Hold Your Nose and Buy the Recap – Sometimes

By Randy Schwimmer

It’s a perennial source of angst for loan buyers that target private equity-backed companies: how do you analyse transactions that finance a distribution to the sponsor by taking invested cash out of the company?

Dividend recapitalisations have been features of the leveraged lending landscape for as long as there’s been a private equity industry. But there’s a perception among lenders that these deals are risky. During the 2000 and 2001 tech bust, and again in the great recession, loan buyers saw defaults rise dramatically, and they made particular note of those in which sponsors took their money and ran.

Studies by S&P comparing recap deals with the overall market show that dividends pose no greater investor risk than other loans. Unsurprisingly, it turns out that leverage drives defaults. Loans that pushed leverage to extreme levels were more likely to default, regardless of whether sponsors were putting money in or taking it out.

Nevertheless, lenders greet dividends with the same enthusiasm as in-laws for a weekend stay-over. In part this is because taking cash out of portfolio investments reduces a sponsor’s “skin in the game”, thus diminishing the incentive to inject dollars to fix future problems. It also burdens the company with incremental debt without the corresponding cash flow from capex or an add-on acquisition.

Of course, returning LP capital is a central fiduciary obligation of GPs, whether in the form of distributions or an outright sale. Fund performance is driven largely by improving enterprise value of companies, not dividends to shareholders. It’s nice to take cash off the table, but it’s an exit that creates outsized returns.

Dividends funded by both loans and bonds are on the rise over the past three quarters. Recap volume picks up during times when more “productive” deals, such as new buyout transactions, are absent. That’s the case with opportunistic loan re-financings and re-pricings.

However, a recent S&P note points out that the current wave of dividends may not enjoy the same head of steam as past trends. Bank regulation has created a more subdued environment and many recap issuers took advantage of previous market conditions and have already sent cash back to investors.

We propose four questions for evaluating prospective recaps. First, has the company met its projections since the original buyout? There’s nothing like seeing a borrower reduce leverage in a new deal to inspire lender confidence that re-leveraging won’t end in tears.

Next, is the recap leverage equal to or less than the LBO? Market conditions help dictate how much debt a transaction will bear, but it’s hard to argue for more leverage when the sponsor is taking cash off the table.

Has the sponsor left any of its original investment in the company? Even if the remainder is nominal, it’s indicative of some measure of support.

Finally, are all the original lending group members rolling into the recap? If so, that’s a pretty good indicator of investor confidence.

There is no perfect resolution to the tension on dividends. Sponsors will always preach the gospel of enterprise value. Lenders will forever seek skin in the game. And it’s hard to reconcile these views when one party is putting money in just as the other is taking it out.

Randy Schwimmer is senior managing director and head of origination and capital markets at Churchill Asset Management, a newly formed credit asset management firm affiliated with TIAA-CREF Asset Management. He is also founder and publisher of The Lead Left (theleadleft.com), a weekly newsletter about trends and deals in the capital markets.

This column first appeared in the weekly newsletter of Creditflux, a leading global information source for the credit trading and investment market.

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