A record year for recaps

Reports that CVC and Permira are planning to take out about £500m (€732m) of equity from their investment in the AA, using a dividend recapitalisation, should not surprise observers. After all, last year private equity firms took out £12.3bn (€17.6bn) from UK investments alone – according to figures from research group Dealogic – about three times more equity than in any previous year.

The AA, like many of the other targets for recaps, is an attractive candidate for such transactions given its dramatic improvement in profitability since the two houses acquired it in July 2004 for £1.75bn. Following an efficiency drive, the company’s 2005 profits were more than double those of 2003 under previous owner Centrica.

Permira has been one of the most active houses in recaps, taking out more than £1bn from its companies, such as the two recaps carried out with Candover to withdraw £1.1bn from gaming group Gala Clubs.

Another high-profile deal was Debenhams, acquired in 2003 by CVC, Merrill Lynch and Texas Pacific for £1.7bn. A few months after the acquisition, the consortium took out £130m and then a further £800m in 2005.

According to ratings agency Fitch, there are increasing examples of LBOs “recycled” within 12 months of the original transaction, such as Dutch paint manufacturer SigmaKalon, UK health club chain Fitness First and German PVC producer Vinnolit, which was tapped by its private equity investors twice last year.

In terms of sectors, Fitch notes that the most popular for recaps in 2004 and 2005 were gaming, leisure and entertainment, partly due to the two Gala transactions, followed by building and materials, fuelled by deals such as Finnish/German bathroom products manufacturer Sanitec Oy, UK plumbing company Caradon and French tiles and bricks business Terreal. Other popular sectors were chemicals, automobiles and consumer products.

Dividend recaps have only become part of the European market in the last three years, as before then the banks did not generally favour such structures unless the private equity sponsors were also able to reduce the debt. But the huge liquidity and aggressive pricing in the lending markets of the past two years has meant recaps have become increasingly common.

It is the scale of the equity withdrawals, and the fact that they are often being made within a very short time of the original acquisition, that is worrying some in the market.

“From a credit perspective there are concerns, as only a couple of years ago the bank market was reluctant to approve more debt being put into transactions through dividends paid to sponsors,” says Paul Watters, a director in the leveraged finance team of ratings agency Standard & Poor’s.

According to S&P, the trend in withdrawing equity at an early stage in the life of transactions increases credit risk by creating a misalignment between the equity sponsors and the lenders. In a report last year, the agency warned that once the equity sponsor has repaid all or part of the original cash investment with dividends, the interests of the sponsor and lender diverge.

“As a result, this could curtail capital expenditure or endanger debt repayment if the enterprise value falls below expectations,” the agency said.

One driver behind the change is that with continued high liquidity in the bank lending market, it is easier for private equity houses to persuade their lenders to approve higher leverage.

But the potential problem, says Watters, is what happens if these highly leveraged companies don’t do as well as expected in the future and he questions whether the commitment of private equity houses to these investments will be affected by the recaps.

“If the portfolio company runs into problems, what will be the response of the sponsors on transactions where their effective equity exposure has been eliminated?” he asks.

Watters adds that this issue will be particularly tricky in cases where a consortium is involved and in which the senior lenders are looking to the various sponsors to be proactive in a difficult situation.

Ian Hazelton, chief executive of debt fund manager Babson Capital Europe, acknowledges that there is an issue around the commitment of the PE house if the equity is reduced.

“If we thought a proposed recap would lead to less commitment from the private equity executives, we wouldn’t go along with it,” he says.

But Hazelton notes that in cases where the performance of portfolio companies has been significantly improved, a recap can make sense from the PE house’s perspective, as it will help it with its IRR return.

“Buyout houses go in with a detailed plan on how to improve profitability or cash generation,” he says and where they achieve that relatively quickly they can justify a recap.

“Sometimes rationalising working capital can provide a quick hit in which the underlying earnings don’t change but there is more free cash available to be distributed,” Hazelton says.

“Or perhaps it was an underperforming business where profitability has been driven up. Some people are cynical about the ability of LBO houses to push up profits in a short time but it does happen quite frequently.”

It is often when an exit is some time in the future and yet performance has improved dramatically that a recap may become attractive, according to James Stewart, director at mid-market house ECI.

“Where a company is at a relatively early stage in its portfolio but generating a higher degree of cash than anticipated it can make sense to recap,” he says.

Stewart cites the case of restaurant chain Tragus, which ECI acquired from Whitbread in mid-2002. “After 18 months the turnaround team had done an excellent job and the cash generation was ahead of plan,” he says. “It was too early to go for an exit because the turnaround was not complete, so we did a recap.”

While Tragus was later sold to L&G Ventures, not all portfolio companies where there have been recaps will find successful exits, believes Andrew Roberts, a private equity partner at law firm Travers Smith.

He says: “If you took a cynical view you could see some recaps as a last-resort transaction for when you can’t get the exit you want – a bit like putting your house on the market and, when it doesn’t sell, remortgaging it.”

Not all recaps are like that, of course. “I did the Wagamama recap 18 months ago for Graphite, as they saw they could get out three-quarters of their original investment in dividends, and then they were able to sell the company eight months after the recap because the business was going from strength to strength,” Roberts says.

The recap trend began to take off, he says, when people were selling businesses but then saw from the prospective purchasers’ financial structure how much debt the business was capable of taking on.

“They thought, ‘hang on, why don’t we take on that debt, pay ourselves a reasonable amount and hang on to the business until it’s a better time to sell?’” he says.

Another scenario has been where a PE house does not have much time to put together a deal, and so deals with one lender but intends to return to the lending market a few months later for a recap on better terms.

The highly liquid debt market and increasing loan multiples at the banks has enabled sponsors to increase leverage so that they can take out as much as 100% of their initial investment in dividends before thinking about an exit.

Watters of S&P says that it is down to the banks whether recaps take place, as they must give approval on particular deals. “The banks are the gatekeepers and it boils down to whether, fundamentally, it’s a business they want to be exposed to,” he says.

Of course, there is also the fact that the banks have had huge amounts of capital to deploy given the enormous liquidity in lending markets.

“We accept that recaps are part of the current market and that the lending market is hot,” says Babson’s Ian Hazelton. But he questions what will happen further down the line to some of the portfolio companies that are highly leveraged.

“The question is, when will this credit cycle end?” Hazelton says, “The current trend for recaps is fine as long as the private equity people are picking good businesses and there’s a benign debt market, but that could all change.”

ECI’s James Stewart argues that the market is already witnessing a flight to quality within the lending market and that banks are more reluctant to consider businesses that do not have a relatively high level of assets and a positive forward earnings visibility. This is affecting sectors where the business outlook is less positive, such as retail, he says.

“In terms of recaps, I think we’ll see a change, with the banks looking for more flexibility on issues such as being able to trade out of positions, so they’ll want the freedom to trade debt instruments in the case of companies that are not performing as planned,” he says.

In response to the claim that recaps are resulting in private equity-backed companies becoming over leveraged, Stewart says he does not agree. “Responsible private equity investors want to create liquidity for the underlying investors but are reluctant to threaten the overall business because recaps are not a proxy for a successful exit,” he says.

“Private equity funds are judged on their ability to generate good returns but also on exiting successfully.”

S&P’s Watters notes that whether the increase in recaps is problematic or not depends in large part on your perspective and that often recaps are pitched as potential IPO candidates in the not-too-distant future, so from that perspective they can be seen as a “glass half full” rather than seeing them from a fundamental credit viewpoint.

“It’s whether you go for the optimistic equity upside story or the hard-nosed realistic credit view,” he says.