Dividend recapitalizations have quietly become the option of choice by private equity investors for achieving liquidity in their portfolio companies.
Until recently, private equity firms used dividend recaps mainly when the window for initial public offerings was closed. But today, despite a robust market for IPOs, many private equity firms are choosing the dividend recap option.
Statistics compiled by Standard & Poor’s show how much the use of this financing technique has grown in the last five years. In the first quarter of 2000, dividend recaps in portfolio companies of private equity firms totaled just $200 million.
Since then, they have risen to a record high of $8.3 billion in the second quarter of 2004, and totaled $5.8 billion in this year’s first quarter. This experience is echoed at PNC Business Credit; we have financed twice as many dividend recaps in 2004 as we did in the two prior years combined.
IPOs, by comparison, slowed to a trickle during the same period. According to Renaissance Capital, proceeds from initial offerings dwindled from $41 billion in 2001, $24 billion in 2002, and just $15 billion in 2003, before a slight resurgence to $43 billion in 2004.
As a result of the recent growth in the use of dividend recaps, this financing technique is no longer viewed as just an alternative to IPOs; instead, it’s now seen as a sister, or side-by-side, liquidity technique.
For the benefit of readers not familiar with the workings of a dividend recap, here’s a hypothetical but typical example of one:
Let’s say a sponsor named E-Group bought 30% of Value Corp. in 2003, paying 5x Value’s EBITDA of $20 million, or $100 million.
Fast forward to the present.
The sponsors’ limited partners are pressuring the private equity firms to realize a return, but E-Group can’t sell any part of Value Corp. until its senior lenders are paid off, and that day can be as distant as five years.
For the purposes of our example, we’ll assume that senior debt won’t be retired for another two years. E-Group decides to do a $10 million dividend recap to keep its investors happy.
The first step in this process should always be to obtain a valuation of the company because it’s necessary to have some sort of benchmark to determine what an appropriate distribution would be. The valuation should be done by an independent third party, preferably one that specializes in providing such estimates and has nothing to gain in the transaction.
The valuation firm sees that since it bought into Value Corp. in 2003, the company’s EBITDA has grown to $50 million. Applying the same multiple of 5x EBITDA that was used in making its investment, E-Group’s believes that its stake in Value Corp. is now worth $250 million. The valuation firm agrees with this asessment of Value Corp.’s worth.
E-Group now arranges for Value Corp. to borrow $10 million as senior debt and distributes the proceeds to its limited partners. This process leaves intact the bulk of the E-Group’s investment so that its full value can be realized later.
It almost goes without saying that dividend recaps are suitable only for companies with little or no debt. And even those that are relatively debt-free may have trouble in obtaining financing for a recap from traditional lenders like commercial banks.
That’s because the money obtained in a dividend recap isn’t being used to build a company; instead, it’s going right out the door to an equity sponsor. Equally distasteful to commercial banks and other traditional lenders is that, in many instances, a dividend recap would leave a company with a leverage ratio much higher than lenders normally allow.
Investment bankers are rarely an alternative source of financing for dividend recaps because they have a different agenda. The objective of most investment bankers is either to sell a company outright or arrange an IPO. An outright sale will yield higher fees than a dividend recap, and an IPO creates not just fees but also product for an investment bank’s retail brokers.
So if a company’s lender balks at financing a dividend recap, a specialist in asset-based loans may be the alternative. Asset-based lenders will lend against accounts receivable and inventory as well as against fixed assets and cash flow of a company.
Why are these lenders so much more accommodating? Because the marketplace has become more competitive and the cost of capital is low. As a result, some lenders have broadened their parameters and have developed a bigger appetite for business; at the same time, companies other than banks have jumped into the lending arena. So there’s plenty of money available to private equity firms that want to provide their limited partners with an early reward for investing in a portfolio company v.
Nehama Jacobs is a senior vice president in the Pasadena, Calif., office of PNC Business Credit, the asset-based lending arm of PNC Bank, National Association, a member of the PNC Financial Services Group, Inc.