Wednesday, October 24, 2012

Private Equity Eyes Dividend Recaps?

Michael Stothard and Dan McCrum of the FT report, Private equity eyes dividend ‘recaps’:
Private equity firms are looking to cash in on the latest rally in the European corporate debt markets by borrowing at low cost against their investments to pay themselves dividends.

So-called “dividend recapitalisations” by private equity groups, which were a prominent feature of the pre-crisis boom years, are showing signs of returning on the back of increased demand from investors for riskier forms of corporate debt.

RAC, the UK car breakdown service, on Tuesday closed the books on a £260m term loan intended to help pay a special dividend to Carlyle, which bought the company in June for £1bn. Also expected is a similar €250m deal by Birds Eye Iglo, the frozen foods business owned by Permira.

Bankers say there are about 10 more European deals being discussed that might come to market in the coming months. “Interest in dividend recaps has grown very quickly post the summer as market conditions continue to be strong,” said Jason Bruhl, head of European high-yield syndicate at Citi.

The market for dividend recaps has already seen strong growth in the US in recent months, with 14 debt-financed dividend recapitalisations worth a total of more than $5.5bn in the third quarter. In just a few weeks since the start of October there have been a further nine bond-based deals worth $6.6bn.
Dividend recapitalisation deals now represent about 25 per cent of the total US leveraged loan and high yield bond market by volume, according to data from Standard & Poor’s LCD, with private equity firms including Leonard Green, Bain Capital and CVC Capital coming into the market.

“If there is a business that is relatively unlevered, dividend recaps make sense today given where the debt markets are,” said Lionel Assant, senior managing director and European head of private equity for Blackstone.

The rise in the number of dividend recaps round the world comes as buyout groups face a tough market to sell their investments. Strategic buyers remain wary, while initial public offerings from private equity-backed companies are running at about a third of the amount raised in 2011.

“You can’t exit, you can’t do a public offering, it’s a way to take the pressure off,” said one private equity executive, adding that as long as investor flows continue to favour fixed income over equities, raising money in the debt markets to fund distributions is likely to continue.

The market for dividend recapitalisations in Europe is now growing, although is unlikely to reach the same heights as in the US. “Traditionally, European investors have been a little more cautious in their approach to these deals,” said Mathew Cestar, head of leveraged finance in Europe at Credit Suisse.

But Europe is still on course to record the highest number of dividend recap loans since the crisis, with $4.4bn-worth done in the first three quarters compared with $4.8bn in the whole of last year, according to Dealogic. This is short of the nearly $40bn in 2007, however.

Waves of dividend recapitalisations have proved controversial, with buyout groups accused of loading portfolio companies with debt to pay themselves big profits. Investors say this time round sponsors are being more cautious.

“The recaps you see today are generally at more reasonable credit multiples than we saw in 2007, but they are still more aggressive and more numerous than any other time in the past few years,” said Jonathan Butler, European head of leveraged finance at Pramerica Investment Management.
The WSJ also reported on how debt is fueling a dividend boom as private equity firms are adding debt to the companies they own in order to fund payouts to themselves, a controversial practice now reaching a record pace:
Leonard Green & Partners LP, Bain Capital LLC and Carlyle Group LP are among the firms using the tactic, which rose in popularity before the financial crisis.

In these deals, known as "dividend recapitalizations," private-equity-owned companies raise cash by issuing debt. The proceeds are distributed in the form of dividends to buyout groups.

The resurgence has been helped by investors' appetite for high-yielding debt at a time of historically low interest rates.
While this practice is controversial, private equity managers argue that dividend recaps make sense in a flat economy. Matthew Bristow, Managing Director of ClearRidge Capital, wrote an article a couple of years ago on how dividend recapitalizations act as cash alternatives for private equity:
For those Private Equity Groups (PEGs) that own a strong portfolio company with high earnings and relatively low debt, they are increasingly turning towards dividend recapitalizations rather than selling ownership in their portfolio company in the short-term.

Before we go any further, let’s clear up the definition of a dividend recapitalization (recap). It occurs when the owner of a company, typically a PEG, as a preferred stock holder, issues new debt to pay a special dividend to their limited partners who provided the cash to fund the initial acquisition of the portfolio company.
A dividend recap is an alternative to way of realizing cash, other than selling the company or trying an IPO. For example, a PEG that invested $10 million cash in acquiring a company, may choose today to pull out $10 million cash in a dividend recap.

In the simplest terms, this is a bonus for the preferred stock holders who backed the acquisition, but it also increases the debt load on the company, and hence increases default risk for creditors and common shareholders, but as with many financial tools, we need to understand more to determine the advantages and disadvantages for all parties.

One thing is certain, however – the dividend recap is becoming an increasingly popular tool for PEGs in a flat economy.

Some of the motivations for a dividend recap:

1) Sell – Alternative A: Selling the company today may not yield the highest price and desired return on investment – if the business has a real opportunity to grow sales and earnings in the coming year or so, many PEGs and common shareholders would rather wait and sell for more money in 2011 or 2012, while focusing on growth initiatives in the meantime.

2) IPO – Alternative B: In the current market, an IPO is often risky and unpredictable, so fewer PEGs are choosing this route as the ideal exit.

3) A dividend recap allows the PEG to pull out money they initially invested while retaining the same ownership in the Company. If this seems confusing, you could consider the example of pulling $100k cash out and remortgaging your home after it went up in value. You are still the 100% common shareholder (owner) of your house, but you now owe the bank a higher principal amount. And just to confuse matters, it is possible that the loan to current value could be lower than when you bought your house, because of an increase in the home’s value, so it does not necessarily increase the leverage on the home from when you originally bought it.

4) There may be tax advantages for the PEG’s limited partners compared to a sale of the company, which is partly dependent on changes in the qualified dividend rate and changes in rules on taxing carried interest.

5) High yield bond financing is historically cheap for those firms that qualify, so interest payments are relatively low. If, however, principal and interest payments increase significantly, the CFO is going to have a tougher time, as there will be less cash available for capital expenditures to grow the company. Tighter cash flow also reduces the margin for error in financial projections, budgeting and planning.

Good news for companies that were acquired by a PEG that is considering a dividend recap:

i) A dividend recap is only available to higher quality, stronger performing companies, so if you’re in this group, you’re company’s performing well;

ii) the default rate for companies that underwent a dividend recap was only 6%, compared to 11% on average for the original LBO that funded the acquisition in the first place*;

iii) the PEG would not attempt a dividend recap unless they were confident that the company would result in a higher sale price in the future, which benefits all shareholders;

*according to a 11/19/10 CFO.com article for deals in the late 1990s and early 2000s.
But not everyone is convinced that dividend recaps are the way to go and some limited partners are dead set against this practice. Back in April, Fortune published an article by Dan Primack, Obama and private equity: Friends or foes?:
Many private equity investors are convinced that President Obama is their enemy, not only because he wants to defeat former Bain Capital boss Mitt Romney in November, but also because of a new corporate tax reform proposal that could make private equity deals more difficult to finance.
The industry's most dangerous enemy, however, is not in the White House. It's in the mirror, due to private equity's pervasive use of dividend recapitalization -- a noxious financial strategy that perverts the industry's mission and threatens its future ability to raise capital.

Here's how it works: When a private equity firm buys a company in a traditional leveraged buyout, it typically uses bank loans to finance much of the purchase price. Since the company being acquired takes out the bank loans, it's the one on the hook for future interest payments -- not the private equity owner. The extra twist comes when, often years later, private equity owners instruct the company to take out even more bank loans. Those proceeds are then funneled to private equity investors in the form of a "dividend," rather than being used for corporate purposes like buying new equipment or hiring new employees.

In most cases, companies can handle the extra debt load. But sometimes the interest payments become unbearable and the company folds, as in the case of Bain's investment in medical diagnostics specialist Dade International. Not only did private equity not increase the company's value, but its actions actually helped destroy value.

Even when the company survives, it's difficult to argue that the added debt has contributed to anything other than private equity's bank balance. And calling it a "dividend" is just plain deceitful, since dividends are supposed to come from legitimate earnings.

According to Standard & Poor's, there was more than $28 billion in dividend recap activity last year and nearly $7 billion during the first two months of 2012 (has since soared to $54 billion). That's just a small fraction of overall private equity activity, but it still represents an unacceptable burden on companies whose only crime was to be acquired by firms that talked a big game about "value added."

So what can be done to stem the tide? The best solution would be self-policing. Unfortunately, that would be like asking kids to choose apples over miniature candy bars while trick-or-treating. That leaves government intervention -- not a prohibition against dividend recaps, but tax policy that would discourage their use.

Last month President Obama proposed a corporate tax reform package that would, in part, stop encouraging corporations "to finance themselves with debt rather than with equity." Among the proposed fixes was an unspecified reduction in the amount of interest that companies are allowed to claim as a tax deduction (now 100%). Depending on the specifics -- and possible exceptions, such as for small-business loans -- such a move could make private equity firms much less likely to engage in dividend recaps by increasing the cost of such capital.

Obama's proposal may sound like an attack on private equity, but it's not quite that simple. While dividend recaps are quick and easy money for the industry, they're bad for business in the long term. Investors in private equity funds -- including public pension systems -- have begun talking a lot about "sustainable" investments, rather than just buy, sell, and move on. These investors also have large public equity portfolios and don't like the idea of private equity removing value from companies that may be taken public, or killing a company, which contributes to unemployment and helps trigger larger macroeconomic troubles. These influential investors could reduce their private equity allocations if they see it happening too much.

So if President Obama's primary goal was to destroy private equity, he might try to encourage even more dividend recaps. Luckily, for all involved, he's doing the opposite.
Influential investors, including large endowments and large public pension funds, have been scaling back on private equity allocations, not because of dividend recaps, but because of poor performance.

In fact, the University of Oxford's investment chief, Sandra Robertson, recently startled the audience at the British Private Equity and Venture Capital Association’s annual summit, accusing managers of failing their clients by charging excessive fees and delivering lacklustre returns:
“Why on earth as a rational investor would I allocate blindly to private equity?” she asked, in a speech calculated to provoke debate among quiescent private equity investors as much as those handling their money.

“We need proof that the time and resources required to invest in private equity is worthwhile. You need to earn your place in our portfolios,” she told the audience at London’s Landmark hotel.

As chief executive of the Oxford Endowment, one of Britain’s more discreet investors, she oversees £1.5bn of assets, including £200m in private equity funds, which have been among the university’s most successful investments. The endowment’s private equity holdings rose 10 per cent in value last year.

Before taking over the endowment five years ago, Ms Robertson was co-head of portfolio management at the Wellcome Trust, another of the UK’s largest institutional investors.

Speaking after some of the industry’s most prominent figures, Ms Robertson said that it had in recent years changed significantly and become a “pain” to invest in. “There is no longer an alignment of interests,” she said. “Entrepreneurs have been replaced by brands and partnerships by organisations.

“It is a battle to get in: fundraising, the legal documents with pages and pages of legal jargon designed by lawyers only to be interpreted by lawyers, the endless legal extensions. And that’s before you’ve even tried to begin calculating carried interest.

“And even once you’re in the partnership you have to deal with GPs falling out, when they stop talking to each other, the endless legal extensions, the fund extensions and figuring out all the fees.”

In one particularly pointed remark, Ms Robertson asked a rhetorical question of William Conway, the co-founder of the Carlyle Group, who spoke before her at the summit.

“Bill, if you’re in the room, I can understand why Carlyle kept the preferred return at 8 per cent,” she said. “Where is the economic generator in Carlyle? It’s not in the carried interest, it’s in the fees.”

Ms Robertson declined to comment further on her speech.
Ms. Robertson is a smart lady, one that clearly understands that big 'brand name' private equity funds have become a big pain in the ass. They have ceased being hungry entrepreneurs looking to unlock value in companies and have instead become large asset gatherers, collecting huge fees, delivering paltry returns. I can say the same thing about hedge funds that have long lost the magic.

Of course, the industry was quick to respond to Ms. Robertson's allegations. Mark Florman, Chief Executive at the British Private Equity and Venture Capital Association, sent a response to the FT stating that private equity is not judged on fees:
Sir, While your reporting (October 19) of the University of Oxford investment chief’s remarks at the British Private Equity and Venture Capital Association’s recent summit was an accurate reflection of what was said, it failed to identify why investors choose to put their money into private equity: the returns private equity investments generate are a more important factor than the management fees earned by private equity firms.
Private equity firms are judged by, and grow as a consequence of, the profit they deliver to investors, and not on their management fees as suggested by Sandra Robertson. The alignment of interests arising from carried interest being a share of realised capital gains is one of the critical reasons that the private equity model has endured so successfully.

Figures published in the UK by the BVCA show both the average since-inception and 10-year rates of return generated across the industry were 14.3 per cent. These figures are based on our annual survey covering 97 per cent of our eligible membership, and provide the most comprehensive picture available of performance within the UK industry. In comparable terms over the past decade, total pension fund assets have returned 5.9 per cent (as measured by the WM Company), while the FTSE All-Share has returned just 4.8 per cent.

It is this outperformance that is the defining characteristic of private equity in the UK, and the prime contributor to the growth of the industry both in the UK and globally: as a simple measure of why so many limited partners invest in the sector, the BVCA’s membership now accounts for more than £200bn of investors’ assets under management in the UK. The robust nature of the private equity model may explain why it has been the outstanding element in the annual reports of so many investors, including, not least, Oxford university itself.
I'm not terribly impressed by this response and doubt it impressed most of the sharp institutional investors I know in private equity. True, private equity has a high hurdle rate, much higher than hedge funds, but it also carries all sorts of risks that accompany illiquid investments, and institutional investors are right to question their private equity investments, scrutinizing their returns and fees.

Below, Bloomberg's Cristina Alesci talks about companies working with private equity taking on more debt. She speaks on Bloomberg Television's "Money Moves." Ms. Alesci also spoke with Pimm Fox on Bloomberg Television's "Taking Stock," explaining why private equity is under pressure to show value.