After peaking in 2007, private equity transactional activity crashed alongside the credit markets in 2008 and 2009. According to PitchBook, a research firm, the total amount of private equity capital invested in the United States declined from over $600 billion in 2007 to approximately $200 billion in 2008 and $60 billion in 2009.1
In late 2009, however, private equity activity ascended from its mid-2009 nadir. In the fourth quarter 2009 and the first half 2010, there were 985 reported deals worth a combined $80 billion – a significant improvement from the 889 deals worth a combined $33 billion in the first three quarters of 2009.2 Not surprisingly, the increase in private equity activity coincided with an improvement in the lending environment. Average lending multiples for private equity acquisitions increased from 3.9x EBITDA in the fourth quarter 2009 to 4.1x in the first quarter 2010, with some banks even lending up to 5.0x EBITDA.3
The improvement in the credit markets in late 2009 also led to the revival of a seemingly forgotten vestige of private equity’s heyday – leveraged dividend recapitalization transactions, more commonly known as “dividend recaps.”
Simply put, a dividend recap is the process of using borrowed money to issue a special dividend to a company’s private equity investors. Private equity firms benefit from this type of transaction for numerous reasons:
Recent Trends in Dividend Recaps
According to S&P’s Leveraged Commentary and Data group, approximately $8.8 billion of debt was issued to pay dividends in the first quarter 2010, compared with $7.9 billion in all of 2009.4 Some notable dividend recaps that took place in late 2009 and early 2010 include:
While dividend recap activity may have improved in late-2009 and early-2010, the $8.8 billion of dividend recap debt in the first quarter 2010 pales in comparison with the $55 billion issued in 2007.6 And, there are some notable structural differences between the 2009 and 2010 deals and their 2007 predecessors. First, in all but a few of the most recent transactions, term loans were used to fund the dividends rather than payment-in-kind notes (in which interest is not paid on a current basis, but accrues over time). Furthermore, in the most recent batch of dividend recaps, private equity firms have generally targeted only their best-performing portfolio companies – i.e., those companies that should continue to generate enough cash flow to service the post-transaction debt. It is no accident that many of the 2009 and 2010 dividend recaps involved companies in the healthcare sector, which is more insulated from economic cycles than other industries. Finally, many of the most recent dividend recap transactions involved companies that were “over-equitized” due to the credit crisis. In 2008 and early 2009, when credit was hard to come by, private equity firms were forced to fund their deals with a much higher percentage of equity relative to historical norms. As the credit markets gradually improved in 2009 and 2010, private equity firms were able to add leverage to these investments through dividend recaps.
These differences suggest that the dividend recap transactions taking place in 2009 and 2010 have left portfolio companies with stronger post-transaction balance sheets compared to companies that underwent dividend recaps in 2006 and 2007, which sometimes took on unsustainable levels of debt. Nonetheless, even these most recent deals – similar to any transaction that adds a significant amount of new debt to a company’s balance sheet – are fraught with risks to the target company, its directors, and its shareholders.
Risks of Dividend Recaps
At the most extreme end of the spectrum, debt-funded dividends that are too large may leave a company too thinly capitalized to adequately fund day-to-day working capital needs. Even moderately-sized leveraged dividends can hinder a company’s future growth opportunities, as cash that could have been used to finance acquisitions, capital investments, or strategic hires is diverted to interest and principal payments on debt.
Delaware law addresses this risk by requiring that corporations only pay dividends from a surplus, defined as the fair value of a corporation’s total assets minus the fair value of a corporation’s total liabilities, less the corporation’s capital. (Capital is generally defined as no less than the aggregate par value of the company’s stock.) Under Delaware law, directors of companies that consent to a dividend recap without exercising due care to ensure that the dividend is being paid from a surplus could be subject to a variety of legal claims.
If a company’s performance deteriorates post-transaction to the point of insolvency, the dividend recap could be “set aside” under fraudulent conveyance laws. Fraudulent conveyance laws, which are included both in federal law (Section 548 of the Federal Bankruptcy Code) and under general state laws (the Uniform Fraudulent Conveyance Act or the Uniform Fraudulent Transfer Act), were put in place to prevent secured creditors, shareholders, and other stakeholders from financially benefiting at the expense of unsecured creditors. These laws not only cover intentional fraud, but also “constructive” fraud. The Federal Bankruptcy Code defines constructive fraud as occurring when a debtor receives a less than reasonably equivalent value for a transfer (e.g., dividend payment or corporate stock redemption) and either: (1) was insolvent on the date the transfer was made or becomes insolvent as a result of the transfer; (2) retained “unreasonably small assets” or “capital” after the transfer; or (3) made the transfer with the intent to incur (or reasonably should have believed that it would incur) debts beyond its ability to pay.
The penalties for fraudulent conveyance can be harsh. Corporate directors could face significant personal liability, and selling shareholders could be forced to return transaction proceeds. In the context of a dividend recap, investors could be forced to return the dividend. Even the professional fees of third-party advisors are at risk under fraudulent conveyance laws.
Given the risks involved, a key question for private equity firms considering a dividend recap is how to best effectuate the transaction while shielding themselves and their company’s directors from liability. It is imperative that the company’s directors fully exercise their individual duties of care and loyalty to the company (and not to the private equity owner and investors). In doing so, the directors will have the benefit of the “business judgment rule,” which provides that the company itself was in the best situation to examine the merits of the proposed transaction and prevents the courts from re-examining their decision after the fact.
In practice, this means that the directors must make reasonable efforts to gather and examine all relevant information to help them determine whether it is in all stockholders’ best interests to effect the dividend recap. As part of these efforts, the board may engage an independent financial advisor to provide a “solvency opinion.”
In short, a solvency opinion determines whether a company will remain solvent immediately after a leveraged transaction, taking into consideration the debt incurred as part of the transaction. Most solvency opinions apply three financial tests: (1) the Balance Sheet Test; (2) the Cash Flow Test; and (3) the Reasonable Capital Test.
The Balance Sheet Test
The Balance Sheet Test determines whether or not the “fair value” and “present fair saleable value” of a company’s assets exceed its stated liabilities and identified contingent liabilities immediately after a leveraged transaction. In this test, the “fair value” and “present fair saleable value” of a company’s assets is typically based upon the company’s going concern enterprise value, estimated using standard valuation approaches and methods. Generally, a company’s liabilities are valued at their face amounts, and contingent liabilities are taken into consideration.
The Cash Flow Test
The Cash Flow Test demonstrates whether or not the company should be able to satisfy its debt obligations – related to existing debt as well as debt incurred as part of the proposed transaction – as they become absolute and mature. In application, this test starts with the projected cash flows of the company and subjects the cash flows to a sensitivity analysis to determine whether or not a margin of safety exists if the company underperforms its projections. Typically, the company’s “base case” projections are tested first, and then downside scenarios are considered. The Cash Flow Test is typically performed over a period of five years or less, and the impact of loan covenants is considered in each year.
The Reasonable Capital Test
Even if a company passes the Balance Sheet Test (demonstrating that its enterprise value exceeds stated and contingent liabilities), the company’s surplus equity may nonetheless be too small to provide reasonable downside protection if business conditions deteriorate. The Reasonable Capital Test seeks to address this problem by demonstrating whether or not a company should have a reasonable level of surplus capital following a leveraged transaction.
The Reasonable Capital Test generally considers the impact of the following factors on the company’s surplus capital:
In practice, the Reasonable Capital Test starts with the Cash Flow Test and performs additional sensitivity analyses to assess the impact of a reasonable level of market volatility to ensure that the company has enough post-transaction equity to withstand routine business fluctuations. For example, a company’s projected cash flows could be adjusted to account for factors such as lower sales growth, lower profit margins, and higher-than-expected capital expenditures to assess whether or not the company will continue to maintain adequate working capital levels and an additional borrowing base under these scenarios.
Dividend recaps remain an effective way for private equity companies to achieve partial liquidity before a portfolio company is ready to be taken public or sold, enhancing internal rate of return in the process. This is especially true for portfolio companies that were “over-equitized” during the credit crisis, as private equity firms seek to take some cash off the table as credit markets stabilize.
Like all leveraged transactions, dividend recaps are fraught with risks to the private equity firm and corporate directors. Unfortunately, no absolute safe harbor exists to fully shield these parties from liability. Private equity investors and directors may significantly reduce the risk of liability by making use of best practices – which includes obtaining a solvency opinion from an independent financial advisor – before consenting to a dividend recap.
1 Private Equity Investment Trends – 3Q 2010 (PitchBook, 2010).
3 Private Equity Investment Trends – 2Q 2010 (PitchBook, 2010).
4 Mark Gongloff, “Bond Buyers Accept More Risk,” Wall Street Journal 5 April 2010.
5 Christine Idzelis and David Carey, “The Recap in an Age of Austerity,” The Deal Magazine, 5 March 2010.