Dividend recapitalization, worked three ways
A dividend recapitalization is when a company borrows new debt and pays the money out to its owners as a dividend. Private equity firms use it to get cash back before selling, which raises IRR because the cash arrives earlier, but it leaves the company with more debt and less room for error. In our worked deal a $200 million recap in year 2 lifts IRR from 19.6% to 22.7% while MOIC slips from 2.45x to 2.36x. Soreno, an AI voice interview practice app for consulting, investment banking and other finance candidates, runs a free debt schedule template with no sign-up, and mock private equity interviews where an AI interviewer asks you to walk a recap through the statements out loud.
Updated
- Borrow, then pay out. New debt in, the same cash out to shareholders as a dividend.
- Equity can go negative. The dividend comes out of equity, while assets don't change.
- IRR up, MOIC down. Cash comes back early, and the extra interest shrinks the exit.
- Lenders set the size. Leverage and interest coverage limits, and the tax deduction for interest is capped.
- Twelve questions below. Short answers in our words and the follow-ups to expect.
A dividend recap in three examples
Every number here is invented by Soreno for practice, in millions of dollars. Our conventions: a 25% tax rate, interest paid at year end on the debt outstanding during the year, and cash earns no interest.
Example 1: the recap on the three statementsEquity down $196 million
A company borrows $200 million at 8%, pays $4 million of financing fees in cash and pays the rest, $196 million, as a dividend. We spread the fees evenly over the loan's 5 years, a simplification of the effective interest method, and assume the interest and fees are deductible for tax.
1. Balance sheet, day one
Debt up $196 million, equity down $196 million
Cash comes in $200 million and goes out $4 million + $196 million, so it ends where it started. Under US GAAP the fees are shown as a deduction from the loan, so debt is carried at $200 million − $4 million = $196 million. Assets don't change. Liabilities rise and equity falls by the same $196 million, so it still balances.
2. Income statement, year 1
Net income down $12.6 million
Interest $200 million × 8% = $16 million, plus $0.8 million of fee amortization, is $16.8 million pre-tax. After tax at 25%, net income falls $12.6 million.
3. Cash flow, year 1
Cash down $11.8 million
Start from net income, down $12.6 million, and add back the $0.8 million of non-cash fee amortization: cash is $11.8 million lower: $16 million of interest less $4.2 million of tax saved on the interest and the fee amortization.
4. The dividend itself
A financing outflow
The dividend never touches the income statement. It sits in financing activities next to the new borrowing.
5. Negative equity
Common after a recap
If the dividend is larger than book equity, equity turns negative. That isn't insolvency, which depends on cash flow and asset values, but lenders and rating agencies will look harder.
Example 2: what it does to the sponsor's returns19.6% becomes 22.7%
A sponsor buys a company with $100 million of EBITDA at 8x, $800 million, with $400 million of 8% debt and $400 million of equity. Cash after interest and tax repays 30, 30, 40, 40, 40 in years 1 to 5. It sells after year 5 at 8x EBITDA of $150 million. In the recap case, at the end of year 2 the company borrows $200 million more at 8% and pays it out. We ignore fees here and assume all interest is deductible. Example 3 shows when it isn't.
1. No recap
2.45x, 19.6%
Debt falls to $220 million. Exit value $1,200 million − $220 million = $980 million of equity. $980 million ÷ $400 million = 2.45x, 19.6% a year over 5 years.
2. The recap
$200 million back in year 2
Debt is $340 million at the end of year 2. The new $200 million takes it to $540 million.
3. Less paydown after
$12 million a year less
The extra interest is $200 million × 8% = $16 million a year, or $12 million after tax, so each of the last 3 years repays that much less. We leave out the small extra interest that the slower paydown itself adds, our simplification. Debt at exit is $456 million, and exit equity is $1,200 million − $456 million = $744 million.
4. Returns
2.36x, 22.7%
MOIC = ($200 million + $744 million) ÷ $400 million = 2.36x. IRR on −400 today, +200 in year 2 and +744 in year 5 is 22.7%.
5. Read it
Faster, slightly smaller
The interest costs the sponsor $36 million of exit equity, so MOIC drops. IRR rises because 50% of the equity came back in year 2. The sponsor has also locked in part of its return, which matters if the exit disappoints.
Example 3: how big a recap can be$182.7 million dividend
At the end of year 2 the company earns $120 million of EBITDA and owes $340 million. Lenders will refinance all of it at 9%, but total debt can't exceed 4.5x EBITDA and EBITDA must cover total interest at least 2.5x. Fees are 2% of the new total facility. These limits are our example's terms, since every credit agreement defines them its own way. For tax, we take adjusted taxable income as equal to EBITDA, our simplification.
1. Leverage limit
$540 million
4.5x × $120 million = $540 million of total debt.
2. Coverage limit
$533.3 million
Interest can be at most $120 million ÷ 2.5 = $48 million. At 9%, that supports $48 million ÷ 0.09 = $533.3 million of debt. The coverage limit binds, so total debt is $533.3 million.
3. The dividend
$182.7 million
New money $533.3 million − $340 million = $193.3 million. Fees 2% × $533.3 million = $10.7 million. Dividend $193.3 million − $10.7 million = $182.7 million.
4. The interest limit
$12 million not deductible this year
Interest is $533.3 million × 9% = $48 million. With no business interest income, section 163(j) caps the deduction at 30% of adjusted taxable income: 30% × $120 million = $36 million. The other $12 million carries forward to next year.
5. The real cost
$39 million after tax, not $36 million
Only $36 million saves tax this year, $9 million. After-tax interest is $39 million, against $36 million if it were all deductible. Higher rates hurt a recap twice: the coverage limit shrinks it, and the deduction cap raises its after-tax cost.
From FASB: ASU 2015-03, debt issuance costs, IRS: questions and answers on the business interest limit and IRS Publication 550, Investment Income.
What the interviewer checks on a recap
In our experience the question starts with a definition and moves fast to the statements and the returns.
The statements
Debt up, equity down, cash unchanged on day one. Interest lowers net income after.
Why sponsors do it
Earlier cash lifts IRR and returns money to the fund's investors without selling.
Who carries the risk
The company and its lenders. More debt means less room if earnings fall.
When it's possible
When earnings have grown, debt has been paid down and credit markets are open.
12 dividend recapitalization interview questions
The short answers are ours. The note says what a strong answer adds.
The basics4 questions
What is a dividend recapitalization, and why would a private equity firm do one?
Show follow-ups
Short answer. The company takes on new debt and pays it out as a dividend. The sponsor gets cash back early without selling, which lifts IRR and returns money to the fund's investors.
Names the cost: more debt and interest, and a smaller exit. Practice it, see a model answer
A company with no debt borrows to pay a special dividend. What happens to its share price?
Show follow-ups
Short answer. Shareholders receive the cash, and equity value falls by about the same amount. Enterprise value barely moves, apart from the tax value of the new interest and any extra risk.
Works the numbers per share. Practice it, see a model answer
A company raises $100 of debt. Walk me through the three statements.
Show follow-ups
Short answer. Cash and debt each rise $100 on the balance sheet, and financing cash flow shows the $100. Later, interest lowers net income.
Then turns it into a recap by paying the cash out. Practice it, see a model answer
Why can a recap leave a company with negative equity?
Show follow-ups
Short answer. The dividend reduces equity while assets stay the same, so a large one can push book equity below zero.
Explains why that isn't the same as being insolvent.
Returns4 questions
What is the difference between IRR and MOIC?
Show follow-ups
Short answer. MOIC is cash back over cash in. IRR is the yearly rate that accounts for when cash came back.
Uses the recap as the case where they move apart. Practice it, see a model answer
Where do the returns in an LBO come from?
Show follow-ups
Short answer. Earnings growth, a higher exit multiple and debt paydown.
Says that a recap moves timing, not where value comes from. Practice it, see a model answer
Walk me through a paper LBO.
Show follow-ups
Short answer. Price, debt and equity, cash generated and debt repaid, exit value, then MOIC and IRR.
Can add a recap midway and say how the returns change. Practice it, see a model answer
How does a private equity firm exit an investment?
Show follow-ups
Short answer. A sale to a strategic or another sponsor, an IPO, or a recap that returns part of the money while keeping the company.
Places the recap as a partial exit. Practice it, see a model answer
The debt4 questions
How do you decide how much debt a company can support?
Show follow-ups
Short answer. From its cash flow: leverage and interest coverage limits lenders will accept, with room for a bad year.
Works one limit through, as in example 3. Practice it, see a model answer
What kinds of debt are used in an LBO?
Show follow-ups
Short answer. Senior secured loans, then high-yield bonds or other junior debt, sometimes mezzanine. A recap usually adds to or refinances the senior debt.
Says why lenders accept a recap at all. Practice it, see a model answer
What is a cash sweep, and how does a recap interact with it?
Show follow-ups
Short answer. A sweep uses excess cash to repay debt. A recap reverses earlier paydown and can reset the sweep on a larger loan.
Mentions that the credit agreement must allow the dividend. Practice it, see a model answer
What are the risks of a dividend recap?
Show follow-ups
Short answer. Less room if earnings fall, higher interest, possibly limited interest deductions, and a weaker credit rating. Creditors and the company carry the risk the sponsor has partly cashed out of.
Gives the conditions where it is reasonable: stable cash flow and debt already paid down.
More to prepare with
Common dividend recap mistakes
Putting the dividend on the income statement
It is a distribution to owners, not an expense. Only the interest and fees touch net income.
Saying cash goes up
Cash comes in and goes straight out. Net of fees, it is unchanged on day one.
Saying it always raises MOIC
It usually lowers it a little, as interest eats exit equity. In example 2, 2.45x becomes 2.36x.
Assuming all interest is deductible
Section 163(j) can cap it. In example 3, $12 million of interest is carried forward.
Sizing on leverage alone
At 9% interest, coverage binds before the 4.5x leverage limit.
Walk a recap through out loud
Soreno's AI interviewer asks what a dividend recap does to the three statements and to IRR and MOIC, then pushes on the risks. You get a scored report on your answer.
Questions people ask
What is a dividend recap?
A company raises new debt and uses it to pay a dividend to its shareholders, often a private equity owner.
How do fees on the new debt show up?
Under US GAAP since ASU 2015-03, debt issuance costs are shown on the balance sheet as a direct deduction from the carrying amount of the debt, then expensed over the loan's life.
Is the interest on recap debt tax deductible?
Business interest is deductible up to the section 163(j) limit: business interest income, 30% of adjusted taxable income and floor plan financing interest. The IRS says disallowed interest carries forward to the next year, and that for tax years beginning after December 31, 2024, depreciation and amortization are added back again in computing adjusted taxable income.
How is a recap dividend taxed to the shareholder?
IRS Publication 550 says ordinary dividends are paid out of earnings and profits, and a distribution that isn't reduces the basis of the stock and isn't taxed until that basis is recovered. Whether a recap dividend is one or the other depends on the company's earnings and profits.
Why would lenders fund a recap?
Because the company's earnings and cash flow can carry the debt, and they earn interest and fees on it. In our experience recaps are more common when credit markets are loose.
Does a dividend recap change enterprise value?
Not much on day one. Debt rises and equity value falls by about the same amount. Over time the interest tax shield adds a little value and the extra risk can take some away.