What is a Dividend Recap?
A Dividend Recap is a strategy utilized by private equity firms to increase their fund returns from a leveraged buyout (LBO).
In a dividend recap, formally called a “dividend recapitalization”, the post-LBO portfolio company of a financial sponsor raises more debt capital in order to issue its equity shareholders (i.e. the private equity firm) a special, one-time cash dividend.
Dividend Recap Strategy — LBO Partial Exit Plan
If a private equity firm completes a dividend recapitalization, additional debt financing is raised with the specific intent to issue itself, the financial sponsor, a special, one-time dividend using the cash proceeds from the newly-raised debt.
While there are exceptions, dividend recaps are generally completed once the post-LBO portfolio company has paid down a substantial percentage of the initial debt to fund the LBO transaction.
Since the default risk is reduced and there is now more debt capacity — meaning that the company could reasonably handle more debt on its balance sheet — the firm can opt to complete a dividend recap without breaching any existing debt covenants.
The availability of sufficient debt capacity is crucial for the dividend recap even to be an option. However, the state of the credit markets (i.e. interest rate environment) is also an important factor that can determine the ease (or difficulty) of achieving a recap.
The rationale for completing a dividend recap is for the financial sponsor to partially monetize an investment without needing to undergo an outright sale, such as an exit to a strategic acquirer or another private equity firm (i.e. secondary buyout), or an exit via an initial public offering (IPO).
A dividend recap is therefore an alternative option where there is a partial monetization from the recapitalization of their investment and receipt of the dividend funded by the newly borrowed debt.
Dividend Recap Pros/Cons
A dividend recap is essentially a partial exit, where the private equity firm can recoup some of its initial equity contribution, which de-risks its investment as there is now less capital at risk.
Moreover, the earlier receipt of the proceeds by the firm can increase its fund return.
In particular, a dividend recap can positively impact the fund’s internal rate of return (IRR), as the IRR is positively affected by the earlier monetization and distribution of funds.
Upon completion of the dividend recap, the financial sponsor still retains majority control over the portfolio company’s equity. Still, its fund returns are increased along with the opportunity to de-risk the investment.
In the exit year, the remaining debt balance is likely higher than if no dividend recap had been completed. However, the firm received a cash distribution earlier in the holding period.
The drawbacks to dividend recaps practically all stem from the risks associated with using leverage.
After the recapitalization, a more significant debt burden is placed on the company, with the following impact on the capital structure.
- Net Debt → Increases
- Equity → Decreases
In short, the strategy can benefit the firm and its fund returns if all goes as planned.
But in the worst-case scenario, the company underperforms post-recap and defaults (and filing for bankruptcy protection).
Not only will the fund returns be reduced significantly, but the fact that the firm made the discretionary decision to perform the recap can cause long-running damage to the firm’s reputation.
In effect, the firm’s ability to raise capital for future funds, work with lenders, and pitch itself as a value-add partner to potential investments are all negatively affected.
Dividend Recap Example — Bain Capital and BMC Software
One example of a dividend recap covered in our LBO modeling course was seen in the buyout of BMC Software, led by Bain Capital and Golden Gate.
Interestingly, only seven months after the $6.9 billion buyout of BMC Software was completed, the sponsors recouped more than half of their initial investment back.
Bain Group Seeks $750 Million Payday From BMC (Source: Bloomberg)