What is Dividend Recapitalization?
Dividend recapitalization (frequently referred to as dividend recap) is a type of leveraged recapitalization that involves issuing new debt by a private company that is later used to pay a special dividend to shareholders (i.e., reducing the company’s equity). The source of dividends distributed as a result of dividend recapitalization is newly incurred debt, not the company’s earnings. The recapitalization directly impacts the company’s capital structure since its leverage increases.
Uses of Dividend Recapitalization
1. To exit an investment
Dividend recapitalization is primarily used by private equity firms and private equity groups (PEG). In private equity, it is frequently used as a method of exiting an investment. In such a case, dividend recapitalization is a viable alternative to conventional exit routes such as a sale of the stake to another private equity firm or an Initial Public Offering (IPO).
2. To recover the initial investment
Additionally, dividend recapitalization can be employed in situations when an investor (investment company) is willing to recover its initial investment without losing its stake in a company.
3. To avoid using earned profits for dividends
Furthermore, dividend recapitalization eliminates the necessity to use the company’s earned profits to distribute dividends to its shareholders. Some companies may also depend on it in a low interest rate environment.
Risks from Dividend Recapitalization
Although dividend recapitalization is beneficial to shareholders who can recover their initial investments earlier, it can also be dangerous for the company that undergoes the process. As a company increases its leverage, there is a higher probability of default on its financial obligations. Therefore, the recapitalization may potentially lead to financial distress and, ultimately, to bankruptcy.
Due to the reasons mentioned above, creditors and shareholders who are not entitled to receiving a special dividend (e.g., common shareholders) generally do not favor the practice as the company becomes more prone to unforeseen business problems and adverse market conditions, In addition, the company’s creditworthiness decreases.
Therefore, private equity firms usually undertake thorough due diligence to ensure that companies are suitable for dividend recapitalization and possess sufficient capacity to take on more debt on its balance sheet. Insolvency tests such as balance sheet test or cash flow test are commonly included in the due diligence process.
Practical Example of Dividend Recapitalization
Imagine Company A that is owned by PE Capital Partners, a private equity firm. Company A is the leveraged company with $50 million in debt and $50 million in equity. PE Capital Partners is willing to realize their initial investment in Company A without losing its stake in the company. Thus, the private equity firm decides to undertake a dividend recapitalization of Company A.
The dividend recapitalization plan includes the issuance of corporate bonds of $25 million by selling the bonds to lenders. After the issuance of new bonds, the proceeds will be used to distribute special dividends to investors who participated in the initial investment in the company.
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