18 Jan A Look at #Dividend Recapitalization
What if, as an investor, you didn’t want to wait for a return on your investment? What if you were looking for a short-term payday long before you ever sold your company? That practice is put into action quite regularly, and is known as dividend recapitalization.
If you’ve heard of dividend recapitalization, then chances are you’re familiar with the animosity that often surrounds it. But before you decide whether this strategy is good or bad, let’s dive deeper into what’s actually at play here.
What do shareholders do in a dividend recapitalization?
During a dividend recapitalization, a private company will connect with a lender (private equity, bank or other institution) for another loan, based on the current worth of the company they own. Think of it as a second mortgage. The loan they receive doesn’t go back into the company; rather, the money is used as a payday for the shareholders and partners (also known as a dividend).
Then, when these entrepreneurs sell off the company, they’ll have to pack back the bank or PEG for this additional loan. The result will be a smaller payout for the company (and a larger repayment to the lender). While that may not seem in the favor of existing shareholders, in fact, this is a beneficial strategy for them as they’re reducing their overall risk with that early dividend payment.
Why do many people dislike dividend recapitalization?
One of the biggest issues with dividend recapitalization is in a scenario where the company takes a turn for the worse. Technically, what occurs during a corporate recapitalization is that companies incur additional debt on their balance sheets – all to pay one-time dividends to shareholders. In other words, the owners have added debt onto the company.
Notice the key phrase there: onto the company.
While existing owners reap the benefits of dividend recapitalization (in the form of an early payout), they are not responsible for that added debt if the company turns into a failed investment. The company is on the hook. In fact, the firm doesn’t have to pay back any of the loan (not the original nor top-up loan). It’s all tossed onto the company itself.
That’s why dividend recapitalization is often viewed so poorly; companies don’t seem to benefit from it, while their sponsors walk way quite happy. It’s also believed that this additional debt weighs down on companies, exposing them to volatile market conditions and, potentially, bankruptcy.
Dividend recapitalization: It may not be as hostile or bad as it seems
More often than not, only healthy companies are the ones who undergo dividend recaps. Sure, they’re assuming additional debt, but it’s matched by an increase in cash flow. This method has been used countless times successfully (and sometimes not) by many a private equity group.
While this surely may not always be the case, chances are if an owner opts for dividend recapitalization, they’re confident that the portfolio company can handle the added debt and still come out on top during a sale.