Friday Letter Why criticism of dividend recaps misses the point

It's leverage people should be talking about.  

'Dividend recaps are back for European LBOs', ratings agency Fitch loudly proclaimed this week. With IPO markets largely shut and strategic buyers still ultra-cautious, private equity sponsors are short of exit options – so many will be looking to take advantage of improved conditions in the high-yield bond and loan markets to recapitalise legacy assets and take some chips off the table, the ratings agency said. It pointed to various recent examples, including Iglo Foods, RAC and Formula One.

This prompted another storm of negative press for private equity. Dividend recaps are, as far as many commentators are concerned, symptomatic of the worst excesses of the pre-crash credit boom. This is private equity at its least palatable, opponents argue: piling extra debt onto an already indebted company, with the sole intention of feathering their own nests through a special dividend.

Dividend recaps unquestionably have a bad reputation. And to some extent deservedly so: some of those companies that were recapitalised during the boom years couldn't handle the additional debt burden when markets went south.

This poses a problem for the industry in and of itself. When you're under the political spotlight, as private equity is in various jurisdictions at the moment, engaging in a practice that is often portrayed as flagrant asset-stripping is less than ideal. The likely result is peculiar legislation or regulation, like the provision within the AIFMD that will preclude EU private equity firms (but not others) from doing dividend recaps in the first two years of owning a company – an arbitrary limit that seems like a PR exercise as much as anything else.

There's also a good argument that dividend recaps affect alignment of interest: if a sponsor recaps a company in a way that effectively pays back all its original capital, the incentive to develop that investment subsequently might be diminished.

But on the whole, criticism of dividend recaps misses the point. They're 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. Acccording 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. Bond and loan investors – many of whom actually want more exposure to high-yield in the current environment, lest we forget – should be perfectly capable of assessing this on a case-by-case basis.

It's also worth remembering, as the FT's Lex column pointed out this week, that private equity firms are by no means the only ones who recapitalise their loans to free up cash – it happens extensively in the public markets too. Which only serves to highlight the central point here: castigating dividend recaps indiscriminately as a symptom of private equity greed is misguided and misleading. There will be good ones and bad ones. It's up to investors to decide which is which.