By Charly Delanoë and Tom Cordes
Let’s talk about personal finance. When asked to give a good reason to take on a personal loan, what’s the first thought that comes to mind? If you followed any 101 business class or if you balance your own check book, you should come up with a sensible answer. Usually we consider taking a loan if we can invest it in order to gain some kind of benefit in the future, in other words, we take on debt to buy an asset. Take this simple example, you were just accepted to the university of your dreams (Bocconi), but you don’t have the funds to pay the tuition. You take on a loan to pay for your studies and a few years later you earn a diploma and a higher salary allowing you to rapidly repay that loan. Here, the math checks out, you end up richer because you took out the loan. Easy.
As elementary as it was for you to justify a reason to take on additional debt, you can just as easily recognize that taking a personal loan to simply increase your disposable income is a bad idea – unless you’re Charles Ponzi. However, in the world of Private Equity, this practice is quite common; we call it a dividend recapitalization.
What is a dividend recap?
In an environment of perennial low interest rates and institutional investors struggling to seize yield on the debt market, financial sponsors have more sway to negotiate pricing and terms on so called corporate junk bonds – reviving a practice laid dormant since the great recession. Using covenant-lite bonds, GPs can raise new debt to generate cash proceeds that, rather than being invested in the portfolio company, are used to pay preferred shareholders a special one-time dividend. This is a dividend recapitalization [cue music]. Together with leveraged share buybacks, a dividend recapitalization is part of a wider category of transactions called leveraged recapitalizations that, as indicated by their name, aim to change the capital structure of the concerned company. During a leveraged recapitalization, large amounts of equity are replaced with fresh new debt. What differentiates a dividend recapitalization is that, unlike a leveraged share buyback, it leaves the shareholder structure untouched. This is an advantage for the financial sponsor in order to maintain control over the target company and to claim additional upside from the investment. While the cash proceeds are favorable, the dividend recapitalization is not entirely painless as it creates an abrupt spike in leverage for the target company and can cause pushback from stakeholders and creditors alike. This begs the question, under which circumstances can a corporate play coupled with a sizable debt burden gain traction.
After a rosy ten-year bull run for the private equity industry, rising entry multiples, dwindling IRRs, geopolitical trade tensions, Brexit concerns and overall slowing of GDP growth are all reasons to fear that the music is about to stop. Timing a recession is key for GPs: over the past two downturns the average LBO purchase price multiple dropped about 20% from its peak before rapidly recovering within two years. This fact proves again that times of crisis represent an outstanding opportunity for investors flush with cash. The phenomenon is no secret within the private equity industry and we have observed changes in investor behavior accordingly. The average holding period for an investment decreased 10% year-on-year in 2018 to 4.5 years, with an increasing portion of “quick-flips” – i.e. investments held less than three years. This reduced holding period for investments allows GPs to accelerate the transition to capital raising. Indeed, raising new capital has been and continues to be a success story motivating private equity funds to tap LPs while investor sentiment remains seasonable. In this environment where uncertainty is compounding, exiting an investment earlier and trading some IRR basis points to weather the next recession is becoming a no brainer for GPs.
Having set the scene, the dividend recapitalization makes its debut. While strategic transaction volumes (the leading exit for buyout-backed companies) are down from an all-time high in 2014 and while IPOs as an exit are too time consuming for many, dividend recapitalization is more appealing than ever as a method to quickly de-risk an investment and return capital to LPs. The investors are then able to re-invest the intermediate proceeds into different funds.
Let’s list the various benefits of a dividend recapitalization for fund managers nowadays.
- Dividend recapitalization is the fastest way to partially exit an investment.
A dividend recapitalization can be seen as a very effective way to quickly recover an initial investment. Compared with other exit options such as IPO or a strategic sale, a dividend recap doesn’t require months of processing to take place. This is especially relevant in times of uncertainty as it allows the financial sponsor to recoup part of his participation in the company which reduces his exposure to the future performance of the target company. Another advantage of an early partial exit is that it generates a positive cash flow for the fund earlier in the lifecycle of the investment. As the proceeds benefit from a shorter discounting period, they boost the main performance metric for fund managers: the IRR. Because of this, the choice to pursue a dividend recapitalization is usually well perceived by the management of the company. When faced with challenges to find a trade buyer to close a fund, a dividend recapitalization is perceived as a valid way to “buy” time (and LP approval) to make a transaction happen.
- Dividend recapitalization as a tool to realign capital structure.
From the above point this transaction might seem to perfectly fit the needs of the financial sponsor, however the criticisms regarding the drastic increase in leverage for the target company must be addressed. Stakeholders’ fear that the portfolio company’s credit rating and overall stability will be at risk is a sensible concern – especially in a torrid market. Indeed, the burden of additional debt and financial risk is not suitable for all companies. Targets that are conventionally chosen for a dividend recap must undergo the very stringent due diligence of the investment fund. All companies that end up being selected should present the symptoms of an under-leveraged company, with strong stable cash flows and low operating risk. Here is an example to help visualize how this could happen: a financial sponsor performs an LBO on a target company. As you may expect, the financial sponsor maximizes the portion of debt at the time of the transaction. During the first two years of owning the company, the operational and financial changes made by the financial sponsor have drastically increased the performance of the target company, which has repaid a large portion of the principal. Now the financial sponsor owns a company that has rapidly drifted away from the targeted optimal capital structure. Here, a dividend recapitalization would be an option to increase the leverage of the portfolio company.
- Dividend recap and the leverage effect.
Which brings us to the last point, dividend recapitalizations and leveraged share buybacks are used to change the capital structure for a wide range of companies, not only LBO targets. The benefits sought after are numerous. It forces management to be more efficient in their use of the company’s resources, it allows the company to benefit from a low rate environment and boost equity returns by paying down debt with operating cash flows and it allows for a greater use of the tax shield on interest payments. Because the sourcing of debt has much to do with the credit markets – viz. availability of credit, tax law and interest rate environment – GPs are able to make use of dividend recapitalizations in today’s temperate conditions.
Dividend recapitalizations are gaining popularity these days, and hopefully you can now appreciate that the justification behind this activity cannot be clarified with a simple explanation. The process is backed by a late cycle economy and a low interest rate environment. However, it is important to remember that this type of transaction is not one-size-fits-all. Financial sponsors have little interest in razing a company they have dedicated multiple years of time and capital to by whimsically leveraging and refinancing debt. The trend in increased recap volumes is more by circumstance as opposed to frenzy and therefore, GPs invest significant time carefully choosing which portfolio company to support additional debt, oftentimes resorting to solvency opinions from financial advisors before acting.
Editor: Eric Peghini
Authors: Tom Cordes, Charly Delanoë