Debt-fuelled dividend recaps prop up private equity

Perhaps it is time to cut private equity managers some slack. In recent weeks, these financial sponsor firms have been big borrowers in the leveraged loan market. Masters of the Universe have issued billions of dollars of new debt to fund so-called “dividend recapitalisations”. Cash raised goes straight into the coffers of investors.

But the latest gusher comes after a year in which private equity firms were forced to contribute higher proportions of equity into leveraged buyouts. Equity injections in 2023 LBOs exceeded 50 per cent, a record contribution, according to data service LCD.

In some instances, dividend recaps will raise the portfolio company’s leverage to elevated levels. But for those few private equity firms able to get deals done last year, the thaw in debt markets offers a chance to do something unusual: reduce equity contributions from conservative to merely average.

In 2023, Apollo took chemicals group Univar Solutions private at an aggregate value of $8.1bn. According to debt documents reviewed by LCD, Univar then issued $4.1bn of new debt, implying an equity contribution by Apollo of 50 per cent.

A typical ratio is 30 to 40 per cent. Univar later borrowed $450mn simply to fund a dividend. That move has increased its leverage to a more conventional level.

Large equity contributions can prove challenging for many reasons. Funds would like to have a diverse group of holdings. That becomes harder when certain deals take up most of the portfolio. Meanwhile, having too much equity can make it impossible to earn target hurdle investment return rates of 20 to 25 per cent.

Many of the recent dividend recaps have, however, occurred with an earlier vintage of deals — with traditionally more leverage. These partial cash-outs, depending on how much debt a portfolio company has already paid off, can raise overall leverage and interest burdens.

Some companies can go bust holding this additional dividend recap debt. Lenders and bondholders could end up taking losses on their principal even as junior equity holders have made some or all of their money back.

Debt investors do not wish to take excessive risk. But in the go-go 2010s they had little choice but to buy debt they would eventually regret owning.

The recent flurry of dividend deals partly results from relatively little debt issuance coming from new M&A deals. Investors will happily soak up paper offered on double-digit yields.

This could be a more sober era for private equity firms. But they cannot resist an opportunity to juice up returns.

Lex is the FT’s concise daily investment column. Expert writers in four global financial centres provide informed, timely opinions on capital trends and big businesses. Click to explore