[Explain a dividend recap?]

In the US, interest payments are tax deductible, though the tax overhaul imposed limits on the amount of deductible interest.  Miller & Modigliani hypothesized that because of the tax shield created by interest deductibility, it should be possible to increase the enterprise value of the firm simply by doing a levered recap.  [in theory, New enterprise value = Old enterprise value + Value of tax shields - Increased likelihood of costs associated with insolvency.] There's been alot of academic work trying to see if the theory is true in practice.  See, e.g.,  https://www0.gsb.columbia.edu/mygsb/faculty/research/pubfiles/319/valuation_of_debt_tax_shield.pdf

[EDIT:  See also Schwab's comment on the whether the "dividend" is a taxable event.]

 

There is also a principal-agent issue.  The levered recap significant increases the potential returns on equity if things go well, and the likelihood of a complete wipeout of the equity.  A PE firm gets alot of the upside when things turn out well via carried interest [the "20" in "2 and 20"], but it is the LPs that bear most of the losses when things go poorly.  Those return profiles can incentivize high leverage at the portfolio-company level, even if it is not in the best interest of LPs.

 

Understood on the first part. The company already shows negligible, if not negative, bottom line so a significant amount of taxes are already shielded. Like I said, they're already levered at 5-6x EBITDA which is abnormally high for a public company... not sure if it's abnormal for private or PE portfolio companies. I just can't understand how another dividend recap makes sense at this point.

 

Your second paragraph pretty closely mirrors Kab's comment. I think this is a pretty important point and much of what I was missing. 

 

Another point is that the cap on interest expense deduction is moving from 30% of EBITDA to 30% of EBIT in 2022, which makes that much leverage look rather stupid in a few years.

[Explain a dividend recap?]

Distributions classified as return of capital aren't taxed. They lower your cost basis instead.

 

What exactly are the qualifications to classify it as a return of capital vs a dividend?

[Explain a dividend recap?]

The lower equity invested after the dividend is paid out makes the returns higher on an absolute and after tax basis. Sometimes the company is just inefficient with working capital so the net debt before working capital doesn’t necessarily go up.

 

If things do go badly, the PE firm can always inject more equity if they think they can make a return on that additional equity.

 

Good point, I never thought of it this way.

[Explain a dividend recap?]

It sounds agressive but from a PE point of view a dividend recap reduces the money they have at risk and it gives the PE firm cash to return to their investors.

 

It means the PE firm is left with a highly levered equity stub that might pay off big or drown in debt, but if it's the latter they just pull the plug and leave the mess to someone else (or negotiate a major haircut on the debt as a condition for injecting fresh equity).

 

The ones that risk getting screwed is debt holders since they might be exposed to equity-like risk but only getting paid a bond return.

 

Kab, that would make sense to me when thinking about a portfolio company that PE has held for a while. But what about a situation in which they immediately do a dividend recap? If you're trying to reduce risk and take capital off the table immediately, then why invest in the company at all...

 

Your second and third sentences do make a lot of sense to me though, thanks for that.

[Explain a dividend recap?]

Could someone who perhaps understands this better than I explain to me the purpose behind a dividend recap? They seem to be very popular among PE firms - where they purchase unlevered, private companies, lever them up, and then essentially distribute out all that cash. I don't quite understand the point of this. Sure, you get a portion of your initial invested capital back, but it can't be tax efficient (and I can't imagine after tax returns look all that enticing?), and you're leaving the company in a much worse situation as well as worth much less than when you found it.

 

I ask because of a personal situation. I have a family member who works for a private insurance brokerage that is owned by a PE firm. The brokerage is essentially a roll up, massively levering up to go after small brokerages at low multiples. When the initial PE firm bought out the private company, it was unlevered. They then did a dividend recap, and continued to lever up to pursue a rollup. At this point, the company is levered around 5-6x EBITDA, with a lot of noise in the EBITDA/adjusted EBITDA numbers they present due to the huge amount of acquisitions they perform every year.

 

This next part is what confuses me. Earlier this year, the initial PE firm sold their stake to another PE firm. This new PE firm intends to perform ANOTHER dividend recap with the already massive amount of leverage. I could probably wrap my head around this at a private company in an industry with highly predictable cash flows. And an insurance brokerage has pretty predictable cash flows... but when you're performing a rollup, buying out small, private mom and pop shops where the only thing you're buying is their book/relationships and they no longer have any incentive to perform for you, that scares the shit out of me.

 

I guess I went off on a bit of a tangent there... but can anyone explain the point of dividend recaps to me? I don't understand how they produce positive results for anyone involved (excluding the banks that is...).