What is a Leveraged Recapitalization?
A leveraged recapitalization involves changing the capital structureCapital StructureCapital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm's capital structure of a company by raising debtMarket Value of DebtThe Market Value of Debt refers to the market price investors would be willing to buy a company's debt at, which differs from the book value on the balance sheet. and reducing equityEquity ValueEquity value can be defined as the total value of the company that is attributable to shareholders. To calculate equity value follow this guide from CFI.. This means a corporation will borrow money (i.e. issue bondsBond PricingBond pricing is the science of calculating a bond's issue price based on the coupon, par value, yield and term to maturity. Bond pricing allows investors) to generate cash proceeds, which will then be used to repurchase previously issued shares and reduce the proportion of equity in the company’s capital structure. Hence the term, leveraged recapitalization.
The term capitalization is a reference to how a company is capitalized, meaning, how much debt and equity it has. Both debt and equity generate a balance on the right side of the balance sheet, which is then used to fund the assets on the left side of the balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. These statements are key to both financial modeling and accounting. The balance sheet displays the company’s total assets, and how these assets are financed, through either debt or equity. Assets = Liabilities + Equity.
A leveraged recapitalization is a useful financial strategy, often used in conjunction with MBOsManagement Buyout (MBO)A management buyout (MBO) is a corporate finance transaction where the management team of an operating company acquires the business by borrowing money to or other forms of restructuring. Higher leverage is beneficial to the company in times of good growth, so often times the objective of a leveraged recap is to bolster future growth prospects.
Motivations for a Leveraged Recapitalization
This often seems counterintuitive to those studying corporate financeCorporate Finance OverviewCorporate finance deals with the capital structure of a corporation, including its funding and the actions that management takes to increase the value of. Why make the company more indebted than it already is? Why use debt to repay equity?
There are several mathematical proofs for the benefit of leveraged recapitalizations. One of these, for example, is the Modigliani-Miller theorem, which forms the basis of modern thought on capital structure. This theorem shows that debt provides a tax benefit or interest tax shield that equity does not.
Furthermore, using debt to purchase stock or pay off older debt reduces the opportunity cost of having to use earned profits to do the same.
Additionally, the economic environment may be such that interest ratesSimple InterestSimple interest formula, definition and example. Simple interest is a calculation of interest that doesn't take into account the effect of compounding. In many cases, interest compounds with each designated period of a loan, but in the case of simple interest, it does not. The calculation of simple interest is equal to the principal amount multiplied by the interest rate, multiplied by the number of periods. are low. Companies may want to take advantage of this interest rate environment to perform a leveraged recapitalization.
Finally, debt prevents dilution of shareholder equityStockholders EquityStockholders Equity (also known as Shareholders Equity) is an account on a company's balance sheet that consists of share capital plus retained earnings. It also represents the residual value of assets minus liabilities. By rearranging the original accounting equation, we get Stockholders Equity = Assets – Liabilities, which issuance of new shares will cause. This creates a positive effect from the point of view of shareholders.
Disadvantages of a Leveraged Recapitalization
Despite all the advantages list above, some argue that leveraged recapitalizations limit the growth potential of a company because it does not take a longer-term view.
A leveraged recapitalization often takes into account the current debt environment, which may not stay fixed forever. In other words, if interest rates change, a leveraged recapitalization may provide a negative effect on the company in the form of increased interest expense.
Most importantly, changing the capital structure towards a heavier debt weighting increases the risk of the business, and if things don’t go according to plan, it could end up destroying a lot of shareholder value.
Additional resources
- Leverage RatiosLeverage RatiosA leverage ratio indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. Excel template
- Unlevered Cost of CapitalUnlevered Cost of CapitalUnlevered cost of capital is the theoretical cost of a company financing itself for implementation of a capital project, assuming no debt. Formula, examples. The unlevered cost of capital is the implied rate of return a company expects to earn on its assets, without the effect of debt. WACC assumes the current capital
- Unlevered BetaUnlevered Beta / Asset BetaUnlevered Beta (Asset Beta) is the volatility of returns for a business, without considering its financial leverage. It only takes into account its assets. It compares the risk of an unlevered company to the risk of the market. It is calculated by taking equity beta and dividing it by 1 plus tax adjusted debt to equity
- Reverse Morris TrustReverse Morris TrustA Reverse Morris Trust deal combines a tax-free spin-off with a pre-arranged merger. A Reverse Morris Trust transaction allows a public company to sell off unwanted assets without incurring tax obligations on gains arising from the sale of these assets.
- Revolving DebtRevolving DebtA revolving debt (a "revolver", also sometimes known as a line of credit, or LOC) does not feature fixed monthly payments. It differs from a fixed payment or term loan that has a guaranteed balance and payment structure. Instead, the payments of revolving debt are based on the balance of credit every month.
