Self Funded Capital Structure Question

July 17, 2020

by a searcher from The University of North Carolina at Chapel Hill - Kenan-Flagler Business School in Raleigh, NC, USA

I'm a self funded searcher trying to outline the capital structure of a potential deal. I don't want want to take on debt in this uncertain times (I'm afraid to get crushed under the weight of debt if an economic downturn to this particular industry), so I have seller financing and equity available. How do I decide how much equity I should keep? I realize potential investors will push back and negotiate their own specific terms, but where do I start? Do I start north of 50% just because I self funded?

Any advice is greatly appreciated.
Austin

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Reply by a searcher
from University of Dallas in Houston, TX, USA

The jist is as follows: 1) You want to maximize the returns for all parties as much as possible without inducing risk. If you look at the SF model broadly about ~1b in the capital has been put in overtime and has produced about ~5-6b in equity with almost ~2b going to searchers. 2) You as a searcher (solo or funded) need to maximize the value you are creating for yourself. You want to have the biggest incentive to grow the business through thick and thin. Investors are not going to do it for you. 3) Equity investors want to make between 30-20%+ returns as reported in the SF models. The failure rate in the space is high. So they want a much higher projected rate of return to make up for losses. So however you calculate the equity getting paid it needs to be around that IRR for them or north of it.

4) Equity financing can take multiple forms within a structure with preferred structures and non-preferred structures. Preferred structures can actually earn less than common because they are getting regular distributions. This is the part for you to get creative. Speaking for myself, I am at the point where I am looking to deploy capital into other searcher's deals and I want to be on equal footing with the searcher where possible. But I also understand their prerogative and want to have them heavily incentivized to perform. I can be virtually certain to get long term returns in the equities market that are certain so I am targeting a hurdle rate significantly higher than public markets.

Reply by an investor
from University of Southern California in Boston, MA, USA

More debt means more risk, but also more return. That’s why it’s called leverage! If you bought a biz with 90% debt on a 10 year term, paid it off, and sold the biz for exactly what you paid, you’d get something close to 35% IRR. If it was 100% equity in that same scenario, IRR is zero. I’d start by seeing how much debt you need to take to achieve 35% IRR for equity holders. This would depend on your value creation plan for the business. Also, don’t rely on multiple expansion as your primary path to IRR. The deal needs to pencil this lever pulled.

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