What is a dividend recapitalization, and why would a private equity firm do one?

A dividend recap, short for recapitalization, is when a company that a private equity firm already owns borrows new debt and uses the cash to pay a dividend to its owner. Nothing is sold. The firm still owns the same share of the company, but the company now carries more debt. The reason to do it is to get money back early. That raises the IRR, because IRR rewards cash that comes sooner. Here's a simple example. A sponsor invests $400 million and expects to sell in year five for $1,000 million of equity. That's 2.5 times and about a 20% IRR. Now suppose in year two the company borrows $200 million and pays it out. At exit the equity is lower by that $200 million and by the extra interest. At 8% interest and a 25% tax rate that's $12 million a year after tax, or $36 million over three years. So the sponsor gets $200 million in year two and $764 million in year five. The IRR goes up to about 23%, but the total is $964 million, so the multiple slips from 2.5 to about 2.4 times. So a recap moves returns forward. It doesn't create value. The cost is more debt on the company.

A dividend recap, short for recapitalization, is when a company that a private equity firm already owns borrows new debt and uses the cash to pay a dividend to its owner. Nothing is sold. The firm still owns the same share of the company, but the company now carries more debt. The reason to do it is to get money back early. That raises the IRR, because IRR rewards cash that comes sooner. It also takes risk off the table, because part of the investment has already been returned. And it's a way to pay the fund's investors when a sale isn't attractive yet. Here's a simple example. A sponsor invests $400 million and expects to sell in year five for $1,000 million of equity. That's 2.5 times and about a 20% IRR. Now suppose in year two the company borrows $200 million and pays it out. At exit the equity is lower by that $200 million and by the extra interest. At 8% interest and a 25% tax rate that's $12 million a year after tax, or $36 million over three years. So the sponsor gets $200 million in year two and $764 million in year five. The IRR goes up to about 23%, but the total is $964 million, so the multiple slips from 2.5 to about 2.4 times. So a recap moves returns forward. It doesn't create value. The cost is more debt on the company. The same business now has higher interest to pay and less room if earnings fall. That's why it suits a company that has paid down debt or grown EBITDA since the buyout, so it has capacity to borrow again, and why loan documents often limit dividends. Before doing one, I'd check that the company still covers its interest in a downside year.