Dividend Recapitalizations: Using Leverage to De-Risk

February 1, 2022

By: John J. Whalen, Group Head
Capital Advisory Investment Banking Group

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It’s no secret that adding leverage to an operating company’s balance sheet poses certain risks; however, when utilized prudently, a dividend recapitalization offers shareholders and other key stakeholders a mechanism to generate liquidity, increase returns, diversify holdings, and manage future tax exposure – especially in circumstances where a business lacks more compelling opportunities to deploy capital in support of growth.

What is a Dividend Recapitalization?
In its simplest form, a leveraged dividend recapitalization is a corporate finance tool that allows both public and private companies to distribute capital to shareholders by assuming additional debt and using proceeds from the issuance to finance the dividend. The incremental debt can take many forms but most often, borrowers employ bank and non-bank term loans given the relatively low cost of capital and ease of execution (i.e. the new term loan tends to fit nicely into a company’s existing capital structure and credit agreement). Depending on structure, the debt used to finance a dividend potentially delivers the added benefit of increasing free cash flow through relatively light contractual amortization – a bonus for both owners and management teams focused on maintaining a hedge against unanticipated performance challenges.

To some, a dividend recap is considered “financial engineering” used only by private equity firms to increase returns for limited partners at the expense of the operating company itself; however, while private equity firms still account for the largest share of dividend recap transactions, it’s also a very useful tool for private businesses with low leverage and stable, predictable cash flows. In the current environment, the convergence of low interest rates, seemingly insatiable lender appetite, historically low default rates, and potential changes in tax policy all contribute to record dividend recap volume.

Reserved for the Select Few?
In the table above, the record issuance numbers still suggest that PE firms are the most prolific users of leverage to finance distributions. Why? Because there are some very smart finance and investment professionals running these private equity portfolio companies and they are incredibly adept at using capital to their advantage; however, the leveraged dividend recap is no longer the sole purview of financial owners/buyers and, when layered into a company’s capital structure, the benefits are meaningful. Many closely-held and multi-generational family-owned entities may find value in borrowing to fund distributions.

Beyond simply increasing returns for limited partners and other stakeholders, distributing capital via a dividend recap facilitates the following:

1. Dividends allow for diversification of holdings and effectively de-risk owners that have a substantial portion of their personal wealth tied up in the company they worked so diligently to build. By taking some “chips off the table”, the modest deployment of leverage to fund a distribution for owners serves to hedge against future deterioration in performance or other unforeseen decreases in enterprise value. It may sound counter-intuitive to suggest that increasing leverage potentially de-risks a company and its owners, but diversifying through dividends is a very efficient wealth planning tool and, with S-Corp structures in particular, the tax impact may be negligible (consultation with a tax advisor is always critically important when contemplating dividends or other forms of restricted payment).
2. Another key benefit for closely-held companies is the maintenance of control. There are many tools at an owner’s disposal to lower risk through diversification. Selling a minority equity position, a preferred equity stake, or even a majority equity stake to monetize shareholders introduces partnership with a third-party owner. A leveraged dividend recap allows for the monetization/liquidity event, and subsequent wealth diversification, without ceding any control over company or culture to a new, outside investor.
3. Redemption of shareholders is also a common use of leveraged dividend recap proceeds especially in multi-generational companies that need a mechanism to transition ownership to the next generation without introducing non-family owners. Likewise, operating companies with a granular shareholder base may find value in distributing capital to redeem smaller shareholders that frequently have different priorities/needs. The use of debt to rationalize a disparate shareholder group is a common practice to increase control for majority owners through a relatively easy, and very cost-efficient deployment of leverage.
4. Tax planning is also a critical variable in the calculus when using leverage to diversify and transition ownership. Specifically, by increasing a company’s debt burden, a leveraged dividend recap allows owners to transfer shares at a lower valuation post-transaction. For example, the equity value of a company is decreased following a dividend recap transaction given that the new debt utilized to pay the dividend is net from the overall equity value and the per share price decreases as a result. As such, shares transfer to future owners at lower values and the potential capital gains tax to be paid when shares are ultimately sold decreases correspondingly. For legacy shareholders inclined to transfer ownership to the next generation by gifting shares through trusts, the lower valuation on the shares also decreases the potential tax burden and uses less of an individual’s lifetime gift exemption (again, please consult your tax advisor). This is what we like to call the “positive negative” of increasing leverage to decrease a company’s net equity value to realize greater long-term value through tax savings.
5. Finally, for capital-intensive companies with concentrations in long-lived assets such as real estate and fixed equipment, leaseholds, etc., a leveraged dividend recap using fee simple real estate as collateral is a great tool for unlocking capital trapped on a company’s balance sheet. In many cases, real estate values have increased over time and tend to build capital on balance sheets that may be better utilized elsewhere, such as for operating company growth initiatives or shareholder redemption. Equity capital “trapped” in long-lived assets is a significant opportunity cost for operating companies with more value-add uses of the embedded liquidity.

With respect to all of the uses referenced above, the borrowing cost associated with a dividend recap is tax deductible whether it be the interest paid or the capitalized and amortized cost to issue the new debt – an added bonus. Below is a fairly simple transaction example that illustrates the basic tax implication of a dividend recap exclusive of the benefits associated with the tax deductibility of interest and potential cap gains savings when selling or transferring ownership.

Notes:
1. Assumes an increase in the dividend tax rate from 20% or 25%. Corporate structure/basis needs to be considered. Not tax advice. Consult with your tax advisor.
2. The tax deductibility of interest costs are not included in this example.

While we outlined many benefits for privately-held entities, it’s also important to note that public companies may benefit from this strategy as well. The employment of leverage to make a one-time special dividend or fund a share repurchase is increasingly common when companies are struggling to find alternative uses for capital. In the case of a lump sum special dividend, a public company uses debt capacity to return capital directly to shareholders in the absence of acquisitive and/or organic growth opportunities. There are obvious tax consequences for a qualified dividend but, if a company’s liquidity position is strong, management teams and c-suite executives may find value in distributing capital when borrowing costs are low and capital is sitting on the balance sheet with no higher and best use. The decision to distribute capital via proceeds from debt issuance is nothing more than a math exercise that compares the relative return of trading the cost of equity capital (to be returned to shareholders) for the materially-lower cost of debt factoring in the tax impact to shareholders. Generally speaking, as is the case with privately-held companies, the cost of borrowing (interest costs) for a qualified dividend is also tax deductible for the company thereby reducing the after-tax impact of the transaction.

The use of leverage to fund a share repurchase program also has merit for some public companies. When repurchasing shares, issuers are effectively “dividending” underutilized capital, repurchasing stock with proceeds, and decreasing the number of outstanding shares. In turn, earnings are calculated on a smaller base of shares outstanding thereby effectively increasing earnings per share. Again, it’s critically important to consult a tax advisor to understand the full cost implication of borrowing to fund a share repurchase program but, in some cases, the strategy may create value for shareholders when alternative uses are few.

Why Now?
As noted above, historically low interest rates and cyclical peaks in both capital availability as well as asset values suggest that now is a perfect time to consider leverage your friend. On top of that, competition among credit providers for good quality borrowers and a limited supply of same continue to loosen credit structures.

What does this all mean? The “market” is as issuer-friendly now as we’ve seen in the past thirty years in the industry. Using leverage to diversify wealth, distribute capital, or simply lock-in terms/liquidity for future use is no longer reserved for private equity firms and other institutional investors; rather, a leveraged dividend recapitalization is a useful tool that, when deployed thoughtfully, offers borrowers an opportunity to add modest “balance sheet” risk to ultimately de-risk the company and shareholder.

Disclaimer
The contents of this publication are presented for informational purposes only by Matrix Capital Markets Group, Inc. and MCMG Capital Advisors, Inc. (“Matrix”), and nothing contained herein is an offer to sell or a solicitation to purchase any of the securities discussed. While Matrix believes the information presented in this publication is accurate, this publication is provided “AS IS” and without warranty of any kind, either expressed or implied, including, but not limited to, the implied warranty of merchantability, fitness for a particular purpose, or non‐infringement. Matrix assumes no responsibility for errors or omissions in this presentation or other documents which may be contained in, referenced, or linked to this publication. Any recipient of this publication is expressly responsible to seek out its own professional advice with respect to the information contained herein.

About Matrix Capital Markets Group, Inc.
Founded in 1988, Matrix Capital Markets Group, Inc. is an independent, advisory focused, privately-held investment bank headquartered in Richmond, VA, with an additional office in Baltimore, MD. Matrix provides merger & acquisition and financial advisory services for privately-held, private-equity owned, not-for-profit and publicly traded companies. Services include company sales, recapitalizations, capital raises of debt & equity, municipal advisory, corporate carve outs, special situations, management buyouts, corporate valuations and fairness opinions. Matrix serves clients in a wide range of industries, including automotive aftermarket, building products, business services, consumer products, convenience retail, downstream energy, healthcare and industrial products.