Overview
In the industry of private equity (PE), dividend recapitalizations also referred to as dividend recaps, have become one of the principal financial maneuvers in driving the returns on invested capital. In times where exits are difficult and options are limited, general partners extract value from portfolio companies in a controversial move, increasing the leverage to levels higher than at entry. In a dividend recap, the portfolio company raises additional debt to pay a dividend to shareholders, typically the private equity owners, thereby unlocking capital while maintaining ownership.
Dividend recaps serve private equity funds multiple benefits: they allow partial returns on invested equity without an exit, help rebalance the leverage in healthy cases and improve the prospects of a new fundraise. However, the highly leveraged post-buyout companies, already constrained by interest expenses and debt covenants, are sometimes subject to a further increase in leverage, often unhealthy and unsustainable. As we are going to see in the case of Staples, this can lead to layoffs, the need of debt refinancing, and store closures.
Regarding technical implications in leveraged buyouts, dividend recaps directly affect the internal rate of return (IRR) and both sides of the balance sheet. For example, a company that takes on $100m term loan to issue a $60m dividend will see its outstanding debt increased by $100m in the liabilities’ structure, retained earnings decreased by $60m in the equity structure, and cash reserves increased by $40m on the asset side. The IRR will increase according to the rest of the financials in each specific case.
Chronology
Dividend recapitalization emerged in the early 2000s as a nifty tool enabling financial sponsors to extract liquidity from portfolio companies without the need for a full exit. This was driven by the low interest rates in the post dot-com bubble era that allowed portfolio companies to support a more leveraged capital structure. Private equity funds were quick to jump on the opportunity to lever up their portcos and write themselves a hefty dividend cheque. Since IRR is very much dependant on the timing of the cash flows, being able to re-lever a portco and make a hefty payout in the form of a dividend enabled financial sponsors to artificially raise their IRRs. Private equity funds also recouped their initial equity investment through leveraged dividend recaps for the first time, long before exiting the investment. This often skewed incentives as the sponsor had less reason to devote time on improving the portfolio company given that they have already broken even on the investment.
In recent years, dividend recaps have made a major comeback. The popularity of dividend recapitalizations is somewhat inversely related to interest rates. As suspected, 2020-2021 saw a boom in dividend recapitalisations in the US leveraged loans markets, with many sponsors raising money to pay themselves dividends in the light of near-zero interest rates. However, when rates started to go up in 2022, leveraged dividend recapitalisation activity hit rock bottom. Whilst there was minimal activity, sponsors were still keen to exit their investments and, given the downturn in M&A activity from strategics as well as sponsors, conducting leveraged dividend recapitalisation was a smart way to return money to limited partners (LPs). As the leveraged loans market has loosened up in the last year, leveraged dividend recapitalizations have made a comeback. January alone saw $8bn of dividend recapitalization deals financed by the US loan market.
Case Study: Staples
Staples Inc. is a leading American office supply retailer that provides products, services and solutions for businesses and consumers. Founded in 1986, the company initially focused on selling office supplies in physical stores but has since expanded to offer a wide range of office products, including technology, furniture, and print services. Staples operates across North America, with a significant presence in the U.S. and Canada, and offers global supply chain solutions through its B2B division. Over time, it has adapted to the digital age by growing its online operations and corporate service offerings, including managed print services and office design solutions. In 2015, Staples announced their intention to acquire Office Depot and OfficeMax but was blocked by the Federal Trade Commission. Following the failed acquisition of Office Depot, Staples began to pivot their strategy by promoting themselves as a “solutions partner” for businesses and as such started building their B2B business.
In 2017, Staples was taken private by Sycamore Partners, a private equity fund specialising in retail and consumer businesses. Sycamore Partners paid $10.25 per share in an all-cash transaction representing a 20% premium, valuing the business at $6.9bn of which $1.6bn was paid in equity. The rest was paid through debt primarily in the form of a $2.7bn term loan priced at 400bps over Libor and a $1bn 8.5% eight-year non-call three-year bond. The substantial leverage the business carried on its balance sheet after the transaction led to S&P downgrading their credit rating to B+ in June 2017, making it non-investment grade. As part of the acquisition, the sponsor implemented a restructuring plan, under which the company was split into three “independently managed and capitalised” entities; the chain’s B2B business, the US retail locations and Staples Canada.
In 2019, Sycamore Partners carried out a large leveraged dividend recapitalization on Staples, refinancing $5.4bn of debt against its ownership in the company and writing themselves a one-time dividend cheque of $1bn. Sycamore partners were able to return roughly 80% of their initial equity investment in less than two years through the dividend recapitalisation. The refinancing was done through $3.2bn term loan B, $750m of secured notes and $1.375bn of unsecured notes. The loans were raised under the delivery business subsidiaries, making the deal more attractive to investors, considering the growth trajectory of the business. Most of these loans and bonds were raised in a cov-lite manner, meaning that little protections were in place for debtholders. As a result of this announcement, the five-year CDS on Staples saw its biggest increase since 2012 according to CMA. Staples faced increased interest expense of $130m and agreed to reduce the size of unsecured debt relative to secured debt to appease creditors.
Since the dividend recapitalisation, the firm has continued its shift to e-commerce. In 2023, Staples announced the closure of almost 1,000 outlets across the US and has also begun layoffs to cut costs. Their partnership with Amazon allows customers to drop off packages they would like to return at the office supply retailer. This summer, Staples were able to carry out a comprehensive debt refinancing in a $5bn debt package, comprised of a $2bn term loan, $2bn of secured bonds and $1bn of unsecured bonds, allowing them to extend maturities by over 5 years. The successful debt placement was driven primarily by 1-2% annual revenue growth over the last decade and three consecutive years of double-digit EBITDA growth. Staples’ credit outlook was improved from negative to stable, and their credit rating held steady at B- in May of this year.
Analysis
Depending on who is being asked, and the specifics of each scenario, dividend recapitalizations may have either good or bad effects for portfolio companies and its stakeholders. This technique has become an important tool for PE funds to receive liquidity from the portfolio companies, and to retain ownership for a longer time. However, it comes at the expense of an increase in leverage for the company in question. While leverage is not particularly bad for companies, as debt has tax advantages and lower costs than equity, it may become harmful when it exceeds acceptable levels. In the past, dividend recaps have affected the daily operations of companies, even leading to reduced wages of their employees. Hence, the effects of dividend recaps are mixed. While some companies, the financial sponsors, and their investors largely benefit from this practice, there are many examples of cases where companies have suffered significantly from the effects of leverage.
On one hand, private equity managers benefit from dividend recaps as it allows them to extract cash from their portfolio companies. By doing so, the funds are increasing the amount of capital they are getting from their investments without exiting from their ownership in the firm. This technique is very useful as it potentially allows the private equities to return some cash to their limited partners when the other forms of exits are complicated. As a result of uncertainty in the market, funds have been less keen to exit their investments because of lower valuations. It’s particularly important as over the past years the ownership periods of portfolio companies have extended, reaching an average of 6.4 years in 2023, the longest since 2008. Hence, when exits via IPO or M&A are not ideal because of lower multiples, or maybe not even an option because of the lack of deal making during some periods, performing a dividend recap allows private equities to receive some cash, which they can then return to their limited partners. Additionally, doing this allows the PEs to raise new funds with ease. Since LPs receive cash returns earlier, sometimes even before the maturity of the fund, they may be more inclined to invest in future funds.
Furthermore, dividend recaps have the potential of facilitating deals that otherwise may have not happened. In periods of high inflation, where there is a smaller incentive to finance a deal with debt, the effects that leverage has on returns is decreased and the financial burden to the funds is increased. The funds are required to invest a larger amount of equity, and the potential to do a dividend recap makes the deal more attractive. The fund may initially invest a larger portion of equity knowing that in the future they will be able to lever the company while returning cash to their investors.
Overall, by performing a dividend recap, private equities de-risk their investments and recover some of their initial investment, without having to sell equity. This allows them to enhance their returns and improve their fund metrics. As PE performance is partly measured through their internal rate of return, and the IRR is positively impacted by early monetization and by receiving cashflows, dividend recaps are a solid boost to PEs. Consequently, from a private equity fund perspective, this tool has become very useful, and, assuming the debt remains under control, it will always provide them with a positive outcome.
On the other hand, dividend recaps have major critics that claim that this type of operations leads to a misalignment of incentives and moral hazards for general partners (GPs). It causes them to pursue activities that diverge from the interests of the LPs, portfolio company employees and the existing creditors. Professors Abhishek Bhardwaj (Tulane Freeman School of Business), Sabrina Howell (NYU Stern School of Business) and Abhinav Gupta (UNC Chapel Hill) conducted a study in which they researched over 47,000 leveraged buyouts in the United States made by 1,200 Private Equity funds between 1995 and 2020 and found around 1,600 dividend recaps. They discovered a causal relationship which showed that the new debt induced by relatively cheap credit, assuming a lower interest rate period, increases risk for the firm, creating a type of agency problem of debt. They were able to show that dividend recaps increased the probability of bankruptcy by 31% in the six years after the financial operation, relative to the usual 1.3%. To the disappointment of debtholders if the company went into distress, the sponsor can be unwilling to put in new money, since they have would have already returned a good portion of their initial equity investment. Whilst the stub equity does have some residual value in this case, it is mostly the call option value in the scenario that the company or industry does make a turnaround. However, when losses are capped and there are better returns to be made elsewhere, it is somewhat futile to spend time and money on these portfolio companies that have gone into distress due to past leveraged dividend recapitalisations. Additionally, as companies become riskier post dividend recaps, there is a chance that their workers will face a negative outcome. Research shows that there may be a significant negative wage growth of -53%, showing the potential detrimental effects on employees.
Moreover, the same authors claim that if successful, the dividend recaps will be beneficial for the financial returns of specific deals, but not necessarily to the fund’s overall returns. For starters, initial success on the dividend recap of a specific portfolio company may make the GP pressure the management of other of their portfolio companies to take on more risk and work towards setting the conditions for a dividend recap, increasing the risk across its portfolio companies. Furthermore, the success in specific deals may incentivize the GP to raise new funds under the pretence of the past returns they have achieved, which don’t necessarily mean the same returns in the future. Then, some funds may centre their attention on the new funds being raised, potentially affecting the companies they own from previous vintages.
Finally, dividend recaps also increase the risk of a potential downgrade in the company’s credit ratings. As some companies are already heavily indebted because of the initial leverage used on the buyout, an increase in debt will only worsen the debt burden for the company. Hence, credit rating agencies may possibly see those loans as an extra pressure on the borrowers, many who are already rated below investment grade. Consequently, the yield paid on existing or future debt will possibly be higher, once again creating a bigger burden for the company.
Resurgence & Outlook
Dividend recaps have seen a resurgence in 2024, driven by numerous high-profile deals involving some of the biggest players in private equity. According to Pitchbook LCD, the loan market issued more than $17.4bn in backing dividend recapitalizations in September 2024, by far the record number for any single month in the US. Year-to-date, the volume reached $69.3bn, on pace to beat 2021’s all-time high of $76bn.
A notable case is Belron, the leading windscreen repair company, backed by Clayton, Dublier & Rice, Hellman & Friedman, Blackrock and GIC, which announced a new raise of €8.1bn through bonds and loans in September. This marks the largest PE-backed dividend recapitalization ever. The investment group will receive a €4.4bn dividend, and a large portion will be used to refinance existing debt. Post-transaction, Belron’s debt will nearly double to €9bn from €5bn, and its debt-to-ebitda multiple will hit 5.8x. This deal is just a single example of the current appetite for dividend recaps.
This year’s economic landscape, including market volatility due to uncertainties and geopolitical tensions, high interest rates and a weak IPO market, make exit opportunities for private equity funds limited. Under continuous pressure from limited partners, PE funds turn to dividend recaps to generate partial liquidity, delivering tangible returns to investors. Moreover, the Fed’s recent rate cut and a high likelihood of more cuts coming soon will likely lead to more dividend recaps due to a more favourable environment. As pressure for short-term returns persists, this manoeuvre will continue to be a frequent occurrence, despite the need to carefully manage the associated financial risk.
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