Dividend Recapitalisation: a Worked Example

A private equity fund that bought a business with debt and equity will usually have paid the debt down from cash flow, while earnings grew. A few years in, the business could carry its original borrowing again. A recap borrows that capacity back and pays it to the owners as a dividend or as repayment of their shareholder loans. The fund returns money to its own investors without selling, which improves its reported returns and reduces what it has at stake.

Owner-managed businesses do the same on a smaller scale, often to buy out a retiring shareholder or pay a long-deferred dividend. The mechanics and the lender's reading are the same; only the sums and the documents differ.

The business gains no asset. Its earnings, customers and plant are what they were the day before. Everything that changes is on the other side of the balance sheet: more debt, less equity, a higher interest bill and a longer road to repayment. A lender therefore reads four numbers before and after, and asks which way each moved.

The last is the one a recap most directly attacks. Every dollar paid to the owners is a dollar of their equity that no longer stands between the lender and a loss.

A sponsor-backed maker of commercial roofing membranes, constructed for this page like every figure in it, earns EBITDA of US$18m. Bought four years ago, it has paid its debt down to US$36m. The sponsor proposes a new US$72m term loan: US$36m to repay the old debt, US$2m of fees, and US$34m to the owners. Capex and tax each take US$3m a year (tax is held flat for simplicity, though the larger interest bill would trim it), the interest rate is 8%, and the business is valued at eight times EBITDA. All of these are the example's, not a market norm.

Leverage doubles, but the line that moves most is repayment: from under four years to over eleven, because the extra interest comes out of the same cash that would have repaid the loan. The new lender is not being asked to fund a riskier business. It is being asked to lend into a structure where half the value is debt and the debt will mostly be refinanced, not repaid.

Of the US$34m, suppose US$14m repays loans the sponsor made to the company at purchase and US$20m is a dividend. Repaying a shareholder loan is repaying a creditor. The dividend is a distribution, and each market tests it differently.

In New Zealand, the board must be satisfied on reasonable grounds that the company will meet the solvency test immediately afterwards, able to pay its debts as they fall due and with assets exceeding liabilities, and the directors who vote for it sign a certificate. In Australia, a dividend needs assets exceeding liabilities by enough to pay it, must be fair and reasonable to shareholders as a whole, and must not materially prejudice the company's ability to pay its creditors. In the UK, a company may distribute only accumulated realised profits less realised losses; borrowing creates none, so the paying company, often a holding company whose profits come from its subsidiaries' dividends, must have US$20m of distributable profits of its own. Meeting that rule is not the end of it: the UK Supreme Court held in 2022 ([2022] UKSC 25) that directors deciding on an otherwise lawful dividend must consider creditors' interests once the company is insolvent or bordering on it, or an insolvent liquidation or administration is probable.

A dividend paid in breach of these rules can be recovered from shareholders in some circumstances, and directors who authorised it can be liable. A lender that funds one reads the directors' certificate or board paper as closely as the model.

DEFINED IN ONE PARAGRAPH → · DEBT TO EBITDA → · LOAN TO ENTERPRISE VALUE →

The existing lenders meet a recap first in the documents. A restricted payments covenant and its permitted baskets decide whether the business may pay anything to its owners at all, and a recap usually needs either a refinancing or the lenders' consent. A lender asked to consent reads it as new lending, because it is: more debt against the same earnings, with the owners' cushion reduced.

The opposite transaction is the useful contrast. A debt-for-equity swap recapitalises a business in trouble by cutting its debt; a recap adds debt to a business doing well. The reading that matters is whether it will still be doing well when the larger loan falls due, because the money that would have absorbed a bad year has already been paid out.

SPONSOR-BACKED LENDING → · REFINANCING A BUSINESS LOAN →