Would it be possible for a private equity sponsor to issue themselves a dividend with the a portfolio company's excess cash flow, rather than by taking on new debt (assuming they have paid their mandatory amortization on the existing debt)?
TLDR; Can a a sponsor do the "dividend" without the "recap"?
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Yeah - they could (and do), but there's usually restrictions in the credit agreements on how much and under what conditions the PE sponsor can take money out of the business (dollar amount, pro forma covenant compliance, liquidity, etc.).
Agreed^ it's typically detailed under 'Restricted Payments' in a credit agreement's negative covenant section. The idea being that certain conditions have to met (marcopolar listed some examples^) before the Company/sponsor can take out cash from the business to do something other than service the debt.
I figured there would be sort of covenant / restriction, but don't those covenants also cover taking on new debt to pay a dividend? Taking out debt to fund a dividend seems like it would be more risky to a creditor than taking out cash to fund a dividend. In one instance, only cash is gone, while in the other, cash is gone and new debt is added.
Why do creditors see dividend recaps as less risky than cash dividends?
Haven't worked too much on dividend recaps, but re-instating debt is typically good for the debtholder. If cash leaves the firm, that's firm value leaving the firm for the benefit of shareholders, NOT debtholders. Reinstating debt gives them a promise that there will be future interest and principal for the debtholder.
Oh I see, so it's a way of aligning the debt and equity holders of the business?
Sorry, stepping in. This isn't correct.
Credit agreements have restrictions on all sorts of activities - taking on additional indebtedness, paying out dividends, using cash to make acquisitions, etc. Many of these are governed by net leverage ratios.
Most LBO debt holders do not like companies to over lever - that's why not all LBOs are done at 6.5x leverage! There are certainly lenders that are looking to put more capital to work and may be willing to lend companies more money to finance acquisitions, dividends etc., but more debt = better for lenders is wrong.
Not sure how you are concluding that div-recaps are less risky than cash dividends. The borrower will be restricted by 2 buckets under a credit agreement if doing a div recap - ability to take on additional debt, ability to make a restricted payment. Borrower will be restricted just by the restricted payment bucket on the cash-payout scenario. In both cases leverage has to be low enough to permit the dividend.
If Dividend Recaps are not less risky than cash dividends (and have more hoops to jump through covenant-wise) why are they more common than cash dividends?
Having debt on the business will always be riskier than no debt, all else equal. A dividend recap by definition boosts the amount of cash you can otherwise take out from the business, all else equal, by definition. To simplify, imagine two scenarios for a sponsor-owned company with no debt, generating $10M of EBITDA annually, that has accumulated $10M of cash on its balance sheet, and lenders in the market are comfortable with a 5x net leverage profile:
(A) At $10M of net cash today, you can immediately raise $60M of debt as part of a dividend recap. After, your net debt is $50M, and you begin paying down the balance over time. The "excess cashflow" annually you otherwise would lose to interest expense from the debt is justified by the ability to take out a chunk of your money (or >100% of your invested capital) in one lump sum, today
(B) You choose to pay out your $10M of cash today, and annually thereafter, you take out excess cash generated, taking out your money over time (with no interest expense / no debt)
This is a big simplification and it's not so extreme in practice, but directionally that's how a recap juices a sponsor's time-weighted return.
I did not insinuate that more debt is necessarily good. Of course lenders do not want the company to over lever. But your points do not really answer the question as to why lenders are willing to accept dividend recaps when value is leaving the firm.
Dividend recaps are rarely done as incremental deals for this very reason. Usually the tx is a completely new facility with a completely new document done on a company that has had broadly syndicated debt and has performed well.
yes, if the “restricted payments” covenant allows. see RP basket. this is why debt knowledge is so valuable
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