During periods of economic uncertainty, businesses tend to adopt conservative financial strategies, such as conserving cash, to ensure they have a safety net in case of market downturns. However, a contrasting trend has emerged among companies controlled by private-equity firms. These firms often borrow substantial sums of money to pay dividends to their owners, a practice known as dividend recapitalization, which significantly increases their debt levels.
Dividend recapitalizations allow private-equity firms to extract capital from their existing portfolio companies without selling them. While this strategy can be lucrative for the private-equity firms, as it boosts returns without losing ownership stake, it also burdens the companies with considerable debt. This added debt appears as a substantial liability on the balance sheet, which can be especially concerning during economic slowdowns.
This year alone, the debt linked to such dividend payouts has surged to $43 billion. Traditionally, dividend recapitalizations were rare during recessions because of the high risk involved. Lenders were typically more cautious, wary of extending credit to companies that might struggle to repay it. However, in today’s low-interest rate environment, investors are more willing to take on greater risk in pursuit of higher returns. The perceived rewards of lending to private-equity firms now outweigh the risks, making such transactions more attractive.
While private-equity firms benefit from these dividends, the companies they manage may find themselves in uncertain financial positions. The rise of dividend recaps has drawn attention to the potential consequences of this strategy. A major concern is that if these debt-funded dividends backfire, “workers, company suppliers and other stakeholders suffer while investors have already locked in gains (Spegele and Cooper 2020). If these highly leveraged companies start to falter, the government could intervene, bringing stricter regulations to the industry.
Although these payouts can enhance returns, they generally do not match the returns from selling the company outright. However, if a private-equity firm believes that holding onto a company is a sound investment, these dividend payments could be worthwhile. According to Raymond James, the return of capital to investors in private equity is at its “fourth lowest in the past 25 years” (Cooper 2024). This trend suggests that private-equity firms are strategically balancing the need for immediate returns with the long-term potential they see in their portfolio companies, opting to hold onto assets they believe will grow in value over time.
A notable example of a significant dividend recapitalization this year is the $2.7 billion recapitalization by Caliber Collision, an auto-body repair company. Backed by a group of investors, including the prominent private-equity firm Hellman & Friedman, Caliber Collision used the borrowed funds to repay existing debts and distribute $1 billion in dividends to equity holders. While increasing a company’s debt to achieve higher future returns can be risky, the private-equity market is showing signs of improvement, reducing the likelihood of defaults. As of early August, private equity deals in the U.S. have risen approximately “10% at $281 billion” (Cooper 2024). Leveraged buyouts are also experiencing significant growth.
As dividend recapitalizations become more prevalent, the spotlight is on private-equity firms and the companies they manage. The long-term impact of this strategy remains to be seen, but it is clear that the stakes are high for all parties involved.
Sources
Cooper, L. (2024, August 16). Private-equity firms desperate for cash turn to a familiar trick. The Wall Street Journal. https://www.wsj.com/finance/investing/private-equity-firms-desperate-for-cash-turn-to-a-familiar-trick-95368c27
Spegele, B., & Cooper, L. (2020, December 17). WSJ News exclusive | risky loans secure private-equity payouts despite downturn. The Wall Street Journal. https://www.wsj.com/articles/risky-loans-secure-private-equity-payouts-despite-downturn-11608216781
Comments