What is a Dividend Recapitalization?
A Dividend recapitalization (aka a dividend recap) involves the issuing of new debt (typically by a private company), that is later used to pay a special dividend to shareholders (reducing the company’s equity financing in relation to debt financing). The source of the dividends distributed as a result of dividend recapitalization is newly incurred debt, not the company’s earnings.
Dividend recapitalizations are a common move in the private equity (and to a lesser extent venture capital) playbook. This is because private equity can take some of the equity out of the business that they have invested & replace it with debt, which has numerous benefits for the investors including limiting downside of their investment whilst keeping upside, increasing their reported distributions to LPs and maximising IRR and carry.
Potential Uses & Benefits Of Dividend Recapitalization
1. To exit an investment
Dividend recapitalization is frequently by private equity firms as a method of exiting an investment. In such a case, dividend recapitalization is a viable alternative to conventional exit routes such as a sale of the stake to another private equity firm or an Initial Public Offering (IPO).
2. To recover an initial investment
Dividend recapitalization can be used in situations when an investor (investment company) wishes to recover its initial investment without losing its stake in a company. E.g. PE firm XYZ invests $10m in a company. The value of this stake grows to $20m. PE firm XYZ recapitalises the business with $10m of debt and pays this out as a dividend. PE firm XYZ now has received its initial investment back in full, whilst keeping potential upside should the $20m equity stake grow to $30 or 40m.
3. To avoid using earned profits for dividends
Dividend recapitalization also eliminates the necessity to use the company’s earned profits to distribute dividends to shareholders.
Risks from Dividend Recapitalization
Although dividend recapitalization is beneficial to private equity shareholders who can recover their initial investments, it can also be dangerous for the company that undergoes the process. As a company increases its leverage, there is a higher probability of default on its financial obligations. Therefore, the recapitalization may potentially lead to financial distress and, ultimately, to bankruptcy.
Because of the increased financial risk involved, creditors and shareholders who are not entitled to receiving a special dividend (e.g., common shareholders) generally do not favour the practice. It leaves the company more vulnerable to unforeseen business problems and adverse market conditions. In addition, the company’s credit rating may decrease.
Therefore, private equity firms usually undertake thorough due diligence to ensure that the company is suitable for dividend recapitalization and possesses sufficient capacity to take on more debt on its balance sheet. Insolvency tests, such as the balance sheet test or cash flow test, are commonly included in the due diligence process.
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