In the realm of private equity, a dividend recapitalization is a process of paying a special dividend to private shareholders in order to assist them in recuperating some of the money they invested in the company. By allowing investors to withdraw a portion of their interests, dividend recapitalization helps mitigate risk. The problem is that this strategy often results in the company taking on more debt for the sake of pleasing a minority of its stockholders. Creditors will see the firm as less reliable as a result.
What is Dividend Recapitalization?
By issuing additional debt and utilizing the revenues to pay a special dividend to shareholders or private investors, dividend recapitalization is a method for businesses to acquire capital. For firms who are unable to issue fresh shares owing to shareholder dilution or legal limits, this might be a very appealing choice. Whenever a company changes hands from public ownership to private investors or a private equity group, a dividend recap is often enacted.
An alternative to paying out dividends on a regular basis, this strategy allows businesses to quickly recoup their initial capital while reducing their overall risk. Reinvesting dividends into the business results in an increase in debt, which is bad for the company's leverage and credit worthiness. For this reason, dividend recaps are often looked down upon by creditors. As a result, ordinary shareholders get nothing from the process of recapitalization.
What Is the Purpose of Dividend Recapitalization?
Private equity firms often use dividend recapitalization as a means of realizing part of their earnings while retaining full ownership. To avoid the need for an initial public offering (IPO), private equity firms often employ dividend recapitalization to return capital to their investors. It is often selected as an alternative to typical exit alternatives such as outright sale or IPO.
Dividend recapitalization is a kind of leverage used to alter the capital structure of a corporation, often by replacing debt with equity. Leverage recapitalizations are a kind of refinancing used by private companies and are often used to distribute funds to shareholders without selling the business. Debt also provides benefits over equity when it comes to capital formation, including tax advantages and the imposition of financial discipline. One further way that a decrease in equity might assist prevent a hostile takeover is by increasing the number of shareholders.
What Dividend Recapitalization Is Used For
To Exit an Investment
Only private equity firms and groups use dividend recapitalization (PEG). It is a common method of getting out of an investment in the private equity industry. Dividend recapitalization is an attractive option when other exit strategies, including selling to another private equity company or going public, are not appropriate (IPO).
To Recover an Initial Investment
When a shareholder (investment firm) wants to recoup its capital outlay without suffering a loss of ownership, dividend recapitalization is one option.
To Avoid Paying Dividends Out of Profits Already Made
In addition, dividend recapitalization removes the need for the corporation to pay dividends out of retained earnings. In a period of historically low lending rates, this might be a lifeline for certain businesses.
Dividend Recapitalization Risks
Shareholders that participate in dividend recapitalization stand to profit from the return of their original investments, but the process is not without risk for the firm itself. Default on financial commitments becomes more likely as a company's leverage grows. As a result, the recapitalization might trigger financial difficulties and eventual insolvency. Creditors and shareholders who are not entitled to receive a special dividend (for example, common shareholders) often do not approve of the practice due to the heightened financial risk involved.
It weakens the firm's defenses against competition and market downturns. Even worse, the company's creditworthiness might fall. For this reason, private equity companies will do extensive due diligence to guarantee that the target business is fit for dividend recapitalization and has the financial strength to handle more debt. Due diligence procedures often include tests for insolvency, like a balance sheet or cash flow analysis.
Example of Dividend Recapitalization in Practice
Picture the private equity firm PE Capital Partners as the owner of Company A. With a total of $100 million in assets, including both debt and equity, Company A is a highly leveraged enterprise. The goal of PE Capital Partners' investment in Firm A is to return their capital with as little loss of ownership in the company as possible. This leads the private equity group to decide to recapitalize Company A through a dividend. As part of the dividend recapitalization strategy, $25 million in corporate bonds will be issued. The revenues from the sale of the new bonds are used to pay out special dividends to the early backers of the firm.
Conclusion
Dividend recapitalization may help corporations obtain funds without having to issue new stock. If, however, doing so will increase the company's debt and so hinder its ability to get financing or expand in the future, thorough consideration of the risks and benefits should precede any such transaction.
