For those Private Equity Groups (PEGs) that own a strong portfolio company with high earnings and relatively low debt, they are increasingly turning towards dividend recapitalizations rather than selling ownership in their portfolio company in the short-term.

Before we go any further, let’s clear up the definition of a dividend recapitalization (recap). It occurs when the owner of a company, typically a PEG, as a preferred stock holder, issues new debt to pay a special dividend to their limited partners who provided the cash to fund the initial acquisition of the portfolio company. A dividend recap is an alternative to way of realizing cash, other than selling the company or trying an IPO. For example, a PEG that invested $10 million cash in acquiring a company, may choose today to pull out $10 million cash in a dividend recap.

In the simplest terms, this is a bonus for the preferred stock holders who backed the acquisition, but it also increases the debt load on the company, and hence increases default risk for creditors and common shareholders, but as with many financial tools, we need to understand more to determine the advantages and disadvantages for all parties.

One thing is certain, however – the dividend recap is becoming an increasingly popular tool for PEGs in a flat economy.

Some of the motivations for a dividend recap:

1)Sell – Alternative A: Selling the company today may not yield the highest price and desired return on investment – if the business has a real opportunity to grow sales and earnings in the coming year or so, many PEGs and common shareholders would rather wait and sell for more money in 2011 or 2012, while focusing on growth initiatives in the meantime.

2)IPO – Alternative B: In the current market, an IPO is often risky and unpredictable, so fewer PEGs are choosing this route as the ideal exit.

3)A dividend recap allows the PEG to pull out money they initially invested while retaining the same ownership in the Company. If this seems confusing, you could consider the example of pulling $100k cash out and remortgaging your home after it went up in value. You are still the 100% common shareholder (owner) of your house, but you now owe the bank a higher principal amount. And just to confuse matters, it is possible that the loan to current value could be lower than when you bought your house, because of an increase in the home’s value, so it does not necessarily increase the leverage on the home from when you originally bought it.

4)There may be tax advantages for the PEG’s limited partners compared to a sale of the company, which is partly dependent on changes in the qualified dividend rate and changes in rules on taxing carried interest.

5)High yield bond financing is historically cheap for those firms that qualify, so interest payments are relatively low. If, however, principal and interest payments increase significantly, the CFO is going to have a tougher time, as there will be less cash available for capital expenditures to grow the company. Tighter cash flow also reduces the margin for error in financial projections, budgeting and planning.

Good news for companies that were acquired by a PEG that is considering a dividend recap:

i)A dividend recap is only available to higher quality, stronger performing companies, so if you’re in this group, you’re company’s performing well;

ii)the default rate for companies that underwent a dividend recap was only 6%, compared to 11% on average for the original LBO that funded the acquisition in the first place*;

iii)the PEG would not attempt a dividend recap unless they were confident that the company would result in a higher sale price in the future, which benefits all shareholders;

*according to a 11/19/10 CFO.com article for deals in the late 1990s and early 2000s.