Picture this scenario: It's 2 am, and I'm playing in an intense game of Texas Hold'em at the Bellagio Hotel 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.
In real estate finance, a sale leaseback (SLB) can be a free roll, too. Let me explain.
As the sale SLB moves quickly into the mainstream, the value that this structure unlocks becomes most obvious in two ways (and we do about half of our transactions under each scenario):
1. 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 CapEx, or paying off debt.
2. Companies and sponsors can use the SLB to fund an M&A transaction, the focus of today’s post. In this case, the acquirer 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 SLB essentially forms the entirety of the capital stack for the acquisition.
How so?
The Free Roll
For a sale 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. Investors in the property 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 SLB 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 does this mean for our clients?
The simultaneous SLB unlocks the arbitrage between the value of the owned real estate to the underlying seller of the business (which is typically based on an appraisal), and the value that an SLB investor can justify, taking into account the credit, the long-term lease, the PE 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 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 their ENTIRE acquisition with SLB proceeds – and even pocket some money from the spread. That’s because often the total acquisition cost (of the real estate and the operating company) is even less than the proceeds generated from the SLB.
For example:
Suppose a sponsor buys a company for $30 million, at say 6x the company’s EBITDA of $5 million. Assume the company owns its real estate and the SLB investor wants at least 2.5x EBITDAR/Rent coverage. This implies a rent payment of $2 million annually. Assuming a 6.5% cap rate, that equates to $30.8 million in SLB proceeds. The investor is buying the business, including the real estate, based on a multiple of its cash flow, and paying $30 million. The sale leaseback investor is paying $30.8 million for $2 million in starting rent, which grows 2.5% per year for the next 20 years. The $30.8 million fully covers the acquisition cost. By simply executing a long-term lease, the sponsor made a quick $800,000 up front without putting any equity into the transaction.
Caveats
Not all SLB investors will buy into 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 PE firm. But not all SLB investors require this assurance. Many private buyers do not get into this level of credit diligence, or they may not be as concerned about tenant credit risk, feeling confident that they can backfill the original tenant if it vacates. Real estate investors in 1031 exchanges tend to be good buyers for these SLB scenarios. 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 scenario sounds crazy – but I promise you it’s not. This “have your cake and eat it too" outcome is not uncommon. One of our clients regularly uses the “free roll” strategy to expand their footprint of gas stations and convenience stores in South Florida very rapidly. They’ve made millions in profits immediately upon closing, with almost no equity invested. It’s essentially a free option.
As long as our client can service its rent payments, it’s pretty much all upside post-closing. We also recently executed this strategy on behalf of a major automotive dealership network in New York. The dealership acquired a location along with its real estate for essentially the same price for which we executed the SLB. We closed alongside the client’s M&A, and they didn’t have to come up with any equity. The SLB investor felt confident enough in the unit-level coverage and the overall credit of the guarantor, that they weren’t turned off by the sources and uses.
Best candidates for SLB
The best candidates for executing this strategy are PE add-ons to platform companies. The reason is simple – it’s all about the credit bump. Even with a sophisticated seller, the value of a SLB 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, everything else being equal. This is the case with add-ons.
Assume you’re a PE owner of a $40 million EBITDA plastic injection molding business – we’ll call it Big Plastics. You’re evaluating the add-on of a $5 million EBITDA standalone operation – we’ll call it Chelsea’s Extrusion House. If Extrusion House executed a SLB on its own of its manufacturing facility in Wisconsin, maybe it could get $12 million for it. If instead, the PE owner of Big Plastics engaged our firm to run a simultaneous SLB of the Wisconsin facility as part of its acquisition financing of the add-on, then the PE owner could generate $20 million from the SLB.
The incremental $8 million from the transaction above is a combination of several important factors, most notably:
1) The higher rent that the broader platform company can afford and also justify to SLB investors, and
2) The lower cap rate given the significantly stronger credit of the $45 million-plus EBITDA business as guarantor compared to the $5 million EBITDA business as guarantor. By bringing the target under the larger umbrella and significantly improving the credit profile of the lease guarantor, the SLB value inherently increases.
This creates significant arbitrage as the target’s seller could not achieve this value on its own. Hence, the PE firm creates spread through the immediate credit enhancement, for which it can capitalize along with the acquisition of the target. How? By using the SLB to finance the acquisition. Often the spread is large enough for the sponsor to use the SLB capital to finance the acquisition of the add-on in its entirety.
That’s why I call it a Free Roll.
Ascension’s SLB Market Study Confirms
According to our most recent SLB Market Study, which provides the latest Private Equity insight into the SLB world, one of the most commonly cited benefits of the sale leaseback structure is the ability to use the SLB proceeds as an accretive source of M&A financing. Additional benefits include:
· Funding dividend payment to the sponsor.
· Reducing the sponsor’s equity in an acquisition.
· Bridging the valuation gap with M&A seller.
· Providing a holistic liquidity solution for the M&A seller.
· Lowering the effective acquisition multiple paid for the business.
NOTE: While a simultaneous SLB structure to fund M&A works well in the U.S. and many European countries, in others, certain timing restrictions do not permit same day closings. Reach out to my team for the latest guidance about whether or not your target acquisition can implement this strategy.
Which industries work best for the free roll?
Luckily for our clients, the free roll strategy lends itself particularly well to many of the most common SLB industries: QSR, automotive (car wash/gas stations/c-stores/dealerships, etc.), and industrial are all top of mind.
These are sectors in which the real estate tends to be a larger component of the overall enterprise value of the company. Therefore, they are most likely to generate significant arbitrage between the real estate and overall acquisition price. I’ve included two recent case studies of successful outcomes my team has created for clients in the industrial and gas station sectors below:
Simultaneous Industrial Sale Leaseback of 5-Property Portfolio
Gas Station Sale Leaseback to Finance Acquisition and Capex Upgrades
Why now?
With the new year, continued volatility in the markets, and the obvious need for innovation in our industry, sharing this strategy with you feels right. I am lucky to meet with private equity professionals regularly at conferences and other events in the U.S. and abroad. When I shared the idea of a simultaneous SLB with attendees, especially in situations in which the SLB proceeds would largely cover the total acquisition cost, the most common feedback I receive is: “I didn’t know you could do that!”
Just a few weeks ago, a premier private equity owner of a very successful industrial business was under the impression that an acquisition was required to close before executing an SLB. After sharing the ability to close simultaneously, I saw light bulbs go off in the heads of the owner and fellow attendees as everyone in the room suddenly got it. “Next time we’ll definitely want to structure it that way,” they exclaimed. “We can use this strategy to fund future add-ons!” Armed with their existing knowledge of SLBs, they can be more creative with their acquisition financing, especially with the conservative nature of today’s debt markets in an M&A transaction.
Timing is critical
SLBs are complex. My recommendation is not to try executing this structure yourself, or even with traditional advisors, many of whom are not well-versed in the peculiarities of a simultaneous SLB. It’s not just the economics that make them complex; it’s the mechanics. You must organize the SLB transaction carefully, with unmatched attention to detail to achieve a successful simultaneous close. As I discussed earlier, a simultaneous closing of the SLB and corporate acquisition can eliminate redundant transaction costs such as duplicative legal fees, diligence costs, and transfer taxes; but most importantly, the SLB proceeds can be included in the cap stack as equity. As a result, both the OpCo and real estate transactions can close concurrently with a simplified funds flow.
Conclusion
The benefits of SLBs 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 SLB free rolls for our valued clients.
Epilogue
So how did my Bellagio poker showdown play out? Contact me to set up a free consultation to talk about it. #AlwaysFreeRolling
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