PRIVATE EQUITY FIRMS BORROW TO PAY THEMSELVES DIVIDENDS: “BUDDY, CAN YOU SPARE ME A (BILLION OR SO)”?

8/7/13

One of the latest crazes among private equity investors is, as it has been from time to time since the advent of the leveraged buyout (“LBO”) and junk financing, to have the companies they own borrow more money to pay dividends to their owners, i.e., the private equity investors.  This, of course, not only returns cash to the private equity investors but reduces their net investments in the firms they own, reducing their downside and enhancing, at least on a percentage basis, their upside.

As I intimated in the first sentence, this is nothing new.   Even back in the bygone days of the ‘80s and early ‘90s, when I was a professional investor in junk bonds, what we then called LBO firms, but which since have acquired the seemingly more respectable moniker of “private equity firms,” borrowed money against the firms they controlled to pay themselves dividends.  The catalyst for the current bout of such activity was the sudden uptick in interest rates of the last few months, from which junk bonds certainly did not escape.  Private equity firms adopted a “last chance” mentality, rushing to borrow money while it was still relatively cheap but perhaps headed much higher.

A natural reaction to private equity guys saddling the companies they own with more debt in order to make themselves, and their clients, even wealthier is abhorrence.  Yours truly has to admit that was my first reaction.  But upon a few seconds of reflection, a far less sinister motive can be ascribed to borrowing money relatively cheaply to pay one’s self a dividend. 

Such activity is a simple financial restructuring, a decision on the part of a firm’s owners to employ more debt, relative to equity, in the firm’s capital structure in response to a change in the cost of that debt and, perhaps, in the cost of the firm’s equity.   When debt is cheap relative to equity, it makes sense to employ a capital structure more heavily weighted toward debt.   Doing so reduces a firm’s overall cost of capital.  This is straight out of the financial management courses that I teach at NIU, Columbia College, and Elmhurst College and that thousands of my colleagues teach at universities and colleges throughout the world.  Of course, I have to stifle my debtaphobic instincts when teaching this concept, but it remains one of the basic principles of financial management.

That having been said, if I were still running junk bond funds, would I be buying debt issued to pay the owners a dividend, further levering up an already highly leveraged balance sheet, and thus increasing a firm’s financial risk?   While it would depend on the circumstances, the most important of which are the existing level of debt at the issuer, the borrower’s ability to generate cash on an ongoing basis, and a logical exit strategy for the buyout firm, my inclination would be to pass on such deals.  In other words, all things being, my inclination would be to avoid deals in which the use of funds is to pay the owners a dividend, even if such a recapitalization might make sense from a pure cost of capital point of view.