What is a Dividend Recapitalization?
A Dividend Recapitalization is a strategy used by private equity firms to increase their fund returns from a leveraged buyout (LBO).
In a dividend recapitalization transaction, often abbreviated as “dividend recap”, the post-LBO portfolio company of a financial sponsor raises more debt capital to issue its equity shareholders (i.e. the private equity firm) a special, one-time cash dividend.
Dividend Recapitalization: LBO Partial Exit Strategy
When a private equity firm completes a dividend recapitalization, additional debt financing is raised with the specific intent to issue a special, one-time dividend using the cash proceeds from the newly-raised debt.
While there are exceptions, dividend recaps are completed once the post-LBO portfolio company has paid down a substantial portion of the initial debt used to fund the initial LBO transaction.
Since the default risk is reduced and there is now more debt capacity — meaning that the company could reasonably handle more debt on its balance sheet — the firm can opt to complete a dividend recap without breaching any existing debt covenants.
The availability of sufficient debt capacity is necessary for the dividend recap to even be an option. However, the state of the credit markets (i.e. interest rate environment) is also an important factor that can determine the ease (or difficulty) of achieving a recap.
The rationale for completing a dividend recap is for the financial sponsor to partially monetize an investment without needing to undergo an outright sale, such as an exit to a strategic acquirer or another private equity firm (i.e. secondary buyout), or an exit via an initial public offering (IPO).
A dividend recap is therefore an alternative option where there is a partial monetization for the sponsor from the recapitalization of their investment and receipt of a cash dividend funded by the newly borrowed debt.
What are the Pros/Cons of Dividend Recaps?
In an LBO, the dividend recap strategy is essentially a partial exit, where the private equity firm can recoup some of its initial equity contribution, which effectively de-risks the investment, since there is now less capital remaining at risk.
Further, the PE firm receives a portion of the proceeds on an earlier date, which increase the fund’s investment returns. In particular, a dividend recap can positively impact the fund’s internal rate of return (IRR), since the IRR is positively affected by the earlier monetization and distribution of funds.
Upon completion of the dividend recap, the financial sponsor still retains majority control over the portfolio company’s equity. However, the dividend increases its fund returns (IRR) and the investment carries less risk because of the reduction in capital at risk.
In the exit year, the remaining debt balance is likely higher than if no dividend recap had been completed. However, the firm received a cash distribution earlier in the holding period.
The drawbacks to dividend recaps stem from the risks associated with using leverage. Following the completion of the recapitalization, a more significant debt burden is placed on the company, with the following impact on the capital structure.
- Net Debt (Total Debt – Cash and Equivalents) → Increases
- Shareholders’ Equity (Total Assets – Liabilities) → Decreases
In short, the strategy can benefit the firm and its fund returns if all goes as planned. But in the worst-case scenario, the company may underperform post-recap and default (possibly filing for bankruptcy protection).
In a bankruptcy scenario, not only would the fund returns be reduced significantly, but the fact that the firm made the discretionary decision to perform the recap can cause long-running damage to the firm’s reputation.
The firm’s ability to raise capital for future funds, work with lenders, and pitch itself as a value-add partner to potential investments would all be negatively affected.
What is an Example of a Dividend Recapitalization?
One example of a dividend recapitalization covered in our LBO modeling course was demonstrated in the buyout of BMC Software, led by Bain Capital and Golden Gate.
Only seven months after the $6.9 billion buyout of BMC Software was completed, the sponsors recouped more than half of their initial investment via a dividend recap.
Bain Group Seeks $750 Million Payday From BMC (Source: Bloomberg)