Saturday, March 17, 2012

Squeezing the leverage lemon to pay out dividend

Imagine you run a private equity firm. Your fund owns a bunch of companies, some of which are doing well. They are not growing rapidly, but revenues are steady. You've called for investor capital a few years back and now it's time to start returning capital back to investors. After all you won't make your incentive fee until you return the principal back to investors plus some minimum return on top of that.

In the good old days, you IPO the companies as your exit strategy. Sometimes you sell your portfolio companies to a strategic investor - another company that wants to do an acquisition. Once in a while you would sell one of your companies to another private equity firm. And you collect all those great fees (that's how Mitt Romney for example made his money). But these days life is much tougher for private equity managers (maybe that's why some of them go into politics). Except for recent private equity IPOs of Allison Transmission and Roundy’s, the IPO market has been closed for firms that don't have tremendous growth opportunities.

But there is another way to get paid. You have your portfolio companies borrow money and pay you a big dividend. It's not exactly great for these companies because they will be saddled with more debt, but it helps the private equity manager return some cash to investors. Private equity returns are measured using the Internal Rate of Return (IRR) methodology. The sooner the cash starts returning to investors the higher the IRR. The fact that it leaves the companies with more leverage, is a secondary issue.

Of course in this shaky economic growth there is a limit to how much leverage these companies can be saddled with. One reason is that increasing leverage hurts the current bond holders and there are often limitations on how much cash can be distributed back to the equity holders. Another reason is that if economic conditions worsen and the revenues take a dive, the company's leverage may increase further, potentially risking default. In the recent dividend distributions private equity firms tended to cap leverage at 4-4.5x. In 2010 a number of companies had been so deleveraged, it allowed private equity firms to take big chunks of cash out and still keep the leverage under 4x. These days, there aren't as many portfolio companies which can be levered much more than they already are. That limits how much cash private equity firms can extract via adding more debt. The chart below from LDC shows leverage before and after the dividend payout. This year the gap between pre and post dividend has narrowed.

The leveraged finance markets have been quite receptive to new debt deals this year as funds continue to flow into HY funds. It allowed private equity firms to squeeze some cash out of their portfolio companies without selling them. But even these hot HY markets are suspicious of deals used to finance dividends particularly those paid to private equity firms. A number of dividend deals got done in 2010 and 2011, often using leveraged loans for companies that were have deleveraged. But it is tougher now since there are not as many firms that could add materially more debt without running into covenant issues or risking becoming too levered. The "low hanging" fruit is gone.

Going forward private equity firms will be looking for strategic acquisitions, IPOs, or hoping the revenue picks up enough to allow them to add more debt and milk these firms for more dividends. That dearth of exit opportunities and limitations on further dividend will cap fee income for private equity firms. As an example, over the past year Blackstone has underperformed the overall market by close to 20%.

As long as HY markets remain open and the economy and the companies' revenue is growing, these dividend financing deals will continue. But should the economy begin to struggle, forcing more debt on already leveraged companies in order to pay the owners or buy back stock will quickly come to an end.
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