Gambling.Now!

The private equity bubble was a wonderful thing.  The following post walks through the mechanics of how PE investors and management teams leveraged the cheap debt market to put tons of money into their pockets.

Leveraged Recaps

The general market is waking up to a standard tactic used by private equity firms to achieve low-risk and high value returns on their investments – the leveraged recap.  Companies take on new or additional debt and use the proceeds to pay shareholders a dividend.  While leveraged recaps have been used since the 1980′s in the past two weeks alone there have been numerous blogs and articles written about this practice.  Check out Abnormal Returns and Going Private for some prime examples.

PwC, in conjunction with MergerMarket, recently released a study entitled Private equity insight: Dividend recapitalizations.  They surveyed 75 private equity firms and found that 97% percent of respondents expect to recapitalize portfolio companies in 2007, with 75% expecting to increase their use of recaps.  Dividend recaps are seen as viable alternatives to IPOs.  94% of respondents consider dividend  recaps an important part of their exit strategies. Indeed, 52% consider recaps an alternative to an IPO, while 16% consider them an alternative to a strategic sale.

So what does this mean for management teams?  The use of recaps to return value to the shareholders will rise dramatically in 2007.  Recaps are a mixed bag for management teams but big winners for boards and investors.  Investors like recaps because they enable them to take a significant return on their investment now with limited risk.  The process of raising debt to finance the recap is very straightforward.  The collapse of the subprime mortgage lending market has hardly put a dent in recap activity.  Check out this article by New York Times columnist Floyd Norris on the recent Attachmate recap (Times Select required).  The majority of the debt issued to finance recaps carries near junk ratings and have ‘lite covenants‘  The biggest risk investors face with recaps is damage to their reputation and their subsequent ability to raise debt for other portfolio companies if their recapped company defaults on the debt.  When you balance the speed, simplicity, and risk profile of a leveraged recap versus an IPO it’s not hard to see why recaps are so attractive.

From a management team perspective leveraged recaps have both pluses and minuses.  The biggest plus is that most teams get to participate in the dividend windfall.  Generally investors will pay management teams a pro rata share of the recap proceeds based on management’s equity stake.  Typically the payments will be streched out over a number of years and specific benchmarks, generally those associated with the loan covenants, must be hit for the payments to be made.  Management always has to have the proper motivation to make sure the business performs.  The opportunity, however, to monetize the value of one’s equity or vested options now is something most teams don’t want to pass up.

Leveraged Recaps Part Duex

While cash is good, there are a number of downsides for management teams associated with leveraged recaps.  The most obvious is that a chunk of the business’ heretofore free cash flow now needs to go to service the new or incremental debt that financed the recap.  With effective interest rates in the 10% to 14% range that is no small cost.  Cash that could have been invested to grow the business now has to go to service the debt.  Maintaining compliance with even ‘lite covenants’ can also impact the business — such as limiting the amount of cap-ex that can be invested each year or watching your cash balance drop when the lenders do an ‘excess cash flow sweep’ on a periodic basis.  However, if your firm is in a very mature market with little organic growth opportunity then investing in growth might not be realistic.  If that is the case dedicating free cash flow to debt service versus investing in growth initiatives that will not pay off is a much better choice.  It takes a seasoned management team and board however to come to such a conclusion.

There are two other downsides management teams should consider in evaluating leveraged recaps.  Once your investors have received a solid return on their investment via a recap their interest in driving your firm to grow by taking a lot of risks declines significantly.  They tend to be satisfied with their investment return and their tolerance for risk decreases dramatically.  Ensuring that the debt is serviced appropriately becomes a high priority since problems can impact the investors reputations in the debt marketplace and potentially spill over and cause problems on other refinancings.  Also, a highly levered business is inherently less interesting to potential acquirers.  This can make an eventual exit via a sale to a public company or another private firm challenging. 

While IPOs are on the rise, firms that chose to do a leveraged recap tend not be the best IPO candidates.  It’s not the debt load that decreases the IPO opportunity — it’s the business conditions.  Most firms that do leveraged recaps are in a situation where investing in revenue growth is not the most attractive option because of market or competitive conditions.  Solid IPO candidates need to show good to strong organic revenue growth to attract market interest.

At the end of the day the core decision to do or not to do a leveraged recap can be boiled down to one question: What is the best use of a company’s free cash flow — investing in growth initiatives that will actually pay off or creating a significant return for investors now by dedicating free cash flow to debt service.