I mean I can see the incentivised case where PE managers may be more aggressive in trying to get increased cash flows so that that can mantain a leverage ratio (after it comes down once debt has been paid) but it still seems like a very "fluffy" reason. Would appreciate clarity on this.
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Dividend recaps benefit only equity holders of the business, as they are a means to reward owners for good performance. The business is burdened by the increased debt quantum and expenses to consummate the dividend recap transaction.
Dividend recaps are primarily financed with debt, thus risk shifts from the equity holders to the debt as owners receive a return of capital whereas debt holders only get repaid if such performance is sustained.
Is a dividend recap the same as a 'distribution'? (just curious if this was just semantics).
'Distribution' is a more general term. In the broadest sense, it's really any disbursement of cash. What we're talking about here are distributions to equity holders more specifically, which could take the form of either sweeping cash off the balance sheet or taking on incremental debt to pay it out, with the latter being a dividend recap.
Recapitalization more broadly just refers to a changing of the capital structure of the company, hence the idea of taking on more debt to pay out equity holders is a 'dividend recap.'
Would you ever model one into an initial model or is it a consideration only when the portfolio company is exceeding performance metrics?
You wouldn’t model it in your initial model at the time of an entry investment. A dividend recap is pursued in lieu of a sale/full exit.
That's not always true. I've looked at deals where a recap was contemplated during initial underwriting, either because EBITDA was expected to ramp pretty fast post-close to re-lever the company close to what typical levels would be or just because the sponsor expected the company to be able to support it 2/3 years out.
Recaps also aren't necessarily a binary choice with an exit. If a sponsor's LPA performance metrics are set off IRR hurdles, recaps allow you to take money off the table faster to help performance from a fund perspective.
Hey marcopolar, thanks for your answer.
Following your comment, I actually picked up a practice model that has a dividend recap included in the initial model. It also includes a management option. I am having trouble how they calculated the management option. Please see my returns section here.
Here is my specific question: why in the formula does it matter if exit equity value is greater than initial sponsor equity less the dividend recap? Specifically, why is it calculated less dividend recap?
The follow up question is a bit of the same thing with respect to wondering about why you factor in the dividend recap: when calculating the actual proceeds of the option, why do you multiple 7.5% by initial sponsor equity less dividend recap, and not just 7.5% by initial sponsor equity?
Thanks so much. Help is greatly appreciated.
What does "LPA" stand for?
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