Private Investment Explained: Dividend Recapitalization

What is a dividend recapitalization?

Some privately owned businesses issue new debt to pay a special dividend to their shareholders. Many take this step to pay investors a dividend without draining existing revenue. The distributions are shared with limited partners (investors, such as pension funds or university endowments), often reducing their exposure to the underlying investment, while enabling them to satisfy other financial commitments. Typically, investors request these dividend recapitalizations.  In many ways, this process is like a homeowner opening a line of credit to tap existing equity in their house without having to sell it.

How does a dividend recapitalization fit into the broader relationship between a private equity fund and a portfolio company?

Private equity funds are long-term investors, on average maintaining an investment in a company for four to seven years before exiting. The success of an investment is primarily based on the ability of a private equity fund to increase the value of company. Capital often flows both directions over the course of the relationship. At times, private equity funds inject more money into their companies to help finance their growth or weather challenging economic environments. At other times, it makes sense to return capital to shareholders using tools such as dividend recapitalizations. Private equity funds make these decisions within the broader context of managing the growth of their portfolio companies.

Benefits for Pension Investors

At the request of limited partners, private equity firms often conduct dividend recapitalizations to generate returns for their limited partners before those investors would be able to collect gains from a sale of the underlying investment. This helps public pension funds meet their obligations to finance the retirements of teachers, first responders and other dedicated public servants. For pension funds, this bolsters their holdings and strengthens the retirements of their beneficiaries.

Small Share of the Overall Debt Market

Dividend recapitalizations represent a very small share of the overall marketplace for debt markets. In 2020, dividend recapitalizations represented just 6 percent of the total market for leveraged loans, according to a report from S&P Global. Of the total $455 billion market, roughly $26 billion was issued for this purpose. This debt generates more consistent returns for limited partners that might otherwise have to wait seven or eight years or longer to realize returns on their initial investment. According to a recent article from the New York Times, “There are signs, however, that portfolio companies could be in a position to handle the swell in borrowing and that concerns about dividends might be overstated … Even with the pandemic, the number of bankruptcy filings by private equity-backed companies declined to 147 last year from 201 in 2019, according to PitchBook Data, which collects information on private markets.” Overall, private equity-backed businesses generally have lower default rates.

Transparent & Sophisticated Market

These transactions are subject to market dynamics. Companies are only able to issue this debt, if investors are willing to fund the loan. Those lenders do not fund this debt unless they are reasonably confident the debt will be repaid. In fact, the default rate on dividend recapitalizations is lower than it is on non-dividend transactions. “More often than not, portfolio companies that undergo dividend recaps are relatively healthy ones,” according to Pitchbook. This is one reason academic research consistently shows private equity-backed businesses are more resilient during downturns than businesses that lacked a private equity sponsor.

Private Investments Support Businesses Across the County

Private equity played a critical role throughout the COVID-19 crisis, investing capital into companies of all sizes struggling to survive the pandemic and the resulting economic downturn. The American Investment Council recently released new data showing that private equity invested more than $561 billion in 4,335 companies in 2020. One such business was Black Rock Coffee, which struggled to operate under COVID restrictions and develop safety protocols for workers and customers. According to Black Rock’s CEO, “[Private equity] saw through the madness and chaos of everything going on in the world … They followed through and made that investment. They gave us some great shortcuts in the long run of how to adapt to this massive change in our industry rather quickly.”

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