This year, dividend recaps have been one of the main ways in which general partners have tried to generate returns for themselves and their limited partners.
In October, Fitch Ratings proclaimed loudly that dividend recaps were back in Europe; while around the same time, Moody’s reported that there were 14 debt-financed dividend recaps worth $5.5 billion in the third quarter this year, following on from the 35 recaps worth more than $11 billion in the first half of 2012.
Should LPs be worried?
It’s true that dividend recaps have a bad reputation. To private equity’s critics, they are symptomatic of all that is bad about the asset class. Unscrupulous owners pile extra debt on a company that is already heavily indebted, with the sole intention of feathering their own nests through a special dividend; meanwhile (so the argument goes) the company is significantly weakened as a result: forced to shell out a higher proportion of its profits on debt service, it has even less cash for investment in people, property, plant and so on.
To some extent this reputation is deserved, because recaps haven’t always been executed with the utmost competence. Particularly during the boom years, there were plenty of examples of companies that were piled too high with debt via dividend recaps – which enriched the sponsor and its LPs, but left the company high and dry when the markets went south in 2010.
As the political heat on the industry has intensified in recent years, critics of the industry have been quick to pounce on some of these examples. This is bad news, because it leads to wrong-headed policy-making – like the provision in the AIFM directive that will bar EU private equity firms from doing dividend recaps in the first two years of owning a company (but not, it would seem, non-EU firms, or other corporates). This may be an excellent demonstration of the regulators’ determination to prevent private equity firms from ‘stripping and flipping’ assets. But as a policy, it’s curious, to say the least.
On the other hand, there were a lot of unwise, capital-destructive practices going on during the credit bubble that had a far worse impact than dividend recaps. Indeed, the number of private equity backed companies that crumpled under the weight of their debts has undeniably been much lower than most people expected (so far).
The LPs I’ve talked to believe that any distribution is a good distribution. And at the moment, GPs don’t have much choice; with the IPO markets largely shut and many trade buyers reluctant to commit, dividend recaps may be their only option. That’s obviously important if their debt package is approaching maturity. But it’s also important if they’re about to hit the fundraising trail, because they need to deliver some distributions to LPs to have any hope of raising fresh capital.
Generally speaking, limited partners generally have no problems with the practice of dividend recaps – as long as GPs are not destabilising the portfolio company by loading up its balance sheet with too much debt.
And that’s the important point here: dividend recaps are not a good or bad thing per se, just as leveraged buyouts are not a good or bad thing per se. The key question is where leverage levels end up afterwards. According to Fitch, the dividend recaps of 2012 will be “much more conservatively structured” than those in the boom years: leverage is likely to go out to 4.5x and 5x on average, well below the average of 6x it recorded in 2006.
Of course, we’re in a very different market now: it will always be a risk to increase debt levels (and thus interest payments) in a flat economy where many companies are struggling to deliver growth.
On the other hand, many of these original deals were done at relatively low gearing, with larger-than-usual equity tranches – and that was due to credit market constraints, not cashflow constraints. So it’s perfectly plausible that some portfolio companies can actually handle higher levels of leverage relatively comfortably.
The other important point that many critics forget is that it is never in a GP’s interest to let a company fail, and particularly not at the moment. I’ve had numerous conversations with LPs about GPs in their portfolio and whether they are considering re-investing. One factor that always comes up is whether that GP has totally lost a portfolio company – i.e. are there are any total “zeroes” in the fund. If so, you can be sure that the whole LP base is aware of it, concerned about it, and will hold it against the GP when considering whether the GP deserves new capital.
Cambridge reported recently that GPs had distributed more than 2.5x the amount of capital they called in the second quarter this year, the first time that has happened in 20 years (see next article). Dividend recaps are a large part of the reason for this. And that’s no bad thing – as long as they’re done in a sensible way.