The risks of early cash withdrawal

With so many LBO transactions taking place over the last 18 months, the number of private equity funds looking for some early cash on their investment has significantly increased, and Standard & Poor’s are starting to worry.

The negative credit impact an early cash withdrawal can have marks it out in comparison to the more creditor-friendly routes that would be used to exit all or part of an equity investment such as an IPO, a secondary LBO or a trade sale. According to S&P’s latest report, Credit Risk Increases In European LBOs As Equity Sponsors ReapRewards, equity withdrawal creates additional credit risk: once the equity sponsor has repaid all or part of the original cash investment with dividends, the interests of the equity and the debt-issuing company become fundamentally misaligned. As a result, there is an increased risk of either insufficient capital expenditure or of sub-par debt repayment if the enterprise value falls below the debt liabilities of the business.

The decision to take out dividends early on in the life of a transaction is, says Mark Owen, a director at NBGI Private Equity, an easy one. “Heads we win, tails we don’t lose, or at least don’t lose as much as we might have. Looking in the crystal ball, the ultimate enterprise value of a business is what it is (or will be what it will be). Therefore, if this can be achieved using a higher proportion of debt enabling us to take out part of our monetary gain early, the effect on our IRR is hugely positive. On the risk front, of course, we have underwritten our downside should the enterprise value subsequently decline (due to events obviously unforeseen by both equity and debt at the time of the cash equity withdrawal!).”While improving IRRs is a good thing, Ian Hazelton of Babson says that taking out cash early can skew a fund’s other performance measurements: “Cash on cash IRRs are a big component in measuring a private equity firm’s success. Therefore, returning cash to investors early will flatter that measure. However, if the business in question cannot service the resulting increased leverage taken on to finance early dividends, then that may prejudice the other main measure of private equity performance, which is cash multiple returned to investors.”The generous debt market has meant that the leverage finance lenders have changed their position to support early equity withdrawals based on the principle that the borrower is able to support the structure. Babson says: “It would be naïve to assume that all such transactions work out satisfactorily but, before supporting a recapitalisation, each lender should be forming a view on the quality of earnings in a business across a wide range of market and business conditions. We must also form a view as to how much a potential purchaser would pay for the business if it underperforms and be comfortable that covenants ensure action is taken before the underlying enterprise value is seriously impaired.”

Owen says the lenders have got to accept some sort of responsibility for an increase in credit risk and make moves accordingly: “Debt providers who are concerned about this type of risk should have included restrictions on the future payment of dividends in the original documentation; this includes most debt providers in most transactions in my experience. By definition, the balance of risk is acceptable to both equity and debt on the original transaction, and the restrictions incorporated provide the basis to veto or control any perceived increase in risk when a cash equity withdrawal is proposed. The risk is real, but no more so than when the debt provider considers a new investment, and the decision to allow the dividend should be judged accordingly. I would view a cash equity withdrawal as an opportunity for all parties to reassess the credit risk, as on a new transaction, rather than introducing additional credit risk.”

With the expected drying up of the debt market over the next year, S&P predicts more private equity firms will be taking out dividends, as well as cash withdrawals through deeply subordinated debt issues, as exit opportunities decrease. Some of the early starters include: Almatis, a producer of alumina-based specialist materials, owned by Rhone Capital; Carlyle’s Italian aircraft engine manufacturer Avio; Cognis, the German chemical company backed by Goldman Sachs, Permira and SV Life Sciences; Inmarsat, the Apax and Permira owned satellite company; and Nycomed, a Danish pharmaceutical group owned by CSFB, Blackstone, AlpInvest.

Taking out cash early doesn’t always mean credit risk however. “It’s important not to generalise,” says Anne Holm Rannaleet, a partner at Industri Kapital. “There is always a risk but it’s not to be exaggerated because it all depends on the company and what sectors. With a company that is highly cash-generative, taking out cash early is certainly not a credit risk.”

Marco Herbst, an associate director at Duke Street, agrees, arguing that it is not necessarily taking out money early which is risky but rather the effect the wider capital market has on a company’s performance: “Over the last 18 months there has been an increasing trend towards early equity release. This has mostly been driven by good business performance as well as increasingly buoyant debt markets. I do not believe that the equity release is a reason for particular concern. What has to be watched carefully is the underlying buoyancy of debt markets.” Taking a different tack, André P. Jaeggi, managing director at Adveq, says as an investor, early cash withdrawal is not a bad thing per se, but it does raise questions about the buyouts manager concerned: “If it’s a classic buyouts manager with a buy-and-build strategy and they take the money out because they can’t think of anything else to do with it, then they have obviously got the strategy wrong. It proves the buyout managers are good on the commodities side of the business (restructuring, improving efficiency and cost cutting), but is that all a buyout team can bring to the table? They all claim to add value, but by taking out money early, it questions their ability to rebuild and restructure.”James Stewart of ECI agrees: “By taking dividends you are changing the deal from a capital gain into an income play; you are looking for a yield rather than trying to build the business for capital gain.”

Taking dividends is, then, not in itself a negative thing but is dependent on the state of the debt market and the performance of the company concerned. Darren Redmayne of the Private Equity Coverage Group at Close Brothers believes that while the risk is there, it should not be overstated: “There is no way to avoid the increased financial risk and the financial sponsor will form a judgement about what an appropriate level of risk is for the benefit of taking out a dividend early. In practice, the technique is usually associated with successful deals that have performed well and which are considered likely to continue to perform.”