Issuing new debt that is later used to distribute a special dividend to shareholders
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Dividend recapitalization (frequently referred to as dividend recap) is a type of leveraged recapitalization that involves the issuing of new debt by a private company, that is later used to pay a special dividend to shareholders (thereby, reducing the company’s equity financing in relation to debt financing). The source of the 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 an initial investment
Additionally, dividend recapitalization can be employed in situations when an investor (investment company) wishes 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 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, 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.
Because of the increased financial risk involved, creditors and shareholders who are not entitled to receiving a special dividend (e.g., common shareholders) generally do not favor the practice. It leaves the company more vulnerable to unforeseen business problems and adverse market conditions. In addition, the company’s credit rating may decrease.
Therefore, private equity firms usually undertake thorough due diligence to ensure that the company is suitable for dividend recapitalization and possesses sufficient capacity to take on more debt on its balance sheet. Insolvency tests, such as the 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 a leveraged company, with $50 million in debt and $50 million in equity. PE Capital Partners is wanting to recoup its 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 in the amount of $25 million. After the issuance of the new bonds, the proceeds are used to distribute special dividends to investors who participated in the initial financing of the company.
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