Recaps dangerous

UK rating agency Standard & Poor’s (S&P) has criticised private equity firms for recapitalisations, arguing that piling on the debt damages credit quality and could increase default rates.

In two reports The Dividend Recap Game: Credit Risk Vs. The Allure of Quick Money, and Not All Companies Can Prosper After a Dividend Recap, S&P looks at the current trend within the private equity industry to return cash to their investors in the absence of a strong IPO market. This has led to a heavier than traditional reliance on dividend recaps. “Dividend recaps essentially replace equity with debt, which generally worsens credit quality – and the rating,” said Steven Bavaria, vice-president and head of bank loan & recovery ratings at Standard & Poor’s. There have been 63 leveraged recaps worth more than US$25bn since the start of this year, and S&P believes in particular that US car hire group Hertz was weakened after its private equity owners, a Clayton Dubilier & Rice-led consortium, paid themselves a US$1bn dividend six months after buying the company in a US$15bn deal.

Not that the blame is totally placed on the shoulder of PE funds. Bankers earn money from these structures as they usually finance the recaps. “They’re sometimes called ‘drive-bys’ because they can be that opportunistic,” says Standard & Poor’s credit analyst Sucheet Gupte. “If the market opens up and the company can push something through, they will.”

Dividend recaps will not automatically put pressure on a company’s ability to repay its debt obligations; Standard & Poor’s leveraged commentary data unit determined that in past years 6% of the loans that backed dividend recaps have fallen into default, and not necessarily because of the payouts: sometimes companies experience troubled times regardless of whether they have returned some cash to their investors.

However, many of the recent dividend recap loans are new enough that Standard & Poor’s believes that their ultimate fate will only become apparent over the next year. Banks are eager to sell these loans to investors eager for their high yields. And in the current strong loan market they’re getting takers. “It’s all a sign of how frothy the market is right now,” says Mr. Bavaria. “They are definitely pushing the envelope. We’ll have to see if and when the market pushes back.”

Tom Allchorne