January/February 2007

Rethinking Recaps

Data from Standard & Poor's suggests financial sponsors' much-maligned dividend recaps may not be so bad for their portfolio companies, after all.

Dividend recaps occur when private equity firms issue debt and use the proceeds to pay themselves special dividends, thereby helping recoup some, if not all, of the equity they put into deals.  Essentially, financial sponsors are funding the dividends by increasing leverage on their companies' balance sheets.  According to the common wisdom, these recaps therefore increase the risk of defaults down the road.

This idea seems to be backed up by the ratings agencies, which have routinely downgraded the credit ratings of companies whose sponsors have funded such recaps.

Although this hypothesis seems to make sense on its face, the facts just don't back it up.

According to S&P's own study, the default rate for companies that underwent a dividend recap between 1995 and 2003 is 6 percent.  That number compares with an 11 percent default rate for all companies bought by LBOs during the same period.

This may appear counterintuitive at first blush.  After all, shouldn't companies with more debt on their books naturally be at greater risk of crumbling under that larger burden?  As Steven Bavaria, a vice president at S&P and head of its bank loan and recovery rating group, puts it, "Dividend recaps essentially replace equity with debt, which generally worsens the credit—and the rating."

But, according to one leveraged finance banker, a closer look shows that S&P's study only confirms what should naturally be the case.

"The universe is self-selecting," says the banker.  "Buyouts where the companies have struggled could never have done recaps in the first place."

Take, for example, car rental company Hertz Corp. and its private equity owners, Clayton, Dubilier & Rice Inc., Carlyle Group and Merrill Lynch Private Equity.  The sponsors borrowed $1 billion in bank loans to pay themselves a dividend, helping them recoup almost half of their original investment in Hertz just six months after they closed the $15 billion buyout.

Hertz is obviously no fly-by-night operation.  The company's first-quarter revenue was up 9 percent over 2005, which increased net cash from operating activities.  That rose almost 33 percent in the first quarter of 2006, to $1.2 billion, compared with $910 million in the first quarter of 2005.

Steven Miller, managing director of the S&P Leveraged Commentary & Data unit, says companies that have been recapped actually have lower leverage multiples on average than traditional leveraged-buyout deals.

According to LCD's numbers, the average leverage multiple of LBOs in 2004 was 4.85 times, compared with 4.39 times for those companies that were recapped.  In 2005, the LBO multiple was 5.25 times, compared with 4.45 times for the recaps.  The LBO multiple for Q1-Q3 2006 is 5.09 times, with the recap multiple at 4.69 times.  This could be explained by most companies that are recapped, such as Hertz, having strong and growing cash flows, which outstrip the increase in debt and keep the multiples low.

Overall, leverage multiples have been going up, and there is every expectation that the default rate will rise in the coming months.  However, the default rate overall is at a historical low of around 1.5 percent.  And if past performance is any indication of future returns, the rate will likely rise more slowly for those companies lucky enough to be in a position for a recap.

This article was written by Vipal Monga and originally ran in The Deal.