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Step-by-Step Guide to Understanding the Recapitalization Concept

Last Updated January 30, 2024

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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:

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).

Equity Recapitalization

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.

Debt Recapitalization

If a company’s capital structure does not contain enough debt, it could be missing out on the benefits of debt, namely the interest “tax shield“.

Assuming the company has sufficient debt capacity remaining, management could determine that the best course of action for maximizing shareholder value is to repurchase shares (or issue dividends) using the proceeds from additional debt.

For a debt recapitalization (or “leveraged recap”), the company aims to:

  • Fund upcoming projects with debt capital until the optimal capital structure is reached.
  • Issue debt and use the proceeds to repurchase equity (i.e. share buybacks) or issue its shareholders a dividend, which we’ll discuss in more detail in the next section.

Following the debt recapitalization, the share price of the company could see an “artificial” increase, which is contingent on how the market perceives the buyback.

  • Positive Share Price Impact: The market could potentially interpret the buyback optimistically as management’s confidence in the company’s outlook for its future growth and profitability, as well as the reduced dilution in equity ownership
  • Negative Share Price Impact: On the other hand, investors could view the move as an irresponsible attempt to boost the share price at the expense of having funds to reinvest into operations (and increasing the risks associated with debt).

Dividend Recapitalization

Another variation of a recapitalization is called a dividend recapitalization (or dividend “recap”), which is one option for private equity firms to increase fund returns from a leveraged buyout (LBO).

A dividend recapitalization occurs when additional debt is raised with the specific purpose of issuing the private equity firm – i.e. the financial sponsor – a one-time dividend with the newly-raised cash proceeds.

Most dividend recaps are completed after the post-LBO portfolio company has already paid down a portion of the initial debt raised to fund the transaction, creating more debt capacity.

The purpose of dividend recaps is for the sponsor to partially monetize an investment without undergoing an outright sale via an exit to a strategic or an initial public offering (IPO), which also helps increase fund returns.

In particular, upon completion of a dividend recap, the fund’s IRR can be positively impacted by the earlier monetization and distribution of funds.

After a dividend recap, the private equity firm remains in control of the company’s equity while increasing fund returns and de-risking its investment.

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