What it means
A company that has been owned for a few years may have paid down debt and built a steady income. Its owners can then take out a new loan and distribute the proceeds as a dividend.
The business is no longer less indebted than it was, but the owners have cash in hand. Private equity owners like the technique because it lifts their returns.
Returning cash early shortens the time their money is tied up, which improves measures such as the internal rate of return (IRR, the annualised return that accounts for timing). It also lets them keep their ownership and still benefit from any later sale.
The risk lies with the company. Higher debt means larger interest payments, less room to survive a downturn and less money for growth.
If trading weakens, the business may struggle to meet payments and could end up in distress. Lenders will therefore check whether the company can carry the extra debt, usually by looking at the ratio of debt to earnings before interest, tax, depreciation and amortisation (EBITDA, a measure of operating profit).
Loan agreements may also limit how much can be paid out. Credit markets need to be open and willing to lend for a recap to happen.
There are also questions of fairness. Minority shareholders, employees and other stakeholders may feel the business is being loaded with debt for the benefit of its owners.
Boards need to consider their duties carefully, particularly if the company's finances are already stretched. Timing is another factor.
Recaps are most common when interest rates are low and lenders are willing, and they often disappear when credit tightens. Owners therefore tend to move quickly when conditions are favourable, which can leave the company carrying debt into less friendly times.
In practice
Real-world examples.
Example
A private equity fund owns a software company that has grown steadily. It arranges a new loan and pays itself a $30,000,000 dividend, recovering a large part of its original investment. The fund keeps its ownership stake, so it still benefits if the business is later sold for a higher price.
Example
A family-owned manufacturer borrows $5,000,000 against its stable profits. The family uses the money to pay a dividend to relatives who want to retire. The loan is repaid over several years from the firm's steady cash flow.
Example
A restaurant group with strong cash flow raises new debt for a dividend, but a sudden fall in customer numbers soon makes it hard to meet interest payments. Lenders later refuse to extend the loan, and the owners have to inject cash.
Formula
Calculation
Leverage ratio = total debt / EBITDA
Maximum new dividend = (target leverage ratio x EBITDA) - existing debt
Worked example: A company has EBITDA of $20,000,000 and existing debt of $40,000,000, so its current leverage is $40,000,000 / $20,000,000 = 2.0 times. Lenders are comfortable with 4.0 times.
Maximum total debt = 4.0 x $20,000,000 = $80,000,000.
New borrowing available = $80,000,000 - $40,000,000 = $40,000,000.
The owners could pay a dividend of up to $40,000,000, ignoring fees. Leverage would then rise from 2.0 times to 4.0 times.
Lenders will usually leave a margin, so the actual dividend is often lower than the maximum. They also look at the ability to pay interest from earnings, not only the ratio.Case study
Seen in the real world.
Tidewater Logistics is a fictional delivery company owned by an investment fund. After four years of steady growth, the fund arranged a recap, borrowing $50,000,000 and paying most of it out as a dividend.
In this illustrative case, the company then faced a fuel price spike and slower trade. Interest payments consumed much of its cash and it had to cancel an expansion plan.
The fund had recovered most of its investment, but the company was weakened and employees were nervous. The illustrative lesson is that a recap rewards owners quickly while pushing risk onto the business. Staff later said the mood had changed once the debt was announced, even though no jobs were cut.
Watch out
Common mistakes.
- Thinking a recap creates value. It moves cash to owners and adds risk to the company; it does not make the business more profitable. It does not improve earnings, so the business is worth the same but carries more debt.
- Ignoring the cost of higher interest. More debt reduces profit after interest and cash available for growth. Interest is paid before profit, so a larger loan leaves less for reinvestment.
- Assuming lenders will always agree. Credit conditions and company performance both determine whether a recap is possible. Lenders look carefully at earnings stability and existing debt before they agree.
Questions
People also ask.
Why do private equity firms do dividend recaps?
They return cash to investors sooner, which boosts measures like IRR. A faster return of cash raises IRR even if total profit is unchanged.
Is a dividend recap legal?
Generally yes, subject to company law tests on solvency and lender covenants, so advisers are essential. Company law solvency tests and loan covenants may restrict the amount.
How is it different from a share buyback?
A recap pays cash to all shareholders as a dividend, whereas a buyback repurchases shares and reduces the number outstanding. With a buyback, shares are repurchased, so the number of shares falls.
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