When a company pays out dividends to its shareholders, it typically does so from its earnings or from the cash on hand. Dividends are usually a distribution of the company’s profits. But there are times when a company may need to borrow money to pay those dividends. This is where dividend recapitalization comes into play.
In this article, we will explain what dividend recapitalization is and how it works. We will also discuss the pros and cons of a dividend recapitalization, as well as some examples of how it can be used.
Finally, we will take a look at why companies might choose to do a dividend recapitalization and what the benefits are for shareholders.
What is a dividend recapitalization?
A dividend recapitalization is a financing tool that companies can use to raise capital to pay dividends to shareholders. In a dividend recapitalization, a company will take out a loan or issue bonds and use the proceeds to pay dividends to shareholders.
The loan is typically structured as a term loan, which means that it will have a fixed interest rate and repayment schedule. The terms of the loan will be negotiated between the company and the lender and will be based on the company's financial situation and creditworthiness.
Dividend recapitalization is particularly common among private companies after a deal. If a private equity company decides to acquire a certain company, or take a public company private, they use dividend recapitalization to recoup part of their initial investment. Instead of selling their equity in the company, the company owners are able to finance themselves, by adding debt to the company’s balance sheet.
How does a dividend recapitalization work?
To understand how a dividend recapitalization works, it is first important to understand how dividends are typically paid. As we mentioned above, companies will usually pay dividends out of their earnings or from the cash on hand.
If a company does not have enough earnings or cash on hand to cover the dividend payment, it may need to take out a loan to make the payment. This is where a dividend recapitalization comes into play.
The process typically works by contacting a reputable lender, such as banks, to provide a loan that will be used to cover the dividend payment. The company will then use the cash from the loan to make the dividend payment.
Some paperwork will need to be filed with the Securities and Exchange Commission (SEC), but the process is typically pretty straightforward.
What are the pros and cons of a dividend recapitalization?
There are both pros and cons to a dividend recapitalization.
Some of the benefits include:
- If the company was recently acquired it allows the acquirer to generate an instant return, and use that capital for other investments
- It can help companies avoid diluting their equity by issuing new shares
Some of the drawbacks include:
- It can increase the company's debt burden, which can be a risk if the company's financial situation deteriorates
- It can be difficult to obtain financing for a dividend recapitalization
Dividend recapitalization examples
Let's say XYZ company is a publicly-traded company that recently was taken private by a private equity firm. The private equity firm committed a large amount of capital to close the acquisition, and one way of generating liquidity is to use the acquired company to issue bonds or access loans. The company can then use the proceeds of the loan or bond issuance to pay a dividend.
This allows the private equity firm to rapidly get cash, and finance their next deal, while maintaining control of the company, and without diluting their ownership of the business.
Why would a company do a dividend recapitalization?
There are several reasons why companies might choose to do a dividend recapitalization. Some common reasons include:
- Raising capital for investors or the parent company: A dividend recapitalization can provide the parent company or investors with the capital they need to grow their business or make acquisitions
- To avoid diluting equity: By using debt to pay dividends, companies can avoid issuing new shares, which would dilute the existing shareholders' ownership stake in the company.
What are the benefits of a dividend recapitalization for shareholders?
The main benefit of a dividend recapitalization for shareholders of the company is that it allows to raise capital rapidly, by issuing debt. This allows shareholders or a private equity firm to pursue other deals that may present themselves, without diluting their ownership of the company.
What are the risks of a dividend recapitalization for shareholders?
There are also some risks associated with dividend recapitalizations for shareholders. Some of these risks include:
- It can increase leverage: A dividend recapitalization can increase leverage and the debt burden of the company, which can be a risk if the company's financial situation deteriorates.
- The share price may fall: If interest rates rise or if market conditions deteriorate, the share price may fall as investors worry about the company's ability to repay its debt.
How does a dividend recap affect returns?
A dividend recapitalization can have a positive or negative effect on shareholder returns, depending on the amount of debt that is used to finance the dividend, and the interest paid on the debt. If too much debt is used, it can increase the risk of default and reduce returns.
Dividend recapitalization: private companies vs public companies
Although dividend recapitalizations are far more common among private companies, and especially when there are private equity firms involved, this practice can also be found among public companies.
When companies encounter short-term setbacks they might choose to maintain their dividend, and take out debt to pay dividends to shareholders. This could be a dangerous move, since the shareholders will be taxed on their dividends, and it might not make a lot of sense.
Companies do this to prevent their share price from dropping following a dividend cut. However, if the company continues to be unable to generate the necessary earnings to maintain its dividend, borrowing to pay shareholders a dividend could put the company at risk of bankruptcy.
As a dividend investor, it is important to understand what a dividend recapitalization is and how it can affect your investment. While a dividend recapitalization can be a positive event for the company and its shareholders, it can also have negative consequences.
If you are considering investing in a company that has announced a dividend recapitalization, be sure to do your own due diligence to understand how it will impact your investment.