Private Equity & Real Estate The View from the Private Equity Side of the Table Real Estate Disposition Highlight Reel: One transaction enabled a Company to pay off 1/2 of outstanding indebtedness and distribute all invested capital back to investors. A second transaction enabled a Company to pay off all outstanding indebtedness 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 outstanding indebtedness, increase cash from operations by $600,000 per annum and raise a $5,000,000 funding commitment for new unit development. 16
  17. 17. Private Equity & Real Estate The View from the Private Equity Side of the Table The Realities of the Sale Leaseback Transaction: It is Not All Sunshine & Lollipops Sale Leaseback transaction is not for all business / real estate owners. Using the Split Sale Leaseback transaction takes much longer to exit a Company. There are many transaction derailers to frustrate the process. 17
  18. 18. Private Equity & Real Estate The View from the Private Equity Side of the Table 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 18
  19. 19. Private Equity & Real Estate The View from the Private Equity Side of the Table A Split Sale Leaseback / Business Sale takes much longer to execute. In a strong market expect the real estate disposition to take an extra 90 days. In a struggling market, it could take a full year. Not all Stakeholders will find this acceptable. Potential Transaction Hazards: Bank Covenants Bank Yield Maintenance Provisions Bank Prepayment Penalties Hedging Arrangements Syndicated Bank Loans Uncooperative Minority Investors Franchisor(s) Rights / Inexperienced Professional Advisors – Agreements Accountant / Legal / Tax Special Permits / Licenses That Tack To The Real Estate 19
  20. 20. Private Equity & Real Estate The View from the Private Equity Side of the Table Sale Leaseback Issues – A Personal Perspective: Working a transaction with syndicated debt can be challenging. Focus on projected net after tax proceeds not gross proceeds. Get in front of issues with line employees and other stakeholders. 20
  21. 21. Private Equity & Real Estate The View from the Private Equity Side of the Table Sale Leaseback Issues – Business Owner Post Closing Considerations: 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 21
  22. 22. Private Equity & Real Estate The View from the Private Equity Side of the Table Sale Leaseback – Factors Critical to Success: Clear and Realistic Client Expectations: →Value / Transaction proceeds →Time 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 in a 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 22
  23. 23. Private Equity & Real Estate The View from the Private Equity Side of the Table Sale Leaseback – Factors Critical to Success: Last, but not Least: Competent Transaction Advisors from Start to Closing! 23
  24. 24. How to Contact Us If you would like feedback regarding a transaction of interest or if you come across 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 jhipp@calkain.com We will act quickly to provide you feedback. Every transaction is treated with the highest level of confidentiality. THANK YOU!! 24

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