Introduction
Picture this scenario: It's 2 am, and I'm playing in an intense game of Texas Hold'em at the Holland Casino. In my hand, I hold the Ace and King of Hearts. I'm heads up with my opponent, a confident postgraduate wearing tinted sunglasses and a black hoodie, who has been boasting all night about his impressive run in the 2019 World Series of Poker main event.
The dealer reveals the flop: Queen of Hearts, Jack of Hearts, and 10 of Spades. Without hesitation, my opponent goes "All In" with a $1,000 bet. I'm thinking to myself - I've landed the winning Broadway straight (an ace-high straight). I'm almost certain he also has the highest straight. However, I hold an advantage with two hearts in my hand and two on the table, setting myself up for a potential flush. I quickly call the $1,000 bet. We reveal our cards, and there's no further betting. My opponent shows the Ace of Clubs and King of Diamonds, confirming he also has the highest straight. But my position is stronger: I not only have the highest straight but also the potential to upgrade to the highest flush or even a royal flush with the upcoming turn and river cards. At the very least, I'll split the pot. If a heart appears, I'll win it all. This is the perfect scenario for me; I'm in a no-lose situation, experiencing the thrill of a risk-free opportunity... I have only upside here – it’s the art of the free roll.
The Free Roll in Corporate Finance
In corporate finance, a sale and leaseback (S&LB) can be a free roll, too. Let me explain.
As the S&LB moves quickly into the mainstream for sponsored businesses, the value that this structure unlocks becomes most obvious in two ways:
- Businesses can redeploy cash previously tied up in owned real estate into a higher and better use, such as reinvesting in their core operations, funding capital expenditures, or replacing expensive debt.
- Companies and sponsors can use the S&LB to fund an M&A transaction, the focus of today’s post. In this case, the sponsor can structure their offer to monetize the target’s owned real estate and use the proceeds as financing to acquire the company’s operations -- all at the same time. The result of this structure is transformational for our clients, as the S&LB can even form the entirety of the capital stack for the acquisition.
How so?
The Free Roll
For a sale and leaseback investor, the nature of their investment thesis relies on securing a long-term, stable flow of income from a tenant that is heavily committed to the subject property, which is mission-critical to the business operations. Real estate investors place a significant premium on the future stream of rental income cash flow and will often pay above-market pricing for the real estate as a result. Additionally – all else being equal – a S&LB investor will pay more for a property leased on a long-term basis to a better credit tenant than to a worse credit tenant.
What This Means for Our Clients
The simultaneous S&LB unlocks the arbitrage between the value of the owned real estate to the underlying seller/owner of the business (which is typically based on an appraisal), and the value that an S&LB investor can justify, taking into account the credit, the long-term lease, the sponsor backing (if applicable), and the mission-critical nature of the asset. The value of this arbitrage can be significant, especially since many sellers may not have a sense of what their real estate is actually worth if they simply consider it as part of the broader business. Additionally, many sellers are simply looking for a holistic exit and aren’t as focused on maximizing the value of both the real estate and the operating company individually.
As a result of this valuation discrepancy, it is not uncommon for an acquirer/sponsor to finance a majority or even their ENTIRE acquisition with S&LB proceeds. This is because often the total acquisition cost (of the real estate and the operating company) is even less than the proceeds generated from the S&LB.
Caveats
Not all S&LB investors will buy into this strategy. Many sophisticated investors want to see that the sponsor has “skin in the game” and that the capital stack shows sufficient equity investment on behalf of the private equity firm. However, not all S&LB investors or deals will require this assurance. Many private buyers do not get into this level of credit diligence, or more real estate-focused investors may not be as concerned about tenant credit risk, feeling confident that they can backfill the original tenant at replaceable rents if the business vacates. I’m not saying it’s always an easy layup, or that we’ll have 15 offers for this type of deal. But in most cases – we’ll have more than one.
In Practice
You may think this scenario sounds crazy – but I promise you it’s not. This “have your cake and eat it too" outcome is not that uncommon. One of our clients regularly uses the “free roll” strategy to expand their footprint of gas stations and convenience stores rapidly. They’ve made millions in profits immediately upon closing their acquisitions, with almost no equity invested. It’s essentially a free option.
Best Candidates for S&LB
The best candidates for executing this strategy are add-ons to an existing sponsored platform company. The reason is simple – it’s all about the credit bump. Even with a sophisticated seller, the value of a S&LB is highly driven by the credit of the underlying tenant. If you immediately grow and improve the credit of a smaller standalone business by bringing it under the umbrella of a broader platform company, the value of a piece of real estate that’s leased on a long-term basis to that company should increase, all else equal.
Why Now?
With continued volatility in the markets and the obvious need for innovative capital solutions in our industry, sharing this strategy now is timely. Sale and leasebacks are complex. My recommendation is not to try executing this structure yourself, or even with traditional real estate advisors, many of whom are not well-versed in the peculiarities of a simultaneous S&LB.
Conclusion
The benefits of S&LBs are clear, however, the complexity of the timing and mechanics should not be underestimated. My team has extensive expertise in the nuances, with a successful track record of implementing S&LB free rolls for our valued clients.
Epilogue
So how did my poker showdown play out? Contact me at chelsea@ascensionadvisory.com to set up a free consultation to discuss. #AlwaysFreeRolling
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