In an LBO scenario, if the company has extra cash after paying mandatory debt amortization, what’s the most Accretive thing to do with that extra cash (use it in a discretionary sweep to voluntarily prepay debt; pay yourself a dividend; etc.)?
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definitely not pay yourself a dividend. That won't be accretive at all
either prepay debt (increase exp decreases so NI increases), or reinvest (should be accretive if you make good investments). It depends on how expensive your interest payments are and how much new projects/investments would add to your bottom line with regards to which one is more accretive.
This. However, from a returns perspective OP, paying a dividend could be more beneficial than paying down debt. You just have to run the analysis.
But, debt covenants may prohibit cash dividends.
WTF are you talking about?
No, you take the extra cash and you pay yourself a dividend if possible. More likely than not, you won't be able to do that as your lenders will require either full cash sweep to paydown debt or a portion pays down debt and the remaining balance remains in the company.
Its beneficial to pay a dividend vs. paydown debt if you have the choice between the 2. You paydown $1 of debt and you created $1 of equity value at exit. You pay yourself $1 dividend and you realized $1 equity value today, vs at exit. The only way this would not be the case is if your post-tax cost of debt was equal to or higher than your cost of equity, which would mean an interest rate of ~38%... i.e., not going to happen.
Agreed. Thanks for the great explanation. PE firms love dividends for the reason Marcus mentioned here. Not only do they pay dividends with spare cash in the portfolio company (no brainer if allowed) but they sometimes have the company borrow even more money in order to pay themselves dividends via the controversial practice of dividend recap. A dollar paid out in dividend today is a dollar of locked-in return. If they wait until exit chance is there may not be any returns at all. In fact there have been instances where the PE fund came out ahead with the dividend payments even when the portfolio company ended up in bankruptcy.
Marcus, I think he was referring to accretion vs. dilution from a Strategic standpoint. The OP's original question asked is it accretive?
Paying out a dividend isn't accretive from an EPS standpoint and I am guessing that is what nontarget was referring to. Which is why I tried to add-on using a returns perspective (i.e. sponsor viewpoint)
First question: why does whether or not it's accretive matter if it's an LBO?
This may seem obvious, but don't forget that excess cash not used to fund the purchase (i.e. as a source of funding with a subsequent use) reduces the EV and the purchase price of the transaction. So excess cash, after repaying debt and purchasing equity, lowers the transaction value.
With that said, why would a company want to have excess cash above and beyond their desired minimum cash balance after the transaction?
I'm speaking with regard to an ongoing basis, not the execution of the transaction. For example, in year 5, if you had cash left over after meeting mandatory debt amortization, what would you do with that cash?
exaclty with peinvestor said: pay down debt early to increase your IRR, use the money to reinvest into the company to increase your IRR that way, or pay out a dividend to yourself to increase your total returns.
Of course it will be beneficial to get some money to shareholders earlier than later (given cost of debt is less than cost of equity which is always the case), so it should definitely improve IRR.
Obvious addition - don't forget to model interest income for your minimum cash balance.
Right, the preferred course of action is to find one that actually creates more value rather than change the timing of cash flows, plan B is the dividend, the rest doesn't really matter:
Dividends are accretive to your IRR but make no difference on money multiple so if there are good opportunities to reinvest the cash to actually create more equity value that would be the best (i.e. accretive M&A or new product launches)
The impact on returns of your treatment of excess cash is generally surprisingly small. For instance say there is only a non-amortizing TLB and you are free to pay down at your own discretion, the difference between a 100% cash sweep and 0% repayment (i.e. bullet repay at exit) is generally smaller than 1% IRR (try it in a model!)
So, try to find a way to invest the money and if there isn't any, pay a dividend!
Not sure if OP understands the terminology then. Because from "an LBO standpoint" accretion (to EPS, that is) is irrelevant. Paying a dividend vs. debt paydown is however accretive to returns.
From a corporate finance perspective (outside the scope of an LBO) I'd argue that if its a one-time dividend, it will never look accretive (unless that cash has a negative yield for some reason, or maybe some complex tax issue I'm overlooking), so its more appropriate to view it as a stock buyback, in which case the true economic value of the capital distribution will be more apparent.
Increase your management fees..... Like a BOSSSSSSS!!!!!
Other than that pay down debt to increase the Equity portion at the Exit
Nonsense is being spoken here. Use that cash to float a huge bond release. Take that cash and watch the company crash and burn under the new debt load and stick it to the bond holders while you sit on massive piles of cash on your island country of choice.
You just described dividend recap, mega PE funds' favorite exit strategy.
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