Today’s Recaps, Tomorrow’s Restructurings? –

Debt, and financing in general, has never been more plentiful and available in the private equity market. Whether you’re looking for equity, senior debt, mezz debt or just a standard recapitalization, the money is relatively easy to find. Consider the SunGard Data Systems deal, in which a private equity consortium agreed to pay $11.3 billion to buy the company, but will only put in $2.3 billion of equity. And while most sponsors complain about hedge funds encroaching on their turf, the hedge funds that provide debt are giving buyers more options.

Arguably the most concerning outgrowth of this debt deluge is the trend toward dividend recaps. Simply put, dividend recaps allow sponsors to refinance their company’s debt and take some money off the top to pay back to themselves and their limited partners. As of June 15, there were $22.7 billion worth dividend recaps in 2005, which is a record high. While LPs are happy to get some actual cash distributions, an increasing number of market pros say the short-term gain may not be worth the long-term loss.

“It’s good news and bad news. We’re getting a lot of cash back, but you have to wonder if those companies might be getting overleveraged,” says one LP.

Even if dividend recaps were to stop now, the damage may have already been done. “A ton of sponsors are doing it, and it’s raising some eyebrows,” says Peter Bennett, a managing director in Goldsmith Agio Helms’ private placement business. “In the late 1990s banks were very active, but then they pulled out, and there were many workout situations. The economy has improved, banks are lending again and everyone is receptive to the dividend recap for the foreseeable future, but eventually a correction has to happen.”

Firms like American Capital, American Securities Capital, Brockway Moran & Partners, Freeman Spogli & Co., Grey Rock Capital, GTCR Golder Rauner and Heritage Partners have all done recaps in 2005-and that’s just naming a few. There’s been a little slowdown in dividend recaps, but we haven’t seen any defaults yet to stifle investors’ appetites. “There’s just a lot of money available for dividend recaps, and the private equity sponsors are taking advantage of it,” says Mark Opel, principal with American Capital. “Are some of today’s deals going to be tomorrow’s restructurings? Absolutely, but the whole market isn’t doing stupid deals.”

Another sponsor is more cautious. “No one wants to get caught in a restructuring two years out, but you have to believe there will be restructuring. With leverage levels at 6x EBITDA, there’s going to be pain,” he says. “There’s a lot of money chasing too few deals and the leverage is what’s allowing these firms to win the deals at very high prices. To add to this, many firms are refinancing even more leverage out of the deals. Well, eventually that’s going to be a problem.”

Indeed, multiples have continued to rise. As of March 2005, leverage levels had crept up to an average of 5x EBITDA, according to S&P’s Leverage Loan Commentary. Anecdotally, PE pros are seeing leverage levels hit as high as 7x EBITDA (and purchase price multiples at or approaching double digits). Either way, leverage levels are the most robust they’ve been since 1998, when they hit 5.6x EBITDA and then fell to as low as 3.7x EBITDA in 2001. While neither the SunGard deal or Toys “R” Us are close to the leverage level that the RJR Nabisco deal hit in 1989 (of the $25 billion invested, only a little more than $1 billion was equity) leverage levels are still creeping up and have the potential to turn today’s deals into tomorrow’s restructurings.

“It’s still a little ways out, but people that do turnarounds are expecting things to remain good and active for a while longer, into late 2006 or 2007. Some of these problems that were created with too much debt will come home to roost,” says one bank lender. “Lenders have a tendency to start feeling good about the economy and they are under tremendous pressure to put loans out so they go for it. I think this is going to get worse as lenders try to hit their budgets. But this is all typical of the cycles.”

Recent Deals

American Securities Capital Partners LLC recently recapped Unifrax Corp. and is taking a $47 million dividend out of the ceramic fiber products company. Wachovia Securities is arranging $180 million of new debt. The financing will increase Unifrax’s debt load to $192 million, which Moodys rated as “moderately high leverage” at 4.2x EBITDA on a trailing 12-month basis.

ASCP acquired a 90% stake in Unifrax in September 2003 from Kirtland Capital Partners, a Willoughby Hills, Ohio-based private equity firm in a secondary buyout. This is ASCP’s second recap of Unifrax, it took a $49 million dividend through an earlier dividend recap.

“This part of the market has been very active, and it’s a proactive way of getting customers to borrow,” says Bob Dean, a managing director with Wachovia Capital Finance. “But lenders really need to be careful when they do this. We want to make sure companies are performing well, but really any company where you overleverage and create too large of a call on cash can create a problem. It’s not just recaps.”

Heritage Partners has done two recaps this year. After a little less than two years as majority owner of Enterprise NewsMedia, Boston-based Heritage recapitalized the community-newspaper publisher, allowing the firm to take out an undisclosed dividend while at the same time freeing up capital to support the company for a run at future add-on acquisitions. Promptly following the refinancing, Heritage unveiled the purchases of The Call Group and The Norwood Bulletin for the platform. As part of the recap, Wachovia arranged and underwrote a $100 million facility, reportedly made up of a $25 million revolver and a $75 million term loan. Heritage originally gained a majority stake in Enterprise through a 2003 recap in which the firm invested $43 million of equity into the company.

“The refinancing allows us to defer amortization payments and generate the free cash flow needed to do that over the next 24 months,” Heritage General Partner Michael Gilligan told Buyouts.

“We’re not leveraging these properties because we have the mindset to take everything, but given our heightened interest in returning money to LPs, coupled with the liquidity in the leverage loan market, it’s the appropriate thing to do,” says Charles Gifford, a vice president with the firm. However, he does add, “I am surprised at the legs the leverage loan market has and how sustained it’s been. Eventually, there’s going to have to be a fall.”

At the end of the day, GPs say returning capital to LPs is their primary concern, and is one of the main drivers of the recap trend. “The dividend is an opportunity to return capital before you exit, it makes good sense. Some can build up the company later on and sell it, but there’s no denying there is a risk,” says Bennett.

As one lender put it, if it wasn’t dividend recaps creating a stir, something else would be. “These recaps can lead to trouble, but not if the equity sponsor is paying good attention. We’ll pause if a sponsor is taking money out of the firm and the bulk of the capital is going to repaying equity, but if the money is going to capital expansion or reinvestment in the company, then it could work out okay,” says a lender.