Cheap debt means private equity finally pays off

(updated with correction)

Private equity firms are taking advantage of low interest rates to refinance their portfolio companies, packing on debt but also providing a long-awaited payday for firms and their investors.

These deals are like a partial exit for private equity firms and their limited partners from portfolio companies, which are loaded with investments that might have been sold by now had it not been for slow economic conditions.

It's good news for limited partners because these debt transactions, called dividend recapitalizations or leveraged dividends, are providing them with much-needed cash through distributions of profits, which had been at historically low levels in recent years.

“For limited partners, there is certainly a positive impact because they are receiving cash back, and that both reduces their basis in the investment and results in a return,” said Mario L. Giannini, CEO of Hamilton Lane, a Bala Cynwyd, Pa.-based alternative investment consulting and money management firm.

In the U.S. alone, there were 77 bond and loan dividend recapitalizations by private equity firms last year valued at a combined $33.4 billion, up from 55 recapitalizations totaling $17.7 billion in 2011, according to Dealogic.

Along with the availability of cheap debt, recapitalizations are also the result of higher valuations of private equity portfolio companies, industry insiders say. Indeed, there were twice as many dividend recapitalizations in 2012 than in 2007, the year before the worldwide financial crisis.

Jessica Reed Saouaf, managing director, in San Francisco-based consulting firm, Hall Capital Partners LLC, said debt levels are rising — not as high as the peak just prior to the 2008 financial crisis, but as much as seven times earnings before interest, taxes, depreciation and amortization, up from five times in 2012.

More cash in limited partners' pockets could make it easier to step up private equity fundraising, which remained lackluster last year as investors pared their rosters of private equity general partners, Ms. Reed Saouaf said.

It took private equity firms an average of 17 months to raise a fund in 2012, up from 16.2 months in 2011, according to Preqin, a London-based alternative investment research firm. Meanwhile, capital raised by private equity funds rose slightly last year to $257.3 billion excluding funds that invest in real estate, from $254.7 billion in 2011. However, this is less than half of the capital raised— $587 billion —by private equity firms at the peak in 2007.

Part of the increase in recapitalizations could have been the result of the uncertainty surrounding the fiscal cliff and the looming possibility of tax rate increases affecting private equity executives. Some private equity firms rushed to complete dividend recapitalizations by the end of last year, said Juan Alva, partner in Los Angeles at specialty finance and business development company Fifth Street Finance Corp., which provides financing for private equity.

Lenders are also pushing these transactions because they have cleaned up their balance sheets, which had been overburdened with debt, and there were not enough mergers and acquisitions to meet their aggressive growth goals, said Gary B. Rosenbaum, partner and co-head of the finance group in the Los Angeles office of law firm McDermott Will & Emery LLP. “We've seen lenders go to private equity firms and ask if they would like to make a leveraged dividend this year,” Mr. Rosenbaum said.

Private equity firms have paid down the debt on some of their portfolio companies, Mr. Rosenbaum said. “These deals are easy to approve,” he said. “It's good for the private equity firm, which can return money to limited partners. Lenders get new assets in the form of new loans and everyone is happy as long as they don't leverage company too much.”

The key question is how much is too much leverage, Mr. Rosenbaum said. If the new loan returns leverage to the level it was before some debt was paid off, then it might go through. If the new loan raises the ratio of equity in the portfolio company to debt, then the private equity firm would most likely have to get a professional opinion from an investment bank or specialist advisory firm certifying that the company is solvent, Mr. Rosenbaum explained.

At the end of 2012, there were a number of dividend recapitalizations that were pushed at “warp speed” so they could be completed by year's end. Along with beating possible tax increases and the fiscal cliff uncertainty, a big motivating factor was private equity firms returning money to investors, he said. Distributions did increase in the fourth quarter of 2012; most likely much of it was the result of dividend recapitalizations, Hamilton Lane's Mr. Giannini said.

For example, the $16.1 billion New Mexico State Investment Council, Santa Fe, received $362.3 million in private equity distributions in 2012, up from $274.6 million in distributions the year before, according to data provided by Charles Wollmann, director of communications for the $16.1 billion council.

Low interest rates allow portfolio companies to incur more debt and still have healthy interest coverage ratios, which is a measure of how easily a company can pay the interest on its debt, Mr. Giannini explained. What's more, many of the companies that engaged in recapitalizations performed well in the past three or four years and have paid debt down during that time, he said.

“Many of them are taking on debt and paying dividends and ending up with balance sheets that are still less levered than they were at the time the company was acquired,” Mr. Giannini said. “So, in many cases, it's a healthy company that's done well and that is in a strong position to pay its shareholders some dividends and still have a solid balance sheet.”

Indeed, much of the companies that are being recapitalized are fairly recent purchases, Mr. Rosenbaum noted. Some firms were the targets of leveraged buyouts within a year but the company had turned around since the private equity firm's investment, he said. “The rest of the deals are not old and cold deals. They are deals within the last couple of years that have positive stories to tell,” he said.