Firms turn to dividend recaps for exits

As the exit climate remains challenging and many leveraged buyouts are at or beyond the typical equity investment period, more private equity firms are looking at dividend recaps as a way to return money to investors, research has found.  

Fitch Ratings, which carried out the research, said the increase is driven by an improvement in financing conditions in the high-yield bond market and a selective risk appetite among loan investors. It expects private equity firms to “opportunistically tap windows of high credit market demand to seek cheap funding for a dividend recap on their legacy assets”, Fitch said in a statement.  

Firms are challenged by an impaired exit environment, according to Fitch Ratings. IPO markets are volatile, strategic sales are often subjected to minority shareholder revolts while secondary buyouts are subjected to valuation disputes, the research said.

GPs, especially those about to hit, or on, the fundraising trail, need other ways to get distributions to their existing limited partners, both to free up space for re-commitments to new vehicles, but also to show their investors that they can return capital. With other options constrained, dividend recaps appear to be the method of choice right now.

However, piling more debt on portfolio companies for purposes of paying investors has not been a very politically popular strategy. The practice has been viewed as firms enriching themselves on the backs of their portfolio companies, which then may have to shed assets to pay down the additional debt.

Earlier this year, Cerberus Capital Management, Sun Capital Partners, and other defendants paid $166 million to settle a case in which they were accused of enriching themselves by extracting valuable real estate assets from department store chain Mervyns and paying themselves dividends, eventually plunging the company into bankruptcy. Both firms admitted no wrongdoing in the settlement.

The media pilloried Thomas H Lee Partners in recent years for taking dividends out of Simmons Bedding during its ownership, prior to the company filing for bankruptcy in 2009. Scott Sperling, co-president of the firm, talked to Private Equity International at the time about accusations the firm sucked money out of Simmons, leaving it vulnerable to falling markets. 

“The company, during our ownership, increased its investment level, built numerous new plants and took market share from its competitors. If you run a company well like that, it generally allows you to do recaps, and when the recaps were done, nobody complained about them. S&P and Moody’s didn’t complain at the time; they noted the company’s strong operating and financial performance,” Sperling said. The full interview can be accessed here.

Loan volumes

Loan volume for dividend recaps has now reached the highest level since 2007, according to data provider Dealogic. Global private equity-related loan volume for dividend recaps has reached $18.1 billion so far in 2012, up 21 percent from the same period last year. In 2012, bond issuance of $8.3 billion for dividend recap purposes was up 69 percent from the $4.9 billion in the same period last year.

Dividend recap loans represent 5 percent of financial sponsor-related loan value so far this year, up from 3.6 percent in the same period in 2011. In the comparable period in 2009 dividend recap loans only represented 0.5 percent of the related loan volume, Dealogic said.  

“Companies that are financed when debt is scarce can bear more debt when markets improve, and the excess can be used to fund a dividend payment,” said Ian Borman, a partner at SJ Berwin. “We have seen very restrained debt packages in recent years and the high yield market has freed up. The ability of funds to recycle cash (or repay fund leverage) has driven some of this activity.”

Recent activity

Frozen foods business Iglo Foods, owned by Permira, plans a €250 million secured bond issue for dividend recap purposes. RAC, a UK car breakdown service, recently completed a £260 million loan, to be used for dividend payments to The Carlyle Group. Leslie Poolmart, a pool supplies retailer, recently took out a $625 million loan for dividend recap purposes for its majority owner CVC Capital Partners, according to Dealogic.

In addition, BJ Wholesale Club, a retail wholesale provider, took out a $1.6 billion loan last month for a dividend recap for CVC Capital Partners and Leonard Green. These loans can contain different tranches for different purposes, for instance for corporate refinancing or add-on acquisitions, or can be used solely to pay dividends. “Usually, but not always, the whole debt package is refinanced,” Borman said. 

“You do often see recaps of businesses as an alternative to a sale, but they are not always connected with a failed sale,” Borman said. “Where a sponsor believes they can bring about longer term returns, perhaps with a new operating model, they may do a recap rather than allow a new sponsor to profit from a secondary transaction, whilst also showing a return to the fund in a normal transaction timeframe,” he added.

While the dividend recaps are rising, it is likely, according to Fitch Ratings, deals will remain much more conservative than those struck in 2006 and 2007. “We expect dividend recaps to leave leveraged buyouts with leverage of between 4.5x and 5x on average, compared with the 6.4x in 40 deals we analysed in 2006,” the statement said.