Alex Lykken January 20, 2014
Before exiting a portfolio company, many private equity firms opt to generate pre-sale returns on their investments through transactions known as dividend recapitalizations. In short, companies that undergo dividend recaps incur additional debt on their balance sheets in order to pay one-time dividends to their shareholders, chiefly their PE sponsors and often their management teams. The practice is usually viewed in a negative light, since companies don’t generally benefit from the added debt while their sponsors receive the windfall and retain their equity stakes. Moreover, the additional debt is thought to weigh down portfolio companies, making them more susceptible to unanticipated market conditions and, potentially, to bankruptcy.
Despite the concerns, PE firms have continued to take out additional loans against their portfolio companies in recent years, particularly for companies acquired at the height of the buyout boom in 2006 and 2007. At times, investors over-equitize (overpay) their companies at the time of purchase, decreasing the potential returns on their investments when it comes time to exit them. Dividend recaps, especially in those cases, help investors harvest a portion of their investment and return capital to their limited partners (LPs), which receive the lion’s share (80% or more) of the dividend’s proceeds.
More often than not, portfolio companies that undergo dividend recaps are relatively healthy ones. Their ability to take on additional debt is buttressed by an increase in cash flow, which is often the result of profitable developments initiated by their private equity sponsors. Investors, then, are able to lock in partial returns on their investments irrespective of their own market conditions (two big markets that PE firms look to for exits, the M&A and public markets, don’t always provide profitable exit ramps for illiquid assets like portfolio companies). The returns made to investors through recaps, large or small, reduce the amount of risk involved for both PE firms and their investors.
On a related note, the ability of firms to quickly return capital to their investors can help grease the overall market for private equity deal-making. Capital returned to LPs can be quickly reinvested in subsequent private equity funds. Dividend recaps allow for a more consistent influx of capital returns to LPs, which otherwise could wait for seven or eight years before seeing any realizations on their investments. Generally speaking, both GPs and LPs benefit from the practice. Lenders also benefit, in part because they can command more favorable terms on the new debt arrangements to offset whatever additional risk is introduced.
While dividends decrease the risk of losing money for PE firms and their investors, they increase the risk of portfolio companies going under altogether.
And additional risk is certainly introduced. There’s an important distinction to be made between “portfolio companies” and “investments,” two terms that are often presented synonymously. While dividends decrease the risk of losing money for PE firms and their investors, they increase the risk of portfolio companies going under altogether. Several bankruptcies can be traced back to additional debt incurred that portfolio companies couldn’t ultimately sustain. PE investors are also often on the losing end of bankruptcies, forfeiting whatever equity they still had in the company. There is a visible disconnect, however—when a firm’s investment in a company can be recouped significantly prior to exit, keeping the portfolio company as healthy as possible isn’t as important as it could be.
Ultimately, debt is an unmovable element of the private equity model, both at the outset of the investment (leveraged buyouts) and during the course of the investment (dividends). Dividend recaps aren’t likely to go away any time soon, given their popularity as a source of liquidity for PE firms, not to mention the current anemic interest rates and an increasingly cooperative lending market available to those firms.