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Financial sponsors are extracting dividends from their portfolio companies while credit is still cheap.
Vincent Ryan, CFO.com | US
November 19, 2010
The recap is back — the dividend recapitalization, that is. Private-equity firms are taking advantage of wide-open credit markets and low interest rates to get liquidity on their investments and releverage their portfolio firms.
Bond sales to fund dividends accelerated in the third quarter to $12.6 billion, about 45% of the volume for the first three quarters of the year. Another $5.7 billion of such issuances took place in the first three weeks of October. About 81% of dividend financing in 2010 has been for private-equity-owned firms, as opposed to public companies, and the average dividend has been 107% of the initial equity contribution by the financial sponsors, says Terence Tchen, a managing director at Houlihan Lokey.
"[Financial sponsors] are getting all the money they invested and an extra 7%, and the ownership doesn't change," says Tchen.
"From the standpoint of a lot of [general partners], the best option right now is a dividend recap," says Alan Wink, director of the private-equity group at accounting firm EisnerAmper LLP. "Would it be their first choice? No. But it's probably their best choice."
The tax advantages of a dividend recap has boosted recap deals over the past few months. The thinking has been that if Congress fails to extend the Bush tax cuts — in particular the 15% qualified dividend rate — or changes the rules on carried interest, PE funds would have a limited time to distribute dividends before taxes increase. "PE funds measure returns on an aftertax basis, so they care about taxes from a performance return standpoint," says Tchen. But with the midterm elections handing control of the House to Republicans, the expiration of the tax cuts appears less likely.
Cheap debt financing has also played a role. There have been 10 straight weeks of inflows to high-yield bond funds. "Some lenders are even willing to do covenant-lite deals," says Karen Miles, a managing director of financial-advisory services at Houlihan Lokey.
Concurrently, the choices financial sponsors have for totally exiting investments are limited. Few financial sponsors want to take the leap of an initial public offering, for one; IPO performance is still erratic. "There's always the risk of whether or not the IPO window will be open," says Tchen. Also, secondary leveraged buyout activity (financial sponsor selling to financial sponsor), while somewhat brisk earlier in the year, has slowed. Such deals totaled just $10 billion over the past six months, according to an analysis of Capital IQ data by CFO.
What kind of companies could be pondering leveraged recaps? Companies and financial sponsors that don't think now is the right time to sell, or want to sell but didn't get started early enough to complete a deal in 2010. "This is a way to pull some money off the table and not relinquish control," says Miles. Of course, the companies also have to have the balance sheet for a larger debt burden and the cash flows to make interest payments.
If the tax advantage is taken off the table, many financial sponsors could choose to wait, especially if they expect a stronger U.S. economy in 2011. The financial sponsor may want to have the company hit improved earnings and cash-flow projections before exiting the investment wholly or in part. "It's a lot easier to sell a company that has a 20% rise in trailing EBITDA versus one that is just promising those results," says Tchen.
The trend to dividend recaps is not without controversy. Not all private-equity firms use dividend recaps or think they are a smart use of capital. When a PE firm gives the money back to investors, it's signaling that it can't invest the money wisely as the investor, says Robert Landis, a partner in origination at The Riverside Co. He says Riverside would do a dividend recap only as a last resort, and only if the portfolio company is significantly deleveraged.
Creditors, investors, and credit-rating agencies also generally dislike leveraged recapitalizations. Dividend recaps make the CFO's job tougher. "All of a sudden [the finance chief] has to worry about making larger interest and principal payments, and might think twice about investing in new plant and equipment," says Wink. "The company can become less competitive."
However, historically, dividend recaps do not appear to blow up companies. In a study of deals spanning eight years in the late 1990s and early 2000s, Standard & Poor's found that companies that underwent leveraged recapitalizations had a 6% default rate, compared with 11% for all companies bought in LBOs. One reason was that only companies with strong cash flows can complete these deals, and companies that were recapped had lower leverage multiples.
The leverage being put on recapped companies this time around is also conservative. Year to date, the average debt-to-EBITDA of recapped companies has gone from 2.5 times to 4.1 times post-transaction. In the third quarter, average leverage rose to 4.6 times, but the numbers fall below the average of the LBO wave earlier this decade, says Tchen of Houlihan Lokey.
"Capital has been growing in these companies as they accumulate cash," says Tchen. "They have strong-enough cash flows and can handle the debt."