Saturday, October 20, 2012

Another Private Equity Game: Dividend Recapitalization

Another Private Equity Game: Dividend Recapitalization

If you’ve gone to a bank lately to refinance your mortgage or tried to take out a home equity loan, you’ve quickly discovered that the banks have much stricter about their lending terms.  In fact, you may have been turned down.  Our friends in private equity are having no such difficulty and have had a fine time pulling all their equity out of some of their companies while retaining total ownership.  The trick is called “dividend recapitalization,” and its use is on the rise.[1]  In “Unvirtuous Circle” written on October 12, 2012, I described one industry tactic to get money out of an investment:  the “pass the parcel” technique, where one private equity firm sells to another private equity firm.  Dividend Recap is another tool in the private equity tool kit.

Legal Update (2010)

In a “dividend recap,” the private equity firm arranges to put a massive amount of debt on a company.  As soon as the debt package is in place, the proceeds are paid to the investors in the form of a gigantic dividend.  Here’s how it works.  Suppose a private equity firm purchased a company for $300 million and used $100 million in equity from its fund and $200 million in debt.  Six or twelve months later, it arranges a second financing in which the company borrows another $100 million.  The new round of financing does not stay in the company; it is paid as a dividend to the private equity fund.  The net result is that the investors have nothing invested in the company but still own 100% of it.  The company is saddled with $300 million in debt.  Even if the company fails, the investors are no longer at risk and still have the opportunity to make money if the company is sold for more than $300 million.  Obviously, the company, its employees, and its creditors bear the risk, as the company has to pay even more interest on its debt and repay the loans.

Why are banks willing to arrange debt for dividend recaps, while mortgage-refinancing standards remain strict?  It turns out there are plenty of institutional investors looking for high yield bonds, as well as bankers eager to make big fees arranging these loans.  Notice that the bank is an arranger of the loan and isn’t taking the risk of holding the loan.  Pension plans and insurance companies looking to increase their income in this low interest rate environment seem willing to acquire this type of debt.   If business conditions deteriorate by just a little, companies that have undergone a dividend recap are apt to wind up in bankruptcy and inflict a great deal of pain on employees and the bondholders.

Once again, the principals at private equity firms are winners because the dividend recap moves them much closer to earning carried interest (profit sharing) under their agreement with their investors.  Amazingly they’ve managed to pull off this feat with a bit of financial engineering rather adding any real value to the business.


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