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Explain a dividend recap?


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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...).

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Having no experience at all in this...but just thinking. Isn't the PE firm strategy a little bit like issuing insurance for the aquirer? If the obligations paying out (ie firm needing money back in) is uncorrelated to each other you basically use the power of diversification. You need less capital running the same amount of business.

 

Often things look uncorrelated until they are not, but I bet it can work for long periods of time. And things hardly ever turn perfectly correlated.

 

Looking forward to better informed answers..

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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.

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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.

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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.

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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.

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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.

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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.

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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?

 

It usually depends how much equity they have on their balance sheet. In Canada, the concept is called paid up capital for tax purposes. Anything above paid up capital is a dividend. Also, in Canada, a dividend to another corporation is often not taxed depending on the type of corporation (to avoid double taxation). I’m not sure if it’s the same case in the US.

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The lower equity invested after the dividend is paid out makes the returns higher on an absolute and after tax basis.

 

I don't think reporting that way is kosher, and it doesn't actually make the returns actually higher. Your returns are based on your risk at the time of investment. You don't get to then take x% off the table through a div recap and say "look how much higher my return on capital is" by reducing your denominator for the distribution. Just think of a basic example where you invest $1B at T=0, take a $1B div recap after 5 years and the rest is worth, say $10MM. You didn't make $10MM on $0, you made $10MM on $1B. That's certainly how your LPs would look at it.

 

It's totally different from a tax perspective, but that is not how you should be measuring your investment returns.

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The lower equity invested after the dividend is paid out makes the returns higher on an absolute and after tax basis.

 

I don't think reporting that way is kosher, and it doesn't actually make the returns actually higher. Your returns are based on your risk at the time of investment. You don't get to then take x% off the table through a div recap and say "look how much higher my return on capital is" by reducing your denominator for the distribution. Just think of a basic example where you invest $1B at T=0, take a $1B div recap after 5 years and the rest is worth, say $10MM. You didn't make $10MM on $0, you made $10MM on $1B. That's certainly how your LPs would look at it.

 

It's totally different from a tax perspective, but that is not how you should be measuring your investment returns.

 

When looking at absolute returns, this is the case.

 

When looking at TWR and the opportunity cost of that $1B invested over the 5 years, it's absolutely not.

 

If you can pull that $1B and reinvest it into something else, then you get that return and the $10M. Further, investing $1B, pulling it out, and getting $10M later is a "risk-free return" for all intents and purposes...so it's still better than having $1B at risk the entire time.

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The lower equity invested after the dividend is paid out makes the returns higher on an absolute and after tax basis.

 

I don't think reporting that way is kosher, and it doesn't actually make the returns actually higher. Your returns are based on your risk at the time of investment. You don't get to then take x% off the table through a div recap and say "look how much higher my return on capital is" by reducing your denominator for the distribution. Just think of a basic example where you invest $1B at T=0, take a $1B div recap after 5 years and the rest is worth, say $10MM. You didn't make $10MM on $0, you made $10MM on $1B. That's certainly how your LPs would look at it.

 

It's totally different from a tax perspective, but that is not how you should be measuring your investment returns.

 

When looking at absolute returns, this is the case.

 

When looking at TWR and the opportunity cost of that $1B invested over the 5 years, it's absolutely not.

 

If you can pull that $1B and reinvest it into something else, then you get that return and the $10M. Further, investing $1B, pulling it out, and getting $10M later is a "risk-free return" for all intents and purposes...so it's still better than having $1B at risk the entire time.

 

Yes, I agree that going forward, you can calculate your incremental return on the remaining capital at risk. But when someone asks what your "absolute return" on a position is, they are asking: (Realized + Unrealized) / Capital Invested. The denominator of that equation *never* changes, unless you invest *more* capital.

 

All I'm saying is that PE firms don't do this to "lower equity invested" to "make returns higher." If they do, they're using funny math. They may be taking out that capital to invest it in other, more attractive opportunities, which will generate higher returns, but they are not doing it to game a mathematical formula. Again, if they are that's not kosher.

 

They usually do dividend recaps when they need to generate cash and/or can't actually monetize their portfolio co.

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The lower equity invested after the dividend is paid out makes the returns higher on an absolute and after tax basis.

 

I don't think reporting that way is kosher, and it doesn't actually make the returns actually higher. Your returns are based on your risk at the time of investment. You don't get to then take x% off the table through a div recap and say "look how much higher my return on capital is" by reducing your denominator for the distribution. Just think of a basic example where you invest $1B at T=0, take a $1B div recap after 5 years and the rest is worth, say $10MM. You didn't make $10MM on $0, you made $10MM on $1B. That's certainly how your LPs would look at it.

 

It's totally different from a tax perspective, but that is not how you should be measuring your investment returns.

 

When looking at absolute returns, this is the case.

 

When looking at TWR and the opportunity cost of that $1B invested over the 5 years, it's absolutely not.

 

If you can pull that $1B and reinvest it into something else, then you get that return and the $10M. Further, investing $1B, pulling it out, and getting $10M later is a "risk-free return" for all intents and purposes...so it's still better than having $1B at risk the entire time.

 

Yes, I agree that going forward, you can calculate your incremental return on the remaining capital at risk. But when someone asks what your "absolute return" on a position is, they are asking: (Realized + Unrealized) / Capital Invested. The denominator of that equation *never* changes, unless you invest *more* capital.

 

All I'm saying is that PE firms don't do this to "lower equity invested" to "make returns higher." If they do, they're using funny math. They may be taking out that capital to invest it in other, more attractive opportunities, which will generate higher returns, but they are not doing it to game a mathematical formula. Again, if they are that's not kosher.

 

They usually do dividend recaps when they need to generate cash and/or can't actually monetize their portfolio co.

 

I disagree. They do DO this. The $1B isn't in a vacuum. It's typically a fund with multiple investments. A $1B purchase with a dividend re-cal allows them to pull their cash back out and make incremental investments in other acquisitions for the fund. Maybe the denominator doesn't change, but having two investmenrs with the $1B versus just the one absolutely changes the numerator in your calculation.

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The lower equity invested after the dividend is paid out makes the returns higher on an absolute and after tax basis.

 

I don't think reporting that way is kosher, and it doesn't actually make the returns actually higher. Your returns are based on your risk at the time of investment. You don't get to then take x% off the table through a div recap and say "look how much higher my return on capital is" by reducing your denominator for the distribution. Just think of a basic example where you invest $1B at T=0, take a $1B div recap after 5 years and the rest is worth, say $10MM. You didn't make $10MM on $0, you made $10MM on $1B. That's certainly how your LPs would look at it.

 

It's totally different from a tax perspective, but that is not how you should be measuring your investment returns.

 

When looking at absolute returns, this is the case.

 

When looking at TWR and the opportunity cost of that $1B invested over the 5 years, it's absolutely not.

 

If you can pull that $1B and reinvest it into something else, then you get that return and the $10M. Further, investing $1B, pulling it out, and getting $10M later is a "risk-free return" for all intents and purposes...so it's still better than having $1B at risk the entire time.

 

Yes, I agree that going forward, you can calculate your incremental return on the remaining capital at risk. But when someone asks what your "absolute return" on a position is, they are asking: (Realized + Unrealized) / Capital Invested. The denominator of that equation *never* changes, unless you invest *more* capital.

 

All I'm saying is that PE firms don't do this to "lower equity invested" to "make returns higher." If they do, they're using funny math. They may be taking out that capital to invest it in other, more attractive opportunities, which will generate higher returns, but they are not doing it to game a mathematical formula. Again, if they are that's not kosher.

 

They usually do dividend recaps when they need to generate cash and/or can't actually monetize their portfolio co.

 

I disagree. They do DO this. The $1B isn't in a vacuum. It's typically a fund with multiple investments. A $1B purchase with a dividend re-cal allows them to pull their cash back out and make incremental investments in other acquisitions for the fund. Maybe the denominator doesn't change, but having two investmenrs with the $1B versus just the one absolutely changes the numerator in your calculation.

 

I'm not disagreeing that taking capital from one opportunity and investing it in an another opportunity with a higher return potential is good for the fund returns overall. I'm still disagreeing with the statement that "The lower equity invested after the dividend is paid out makes the returns higher on an absolute and after tax basis." You don't get to say that you made a 10-bagger on a $1B investment because you did a div recap for $990MM and then made $100MM on the last $10MM you had in there. Thinking of risk and return in this way is really flawed. You made $1.1B on $1B.

 

It's more than just semantics because most funds calculate their carry on a position by position basis, not fund-level/European style. So following the logic in the example above, they'd calculate their carry as if they made a 10-bagger on $10MM when in reality they probably haven't even triggered carry with a 10% return.

 

It most definitely does not make your returns higher. How can nobody see that if I give you $10 and then you give me $9 back, and then give me another $2 a year later, I haven't made 100%, I've made 10%? Ultimately that is all that matters.

 

I'm also still harping on this because I'm shocked people actually think of risk and return in this way.

 

 

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The lower equity invested after the dividend is paid out makes the returns higher on an absolute and after tax basis.

 

I don't think reporting that way is kosher, and it doesn't actually make the returns actually higher. Your returns are based on your risk at the time of investment. You don't get to then take x% off the table through a div recap and say "look how much higher my return on capital is" by reducing your denominator for the distribution. Just think of a basic example where you invest $1B at T=0, take a $1B div recap after 5 years and the rest is worth, say $10MM. You didn't make $10MM on $0, you made $10MM on $1B. That's certainly how your LPs would look at it.

 

It's totally different from a tax perspective, but that is not how you should be measuring your investment returns.

 

When looking at absolute returns, this is the case.

 

When looking at TWR and the opportunity cost of that $1B invested over the 5 years, it's absolutely not.

 

If you can pull that $1B and reinvest it into something else, then you get that return and the $10M. Further, investing $1B, pulling it out, and getting $10M later is a "risk-free return" for all intents and purposes...so it's still better than having $1B at risk the entire time.

 

Yes, I agree that going forward, you can calculate your incremental return on the remaining capital at risk. But when someone asks what your "absolute return" on a position is, they are asking: (Realized + Unrealized) / Capital Invested. The denominator of that equation *never* changes, unless you invest *more* capital.

 

All I'm saying is that PE firms don't do this to "lower equity invested" to "make returns higher." If they do, they're using funny math. They may be taking out that capital to invest it in other, more attractive opportunities, which will generate higher returns, but they are not doing it to game a mathematical formula. Again, if they are that's not kosher.

 

They usually do dividend recaps when they need to generate cash and/or can't actually monetize their portfolio co.

 

I disagree. They do DO this. The $1B isn't in a vacuum. It's typically a fund with multiple investments. A $1B purchase with a dividend re-cal allows them to pull their cash back out and make incremental investments in other acquisitions for the fund. Maybe the denominator doesn't change, but having two investmenrs with the $1B versus just the one absolutely changes the numerator in your calculation.

 

I'm not disagreeing that taking capital from one opportunity and investing it in an another opportunity with a higher return potential is good for the fund returns overall. I'm still disagreeing with the statement that "The lower equity invested after the dividend is paid out makes the returns higher on an absolute and after tax basis." You don't get to say that you made a 10-bagger on a $1B investment because you did a div recap for $990MM and then made $100MM on the last $10MM you had in there. Thinking of risk and return in this way is really flawed. You made $1.1B on $1B.

 

It's more than just semantics because most funds calculate their carry on a position by position basis, not fund-level/European style. So following the logic in the example above, they'd calculate their carry as if they made a 10-bagger on $10MM when in reality they probably haven't even triggered carry with a 10% return.

 

It most definitely does not make your returns higher. How can nobody see that if I give you $10 and then you give me $9 back, and then give me another $2 a year later, I haven't made 100%, I've made 10%? Ultimately that is all that matters.

 

I'm also still harping on this because I'm shocked people actually think of risk and return in this way.

 

I was referring to a dividend recap mainly when the acquisition is completed. For example, if a PE buys a company for say 6x EV/EBITDA that say has 1 turn of debt/EBITDA and they think the business can sustain 3x debt/EBITDA, they can take leverage up to 3x and pay out 2x debt/EBITDA as a dividend (the dividend recap). The equity was purchased directly from the former equity holders at 5x equity/EBITDA but now the net equity put up is only 3x EBITDA. Can we agree that adding this financial leverage will help returns if the business performs well and this isn't some sort of manipulation of returns?

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You can't eat IRR, but that is what PE serves. Taking out equity boosts IRR, while it won't affect absolute returns (from initial investment).

 

A higher IRR on your total capital results in more dollars, which can be used to buy food, which you can eat  ;)

 

"It won't effect absolute returns" is not correct.  It is correct if you assume the dividend sits idle in a bank account and isn't reinvested elsewhere at higher returns.  Basically, if you think your equity costs you 15% (i.e., you can put it elsewhere earning that return) and you can refinance the business to free up equity costing 15% and swap it for debt paying 5%, that's a trade you should do. 

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The lower equity invested after the dividend is paid out makes the returns higher on an absolute and after tax basis.

 

I don't think reporting that way is kosher, and it doesn't actually make the returns actually higher. Your returns are based on your risk at the time of investment. You don't get to then take x% off the table through a div recap and say "look how much higher my return on capital is" by reducing your denominator for the distribution. Just think of a basic example where you invest $1B at T=0, take a $1B div recap after 5 years and the rest is worth, say $10MM. You didn't make $10MM on $0, you made $10MM on $1B. That's certainly how your LPs would look at it.

 

It's totally different from a tax perspective, but that is not how you should be measuring your investment returns.

 

When looking at absolute returns, this is the case.

 

When looking at TWR and the opportunity cost of that $1B invested over the 5 years, it's absolutely not.

 

If you can pull that $1B and reinvest it into something else, then you get that return and the $10M. Further, investing $1B, pulling it out, and getting $10M later is a "risk-free return" for all intents and purposes...so it's still better than having $1B at risk the entire time.

 

Yes, I agree that going forward, you can calculate your incremental return on the remaining capital at risk. But when someone asks what your "absolute return" on a position is, they are asking: (Realized + Unrealized) / Capital Invested. The denominator of that equation *never* changes, unless you invest *more* capital.

 

All I'm saying is that PE firms don't do this to "lower equity invested" to "make returns higher." If they do, they're using funny math. They may be taking out that capital to invest it in other, more attractive opportunities, which will generate higher returns, but they are not doing it to game a mathematical formula. Again, if they are that's not kosher.

 

They usually do dividend recaps when they need to generate cash and/or can't actually monetize their portfolio co.

 

I disagree. They do DO this. The $1B isn't in a vacuum. It's typically a fund with multiple investments. A $1B purchase with a dividend re-cal allows them to pull their cash back out and make incremental investments in other acquisitions for the fund. Maybe the denominator doesn't change, but having two investmenrs with the $1B versus just the one absolutely changes the numerator in your calculation.

 

I'm not disagreeing that taking capital from one opportunity and investing it in an another opportunity with a higher return potential is good for the fund returns overall. I'm still disagreeing with the statement that "The lower equity invested after the dividend is paid out makes the returns higher on an absolute and after tax basis." You don't get to say that you made a 10-bagger on a $1B investment because you did a div recap for $990MM and then made $100MM on the last $10MM you had in there. Thinking of risk and return in this way is really flawed. You made $1.1B on $1B.

 

It's more than just semantics because most funds calculate their carry on a position by position basis, not fund-level/European style. So following the logic in the example above, they'd calculate their carry as if they made a 10-bagger on $10MM when in reality they probably haven't even triggered carry with a 10% return.

 

It most definitely does not make your returns higher. How can nobody see that if I give you $10 and then you give me $9 back, and then give me another $2 a year later, I haven't made 100%, I've made 10%? Ultimately that is all that matters.

 

I'm also still harping on this because I'm shocked people actually think of risk and return in this way.

 

I was referring to a dividend recap mainly when the acquisition is completed. For example, if a PE buys a company for say 6x EV/EBITDA that say has 1 turn of debt/EBITDA and they think the business can sustain 3x debt/EBITDA, they can take leverage up to 3x and pay out 2x debt/EBITDA as a dividend (the dividend recap). The equity was purchased directly from the former equity holders at 5x equity/EBITDA but now the net equity put up is only 3x EBITDA. Can we agree that adding this financial leverage will help returns if the business performs well and this isn't some sort of manipulation of returns?

 

Yup, agree 100% on that point.

 

That said, it's a bit of a bizarre construct; I haven't seen a dividend recap at the time of the initial acquisition. Why wouldn't you just do the acquisition with higher leverage/lower equity in the first place instead of this 2-step process that gets you to the same place but with millions of extra fees. I'd be curious if you could post a couple examples of this occurring.

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