Dividend recapitalization is a transaction in which a company borrows in order to pay a large (or “special”) dividend. In doing so, the company significantly changes its capital structure, as net debt increases while equity is dramatically reduced. The source of the dividends distributed as a result of dividend recapitalization is newly incurred debt, not the company’s earnings.
Dividend recap is one of the methods of Leveraged Recapitalization. Such recapitalizations are executed via increasing debt capital to raise money and using the proceeds to buy the company’s stock or to pay dividends. Such a manoeuvre is called a leveraged buyout when initiated by an outside party, or a leveraged recapitalization when initiated by the company itself for internal reasons. These types of recapitalization can be minor adjustments to the capital structure of the company, or can be large changes involving a change in the power structure as well.
Prior to exiting a portfolio company, some private equity firms and activist investors opt to incur additional debt on the balance sheet of the company in order to deliver early payments to their limited partners and/or managers. This reduces risk for the PE firms and their shareholders.
There are two main changes occur post recapitalization
- Existing shareholders have ended up with more cash and reduced equity claim on the business, without any change in the ownership of the business.
- The management will be forced to focus on generating more cash flows and operational efficiency enhancement measures as the company is much more levered.
In the simplest terms, this is a bonus for the preferred stock holders who backed the acquisition, but it also increases the debt load on the company, and hence increases default risk for creditors and common shareholders, but as with many financial tools, we need to understand more to determine the advantages and disadvantages for all parties.
Uses of Dividend Recapitalization
- Dividend recap is used as an exit strategy by private equity investors as a viable alternative to conventional exit routes such as a sale of the stake to another private equity firm or an Initial Public Offering (IPO).
- Sometimes, dividend recap is used as a method to recover the initial investment by investors without losing its stake in a company.
- Furthermore, dividend recapitalization eliminates the necessity to use the company’s earned profits to distribute dividends to shareholders.
- To benefit from lower interest rate environment.
- To increase use of tax shields
- To create room for manoeuvre without affecting the existing credit rating
Companies that have high operational risk or that already have high leverage or a weak credit rating should avoid additional leverage resulting from a dividend recap.
As a company increases its leverage, there is a higher probability of default on its financial obligations. Therefore, the recapitalization may potentially lead to financial distress and, ultimately, to bankruptcy.
Creditors and shareholders who are not entitled to receiving a special dividend (e.g., common shareholders) generally do not favor the practice of dividend recap as it increases the financial risk on the company. It leaves the company more vulnerable to unforeseen business problems and adverse market conditions. The company’s credit rating may get affected due to increased leverage.
This form of recapitalization can lead a company to focus on short-term projects that generate cash (to pay off the debt and interest payments), which in turn leads the company to lose its strategic focus.
In December 2017, Dover Corp. announced that it would spin off its oilfield services business, Wellsite. Wellsite would become a separate company, focused on specialized equipment – specifically, artificial lifts, which squeeze the final drops from oil wells after they’ve been fully drilled. As part of creation of this distinct entity, parent company Dover planned to issue a dividend recapitalization of ~$700 million, leaving Wellsite with long-term debt of 3.4 X EBITDA. While regular dividends go to preferred and common shareholders, in this example, the dividend is planned to fund a $1 billion buyback on Dover’s behalf, supported by activist investor Third Point, LLC. (Source: www.investopedia.com )
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