What is Recapitalization?
Recapitalization is a catch-all term referring to measures taken by companies to adjust the debt-to-equity (D/E) mixture within their capital structures.
Recapitalization Definition: Capital Structure Transaction
Recapitalization occurs when a company adjusts its capital structure, often with the goal of shifting its D/E ratio closer to its optimal capital structure.
Such measures are taken by companies to reach their “optimal capital structure” – either to:
- Maximize Shareholder Value (or)
- Fix an Unsustainable Capital Structure
The term frequently appears in restructuring, in which a company is forced (rather than choosing to do so voluntarily) to undergo a recapitalization to stabilize its capital structure.
For example, a company’s capital structure could be deemed unsustainable, causing debt restructuring to become necessary. In such a scenario, the recapitalization’s objective is to reduce the company’s proportion of debt on its balance sheet (and lower its default risk).
If the purpose of a recapitalization is to lower the amount of leverage in the total capital structure – i.e. due to the absence of an adequate amount of equity – then the company has two choices:
- Issue new equity and use the proceeds to pay down existing debt obligations.
- Use its retained earnings (i.e. the accumulated profits kept by the company) to pay down debt and lower its leverage risk.
For distressed companies, an equity recapitalization is typically difficult to complete due to the lack of interest in the capital markets.
The claims held by equity holders (i.e. common and preferred equity) are placed at the bottom of the capital structure, so shareholders represent the lowest tiers in terms of liquidation priority.
A more common strategy for distressed companies is called a “debt-for-equity swap”, in which claims held by certain debt holders are exchanged into equity as part of the restructuring process.