The slowdown in mergers and acquisitions as a result of global economic uncertainty has prompted private equities to take the dividend recapitalization route to bolster returns. Data from credit agency Standard & Poor’s shows that debt issued to fund private equity dividends has already topped $54 billion this year, easily beating the record $40.5 billion in dividend recapitalization reached in all of 2010. Well known private equity firms Leonard Green & Partners, Bain Capital and Carlyle Group are among the firms actively employing the tactic.
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Dividend Recaps Employing Higher Leverage
The practice of dividend recapitalization among private equity owned companies is often viewed as controversial since private equity firms pay themselves in the form of dividends with the money raised from issuing debt. Such a transaction minimizes the exposure of private equity to the companies it owns and increases the debt-burden of companies. During the third quarter of 2012, rating agency Moody’s downgraded 27 percent of companies that recapitalized compared to less than 15 percent in the first six months of 2012 on concerns over highly leveraged deals. Six of the 14 deals during the September quarter had pro forma leverage of more than six times earnings before interest, taxes, depreciation and amortization (EBITDA), compared with one in four such transactions in the first half of 2012.
Emergence of Risky Debt Structures
The prevailing low yields on bonds have led to strong demand in the high-yield market and this has resulted in private equities issuing a risky type of debt known as payment in kind toggle or simply PIK-toggle. These bonds give companies the option to add more debt to pay interest. Already six private equity owned companies have sold PIK-toggle bonds to pay private equity dividends in just the months of September and October, double the number sold in the previous 14 months. According to a study by Moody’s Investors Service, the default rate for companies that sold PIK-toggle bonds was 13% from 2006 to 2010, twice the default rate for comparably rated companies that didn’t use the bonds.
Impact on Jobs
The increase in dividend recapitalization among private equity owned companies is a sign of hard times for the private equity
industry. The continued softness in the initial public offering market is blocking the easiest exit route for private equities. M&A activities are also weak. Data from credit agency S&P reveals that as of July this year there were 14 IPOs and 29 private equity backed M&A transactions, compared with 44 dividend recaps. Given such difficult market conditions, it is likely that the private equity job market will remain soft in the near term.
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