Publicly traded companies often distribute quarterly dividends as a way to reward investors with a share of their profits. However, private equity firms take a different approach, sometimes issuing special dividends through a financial strategy known as dividend recapitalization. In this process, a company raises capital by taking on new debt and using the borrowed funds to pay dividends to its investors. While dividend recaps can provide immediate liquidity and allow private equity firms to recover some of their initial investment without selling their stake, they also introduce significant financial risks. Increased debt levels can strain a company’s balance sheet, reduce financial flexibility, and potentially lead to long-term instability.
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Understanding Dividend Recapitalization
Dividend recapitalization, often referred to as a dividend recap, is a financial strategy used primarily by private equity firms to extract value from their portfolio companies without selling their ownership stake. This process involves the company taking on new debt and using the borrowed funds to pay a special dividend to its shareholders, typically the private equity owners.
Unlike regular dividends paid by publicly traded companies, which are funded by profits, dividend recaps rely on leverage, meaning the company assumes additional financial obligations to facilitate the payout. While this strategy allows investors to realize returns before an official exit, it fundamentally shifts financial risk onto the company itself.
The primary motivation behind a dividend recapitalization is liquidity. Private equity firms often operate with a defined investment horizon, aiming to maximize returns within a set period. By using a dividend recap, they can recover a portion of their initial investment early while retaining ownership and control of the company.
This allows them to continue executing their growth strategy, potentially increasing the company’s value before an eventual sale or public offering. Additionally, dividend recaps can be attractive in favorable credit environments when interest rates are low, making borrowing cheaper and increasing the viability of this approach.
Reasons to Complete 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 (IPO).
- 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. This allows more of the business to be transferred with a lower impact on lifetime exemptions.
Potential Risks
Dividend recapitalization can be a useful strategy for private equity firms, but they do come with several possible risks that should be considered:
- Downgraded credit rating: A dividend recap makes a company more leveraged, which creditors may not see favorably. This is because it could put the company more at risk should unforeseen problems arise. And 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
A few years ago, 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.
Bottom Line
Dividend recapitalizations offer companies a strategic way to distribute special dividends to shareholders by leveraging new debt. For private equity firms, this approach provides an opportunity to recoup a portion of their initial investment without relinquishing their ownership stake. However, while dividend recaps can deliver immediate financial benefits, they also introduce significant risks. By increasing a company’s debt burden, these transactions can heighten financial strain, reduce operational flexibility, and make the business more susceptible to economic downturns or industry volatility. If not carefully managed, the added leverage could compromise long-term stability, potentially leading to credit downgrades or financial distress.
Tips for Investing
- Always work with a financial planner before considering a new investment, especially when investing in a single company. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goal, get started now.
- It can be tricky to know how much your investment will grow over time. Use SmartAsset’s investment calculator to estimate your portfolio’s returns.
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