Dividend recapitalization can be an attractive mechanism for an owner of a midsize company who wants to diversify his or her net worth without surrendering equity or corporate control. In a dividend recap, a company incurs a debt to pay a special dividend to private investors or shareholders.
Even though the private equity world has deployed dividend recapitalizations for years, they have a lower profile in private middle market companies.
“Many business owners are often not aware their company has reached a size and cash-flow profile that gives them access to a financing market that could provide a dividend recap,” said Roger Wilson, corporate finance lead for SunTrust specializing in middle market companies. “As a result, they may not realize there is an alternative outside of selling equity to create a liquidity event for themselves or their family.”
Even so, use of this tool is rapidly rising. Dividend recaps totaled $18 billion through May 2017, a 309 percent increase from the $4.4 billion total at the same point a year ago. Wilson says the surge is due to the attractiveness that dividend recaps exercise for both borrowers and lenders. Business owners are attracted to the availability and low cost of debt, while lenders are actively seeking to put their money to work in a market awash in capital.
Interest in dividend recaps is expanding in tandem with the rise of buybacks, in which large public companies put debt on the balance sheet to repurchase shares as opposed to providing a cash dividend to shareholders.
“It’s a similar process but effected in a different way,” Wilson explained.
Consider Your Acquisition Strategy
Wilson says dividend recaps can make sense for a company that has a stable cash flow and a growing business, where the company doesn’t intend to use its debt capacity for acquisitions or growth capital expenditures.
In contrast, dividend recaps might not be prudent for companies that operate in highly cyclical industries.
“If the future cash flows are volatile, a company may not want to put leverage on the balance sheet that isn’t directly supporting future growth,” Wilson said.
Since dividend recaps do not build or create value for the company, lenders will closely scrutinize historical and projected cash flows. Lenders are more apt to provide capital for dividend recaps in booming economies when they anticipate positive growth trends.
From the business owner’s standpoint, the impact of capital gains is another factor in weighing the use of dividend recaps. If the tax environment is favorable (or, conversely, is expected to become negative in the future), a business owner might be more likely to consider a dividend recap to diversify his or her net worth or buy out a minority stockholder and consolidate ownership using debt.
“In late 2016, before the presidential nominees were known, many people were anticipating a higher tax rate environment and looking closely at dividend recaps,” Wilson said. “With the current administration, more people seem to be taking more of a wait-and-see approach.”
A Philosophical Decision
In considering liquidity options, a business owner faces a philosophical decision about whether or not to sell a portion of the business. For example, an owner might choose a minority recap, in which the owner maintains control of the business and sells some of his or her equity to a financial or strategic buyer. This provides liquidity from the business without putting a debt burden on the balance sheet.
“In that event, you might ask yourself if the new minority owner brings value to your business that will help it grow and maximize a liquidity event down the road,” Wilson said. “Or is the minority investor really a means to an end in terms of just providing liquidity and capital?”
Carefully weighing such considerations can help the owner determine what liquidity strategy makes the most sense in his or her individual circumstances. “It comes down to understanding the owner’s priorities, and then working through the art of the possible,” Wilson said.