Publicly traded companies sometimes issue quarterly dividends to reward investors. In contrast, private equity firms sometimes issue special dividends. They may do this by raising capital through a dividend recapitalization. There are several reasons a company may pursue a dividend recapitalization, and they can have many benefits. But they also come with their own set of risks that management should carefully consider. We’ll break down what a dividend recapitalization is, the purpose it serves for companies and what the risks could be.
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What Is Dividend Recapitalization?
Dividend recapitalization — sometimes called dividend recap — is a kind of leveraged recapitalization. That leverage comes from issuing new debt, such as bonds, to raise cash for a special dividend. Typically, a private equity firm owns a company which then pursues a dividend recap.
While this strategy has the benefit of raising capital, it also changes the firm’s capital structure. Specifically, it may increase its debt while reducing the company’s equity. The increase in leverage means the company must generate additional cash flows to offset its larger debt burden. If it is unable to do so, it may increase its risk of default.
A dividend recap is an alternative to a normal dividend, where a company would issue dividends from retained earnings. Normal dividends are usually much smaller than the special dividends that come from a dividend recap.
Reasons for a Dividend Recap
There are several reasons a private equity (PE) firm may consider a dividend recap. Despite their risks, they can still be beneficial under some circumstances.
- Reduced risk for PE firm: A dividend recap can reduce the risk a private equity firm assumes due to its reduced equity position in the company issuing the debt. However, it also increases the debt on the portfolio company’s balance sheet.
- Capitalizing an investment: A PE firm might be heavily invested in a company and want to recover some of its investment. A dividend recap allows it to do that without selling its position in the company.
- Exiting a position: Alternatively, a dividend recap might be used to exit an investment entirely. It could do this instead of selling the company outright or pursuing an initial public offering.
- Issuing dividends from debt instead of earnings: A dividend recap could allow a company to issue dividends without having to pay out of its retained earnings.
- Low interest rates: A private equity firm must assume new debt in order to fund a dividend recap. Hence, low interest rate environments could make a dividend recap more attractive than usual.
- Estate planning: A dividend recap can be used as part of an estate planning strategy, especially in the case of family-owned businesses. This is because dividend recaps decrease the business’s equity value, allowing more of the business to be transferred with a lower impact on lifetime exemptions.
Dividend recapitalization can be a useful strategy for private equity firms, but they come with several possible risks that should be considered before moving forward.
- Downgraded credit rating: A dividend recap makes a company more leveraged, which creditors may not see favorably because it could put the company more at risk should unforeseen problems arise. This could result in a downgrading of the portfolio company’s credit rating.
- Risk of default/bankruptcy: Depending on the portfolio company’s overall financial health, the increase in leverage could put it under increased financial stress. If that stress escalates, the company could default on its debt or even be forced into bankruptcy.
- Recessions and financial crises: Economic slowdowns could pose a risk for companies that recapitalize. For example, if a company’s cash flows decrease due to economic conditions at the same time that its debt increases, it could be at increased financial risk.
Example of Dividend Recap
In April 2022, Comvest Credit Partners provided senior secured credit to Saatva, a luxury mattress and sleep products company. Saatva, along with TZP Group, a private equity firm, used the credit to pursue a dividend recapitalization. While the amount of credit is not stated in the news release, it notes that credit facilities typically range from $25 million to $250 million-plus for companies with revenues greater than $20 million. Saatva easily clears that hurdle; it was reported in 2021 that the company was on pace for $400 million in revenue.
The Bottom Line
Dividend recaps allow companies to pay a special dividend to shareholders by taking on new debt. That cash may allow private equity firms to recover some of their initial investment without selling their stake in the company. However, dividend recaps come with several risks; namely, they can make the company issuing the debt more vulnerable due to the increased debt load.
Tips for Investing
- Always work with a financial planner before considering a new investment, especially when investing in a single company. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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