Private Eye: Even in long-duration funds, investors can cash in quickly

Raising long-duration funds gives buyout shops the flexibility to own companies for far longer than they would through conventional limited partnerships. But that doesn’t mean their investors will necessarily be starved for liquidity.

Take the example of Ascend Learning, a professional training and testing company that in mid-February borrowed $350 million to help pay a dividend to its financial sponsors, Blackstone and Canada Pension Plan Investment Board.  It’s been less than two years since the pair acquired Ascend from sellers Providence Equity and Ontario Teachers’ Pension Plan. At the time Reuters estimated the price tag at more than $2 billion.

Blackstone acquired its interest through its Blackstone Core Equity Partners LP, a 20-year-duration fund that as of early 2017 had raised some $5 billion, part of a wave of similar fundraises. Other firms to raise or launch long-duration funds include AltasCarlyleCove Hill and CVC.

To be sure, having a portfolio company borrow money to pay its sponsors a dividend — a dividend recap — remains a standard, if controversial, part of the PE playbook. Dividend-taking comes in handy when a buyout firm wants to take money off the table while maintaining full ownership of a company.

In one sense, the maneuver derisks the investment; no matter what happens post-dividend, the sponsor and its LPs have already cashed in some chips. On the other hand, the remaining investment grows riskier due to the leverage.

The Ascend recap raises an interesting question about long-duration funds. Will sponsors borrow money to take dividends at every chance, paradoxically giving their investors even more liquidity than they’re used to in conventional limited partnerships? After all, sponsors of long-duration funds by their nature won’t be looking to cash in on the delevering of their companies through sales — at least not in the near term.

Of course, the answer to that question depends on the deal, and in the case of Ascend, the answer isn’t straightforward. A source familiar with the transaction said the company will first look to use the extra cash it generates for small tuck-in acquisitions, and for investments to spur further organic growth.

To finance larger acquisitions, the company might borrow money. Would the company, which has been performing well, take more dividends under certain conditions —say, with cash piling up, capital markets favorable and the outlook for acquisitions subdued? It may, but taking a series of dividends to maintain some optimal level of leverage isn’t necessarily core to the investment thesis.

A second source familiar with the transaction wrote in an email: “Given the strong cash flow and debt paydown from … core companies generally, it’s fair to say it’s part of the general core strategy to refinance … companies from time to time and pay dividends. In Ascend’s case, this happened a bit sooner than usual because the company has performed well above expectations.”

Standard & Poor’s raised concerns about debt levels at Ascend Learning in a report evaluating the proposed dividend recap.

According to an S&P news release, Ascend as of Feb. 11 planned to issue $300 million in unsecured notes due 2025 to pay the dividend, along with $100 million of cash on hand. The actual offering, which closed Feb. 14, ended up at $350 million. The sponsors haven’t settled on the size of the dividend, but it will likely be closer to $400 million than to $450 million, according to my first source.

S&P expected the original plan for borrowing to take the company’s pro forma adjusted free operating cash flow-to-debt to about 6 percent; meantime, the company’s pro forma adjusted debt-to-EBITDA multiple would rise to more than 8x. As a result, S&P cut its issuer credit rating on Ascend to B- from B, with a stable outlook. Our sources familiar with the transaction noted that the bond offering returned the credit metrics to roughly what they were at the time of the acquisition.

“The downgrade reflects the company’s aggressive financial policy and weakened credit metrics,” S&P wrote in the news release. Interestingly, S&P noted plenty of signs of strength at Ascend Learning. These include an anticipated rate of revenue and EBITDA growth in the mid- to high-single-digit range. The credit-rating company predicts that the company will generate positive free operating cash flow of some $50 million over the next year, and sees the potential for the company to deleverage to less than 7.5x. But S&P also wrote, “we believe Ascend will continue to opportunistically reward its private equity sponsors with dividends or pursue debt-funded acquisitions.”

Dividend recaps such as that Ascend took haven’t garnered a lot of attention in the press in recent months. But if the economy weakens, you can be sure that will change. In an October report on LBO credit quality, Moody’s Investors Service observed that since 2009 nearly a third of the 308 PE-backed companies it has rated have paid debt-funded dividends, which it called “risky transactions.”

In general, the credit-rating company called the credit quality of those 308 companies “weaker” than those of speculative-grade companies not owned by PE firms. “The aggressive financial policies, weak structures and loose covenants accounted for in the ratings of PE-backed companies do not bode well for them when the economy turns,” Moody’s said.

Correction: The original version of this report suggested that the story references multiple S&P multiple reports on the Ascend Learning dividend cap. This story references just one report.