With merger and acquisition activity down over the course of 2012 into 2013, and a weak market for initial public offerings (IPOs), many private equity firms have turned to leveraged dividend recapitalizations (recaps) as a means to extract value from their portfolio companies and create partial liquidity for distributions to their limited partner investors. A leveraged dividend recap may also be pursued when an equity investor seeks to realize value from its investment in a private company without selling or diluting its equity interests. Unlike a typical dividend that is paid from a company’s earnings, a leveraged dividend recap is a type of transaction often used by private equity firms that results in the replacement of a portion of a firm’s appreciated equity investment in a portfolio company with debt (typically bank debt or the issuance of bonds) on the portfolio company’s balance sheet and the distribution of the proceeds of such debt to the portfolio company’s equity holders.
Recent Resurgence and Motivation for Leveraged Dividend Recaps
Leveraged dividend recaps have grown in popularity over the last decade among private equity firms, peaking in 2007 prior to the start of the global financial crisis. Starting in early 2010, the number of leveraged dividend recap transactions was once again on the rise. According to Standard & Poor’s (S&P) Capital IQ LCD report, in 2012, private equity portfolio companies borrowed more than $64 billion in debt to pay dividends to their equity holders, which is nearly double the volume of debt incurred by portfolio companies for leveraged dividend recaps in 2011, and, through the end of April 2013, portfolio companies had borrowed almost $20 billion to finance equity holder dividends, which is comparable to the amount of borrowing for the same period in 2012. However, according to a recent S&P report, 14 proposed leveraged dividend recap transactions collapsed in June 2013 following a general cooling in the loan markets after the Federal Reserve’s announcement that it could begin to slow its bond-buying program. This suggests that the resurgence of leveraged dividend recaps may be slowing as we head into the second half of 2013. Similarly, a recent Moody’s report indicates that it does not believe the pace of leveraged dividend recaps will continue in 2013 because of the resolution of the fiscal cliff tax issues on January 1, 2013. Several deals that have come back to the market reflect pricing and covenant terms that are much more lender friendly than when these transactions were first launched.
Private equity firms benefit from leveraged dividend recaps in a number of ways, including the following:
- A firm’s internal rate of return on an investment is accelerated.
- There is no dilution of ownership in the portfolio company—the private equity firm maintains operational control of the company while pulling out part, if not all, of the firm’s initial investment.
- Private equity firms are positioned to capture the full benefit of future portfolio company growth when the firm exits its investment in the portfolio company via a sale or an IPO.
- Interest payments by the portfolio company on the newly issued debt are tax deductible.
In addition to the benefits described above, the resurgence of leveraged dividend recaps over the course of 2012 and into May 2013 can specifically be attributed to following market conditions:
- Generally improved lending environment making it easier for companies to borrow
- Expected end of the “Bush-era” tax cuts and increases in the federal capital gains and dividend tax rates at the end of 2012
- Investors seeking high-yielding debt instruments during this period of historically low interest rates
- Relatively stagnant merger and acquisition activity and IPO market resulting in excess available liquidity to finance dividends
Risks of Leveraged Dividend Recaps
Private equity firms should consider the risks and potential consequences prior to consummating a leveraged dividend recap. Most significantly, entering into such a transaction creates additional debt for a portfolio company without any increase in cash flow or revenue, which could hinder a company’s ability to fund day-to-day working capital needs, cause a company to lose sight of its long-term strategic goals by focusing on generating immediate cash flow, or put a company into bankruptcy. A recent study by S&P of leveraged dividend recap transactions completed in 2012 and through April 2013 found that, on average, private equity firms were able to extract 55 percent of their initial capital contribution through a leveraged dividend recap while increasing leverage on the portfolio companies by 1.3 turns of EBITDA. In some instances, the increased leverage has prompted a credit ratings downgrade, leading to questions about the long-term viability of certain portfolio companies in the event of an economic recession or slow down.
If the portfolio company making a leveraged dividend is insolvent, or rendered insolvent by paying the dividend, the transaction may be set aside by a court as a fraudulent conveyance. Fraudulent conveyance laws, which exist under both federal and general state laws, were established to prevent secured creditors, equity holders and other interested parties of a company from financially benefitting at the expense of unsecured creditors. Two types of fraudulent conveyance claims exist:
- A conveyance made with actual intent to hinder, delay or defraud creditors
- A conveyance deemed to be constructively fraudulent because it is made for less than reasonably equivalent value while a debtor is (a) insolvent or rendered insolvent as a result of the transaction, (b) undercapitalized or (c) otherwise unable to pay its debts as they become due
The consequences of a fraudulent conveyance can be severe, as courts have been known to unwind transactions (i.e., repayment of the dividend paid to the equity holders) and void security interests, and lenders and directors can face liability for their involvement in leveraged dividend recaps that are characterized as fraudulent conveyances.
As a result of these risks, lenders, directors and private equity firms have increasingly turned to a solvency opinion from an independent financial advisor to demonstrate that a company will remain solvent immediately following a leveraged dividend recap after taking into consideration the debt incurred as part of the transaction. A typical solvency opinion applies three financial tests: a balance sheet test, a cash flow test and a capital adequacy test, each of which must be satisfied in order for a company to be considered solvent. In addition, certain states may require that dividends be paid out of capital surplus. For example, in Delaware, a capital surplus is deemed to exist if the fair value of a company’s assets exceeds the sum of its liabilities and the total par value of the company’s issued capital stock. In such cases, it may be prudent to receive a capital surplus opinion to support a company’s position that the amount of the proposed dividend would not exceed the company’s statutory capital surplus.
In addition, company directors must exercise their duties of care and loyalty to the company, not to the private equity firm owners and other investors, when considering whether or not to approve a proposed leveraged dividend recap. This means directors must consider all relevant information and exercise all necessary corporate governance measures to determine whether it is in a company’s best interests to effect a dividend recap, which may include conducting a formal board meeting with presentations from officers of the company and outside advisors, as well as the formation of a special committee of the board of directors with independent directors charged with the task of evaluating the merits of a leveraged dividend recap.
Leveraged dividend recaps remain an effective tool for private equity firms to achieve partial liquidity from their investment before a portfolio company is ready for an IPO or to be sold. Over the past year, many private equity firms have used leveraged dividend recaps to enhance their internal rate of return on investments, particularly portfolio companies that became “over-equitized” during the credit crisis of 2008 and 2009. However, like any leveraged transaction, leveraged dividend recaps have risks, including bankruptcy, a fraudulent conveyance characterization or a payment of a dividend when insufficient capital surplus exists, which can result in liability for directors. Private equity firms, directors and equity holders can significantly mitigate these risks by obtaining a solvency opinion from an independent financial advisor and adhering to required corporate governance measures when considering whether to consummate a leveraged dividend recap.