Buoyant debt markets have allowed buyout groups to return capital to investors through dividend recaps. Given volatile equity capital markets (largely precluding IPOs) and cautious corporates, it seems just about the only way to do so.
Dividend recaps have a bad reputation, often with good reason. If the traditional buyout model involves leveraging an asset at acquisition, and then paying down that debt over the lifetime of the investment before exiting, it makes little sense to re-leverage it half-way through. More pertinently, if leveraged back to acquisition levels, growth prospects are diminished because most cost reductions have already been made.
But private equity firms are beholden to their LPs, and LPs want to see capital coming back. If the only way to do that is via a dividend recap, then so be it, argue GPs.
That was certainly the view of Leonard Green & Partners managing partner Jonathan Sokoloff, speaking at the Milken conference in Los Angeles earlier this month. “We have div recapped, refied, repriced or sold just about everything we can,” he said.
It’s commonly agreed that leverage reached excessive levels in the run-up to Lehman’s collapse, so to see leverage multiples creeping upwards again after several years of prudent deleveraging, is potentially worrisome. The caveat of course is that there’s still a long way to go before we see eye-watering boom era multiples again.
Standard & Poor’s, which came up with that headline figure of €2.3 billion in a report published today (against a 2012 full year figure of €1.87 billion), took a measured view of the findings. “While this development carries risks, the value of these payments is nowhere near that seen at the top of the last cycle in 2006 and 2007 [peaking at €11.3 billion],” the group said. “What's more, the companies executing these transactions are by and large performing well and have the capacity to releverage their capital structures,” wrote S&P’s analyst Taron Wade.
However, S&P also sounded a note of caution: “The risks may rise as more highly leveraged companies lower down the credit curve opt for such payments”.
What does this mean for the providers of debt used in such recaps? If appetite for debt-based recapitalisations is rising, that represents an opportunity for lenders (including private debt funds), to work their way into capital structures. Any sensible lender will due diligence the asset in question and structure any new loan accordingly. Interestingly however, the bond market has accounted for a greater slice of the recap pie than in previous years, suggesting the opportunity (at present at least) may not be all that significant for leveraged finance providers after all.
And for existing lenders, the implications are potentially more serious. S&P’s notes that recovery prospects in the event of a default can be impaired following a recap, depending on how it is structured. If the new debt is senior or super-senior, then recovery prospects for existing holders of the debt can be reduced. There’s also the perception that if an equity sponsor has taken money off the table, their incentive to develop the asset to the best of their ability is lessened.
To conclude, dividend recaps are undoubtedly making a comeback, but for the time being, it’s mainly stronger-performing, modestly-levered companies that are tapping this opportunity. High yield bond markets are so strong that sponsors are, perhaps sensibly, capitalising on the opportunity to return money to investors. So for now, there’s no need to worry. If the market starts to support weaker companies going down a similar route however, that’s a different story altogether.