Ratings

If a company acquired by a private equity firm is able to spin off enough cash, it can afford the expensive debt that pays for dividend recaps. "If all goes as planned, the bank loans or bonds will be repaid in full and on time," said Mr. Bavaria. "And the company can still be taken public later on or sold privately—sometimes even to yet another private equity fund—adding to the sponsor's profits." Such is the allure of quick money—sometimes within a year or two of a company being taken private—that dozens of these deals, both in the U.S. and Europe, have been completed or are underway just since the beginning of 2006.

These transactions can happen rapidly. A private equity group consisting of Clayton, Dubilier & Rice, The Carlyle Group, and Merrill Lynch Global Private Equity acquired Hertz Corp., which was formerly owned by Ford Motor Co., in December 2005. Approximately six months later, the new owners extracted a dividend of $1 billion—close to half their original cash investment—funded by bank debt. We believe that such a transaction will weaken Hertz's financial profile, although we haven't yet determined to what extent, and we haven't yet revised its rating. With borrowed money still relatively cheap, however, few investors are openly resisting the chance to purchase loans that can yield substantially more than many other debt instruments—anywhere from two to five percentage points higher than the benchmark three-month LIBOR rate.

While dividend recapitalization plans aren't new, their popularity has expanded dramatically in the past three years. "There has been a recent increase in the number of paydays for a variety of reasons, some related to the sponsors and their responsibilities to investors and some related to individual company circumstances, such as expected future operating performance," said Mr. Kaplan. "The timing is also related to conditions in the debt and equity markets: Debt markets are more receptive to speculative-grade issuers than they have been in the past, and equity markets are not currently available to all issuers." (See chart.)

A few years ago, the game plan for a private equity firm buying the shares in a target company was relatively straightforward: Acquire the company, cut the fat, improve operations, and make a profit by taking it public again. But in 2002 and 2003, the weak market for IPOs made this difficult. Throughout the entire world, IPO activity in the first quarter of 2003 totaled only $4 billion, with 171 deals, according to Big Four accounting firm Ernst & Young. The next quarter was little better, with $7 billion raised for 130 deals. That left the private equity owners without a reliably quick exit strategy.

But one mechanism to fill the void the lackluster IPO market created was the dividend recap. And they've kept filling it even as IPO activity rebounded in the last quarter of 2005. In the first half of 2006, the IPO market has been relatively healthy, with 580 deals worldwide worth about $97 billion, according to Investment Dealers' Digest. Yet with interest rates still relatively low and private equity groups in possession of a proven model to extract cash from sponsored companies, dividend recaps remain an attractive option for private equity investors.

So what could go wrong? Plenty, as it turns out. Standard & Poor's believes that these deals can potentially erode a company's credit quality. Many businesses involved in dividend recaps—and most often they're midsize to smaller companies—have subsequently seen their ratings drop even further. Lower ratings are, of course, indicators of a higher risk of default. A company whose loans rated 'BBB' might default at a 2%-3% rate. But that rate rises to about 10% for 'BB' rated paper, and higher for lower ratings.

Dividend recap deals can unravel, despite the best-laid plans of their sponsors, if a company's business risk suddenly changes and it cannot afford the debt payments necessary to sustain the leverage it has incurred. And because the bank debt that funds dividend recaps often carries a floating interest rate, higher interest payments are a risk if rates rise.

The size of the dividend isn't necessarily limited by the size of the loan, with some companies paying out even more than they borrow. In addition, some companies undergo multiple dividend recaps. A recent Standard & Poor's analysis of loan recovery ratings found that recaps with larger dividend payouts are clearly more likely to have lower recovery ratings than those with smaller payouts (see "Recovery Ratings Illustrate The Temptation Of Leverage In A Highly Liquid Loan Market" published April 24, 2006, on RatingsDirect).

The temptation to load up on debt is exacerbated by the fact that dividend recaps can be planned and carried out quickly—sometimes within a matter of days. "They're sometimes called 'drive-bys' because they can be that opportunistic," said Standard & Poor's credit analyst Sucheet Gupte. "If the market opens up and the company can push something through, they will. Bankers are pretty aware of this. Sometimes it's not the company but the banker who pushes for it."

Some dividend recap deals also contain a particular type of potential financial time bomb known as payment-in-kind (PIK) debt. Although PIK debt comes in several varieties, in its simplest form this type of financing essentially pays interest with an IOU—more bonds—instead of cash. Those IOUs are then added to the initial principal, increasing the total debt load. PIK financing isn't limited to companies undertaking dividend recaps, but it's symptomatic of some companies carrying a heavy debt burden or those requiring greater financial flexibility because they face significant business uncertainty.

In most instances, however, a point comes when all that paper must be redeemed for cash. If a company doesn't have it, can't refinance, or can't be sold, the enterprise might wind up in serious trouble. Without careful financial management, dividend recaps using PIK financing could be disastrous.

Some private equity owners using PIK financing, however, have so far avoided the worst-case scenarios. PIK financing was part of the large 2004 dividend recap at Warner Music Group (WMG), which had been sold by Time Warner Inc. to a private equity group. Subsequently, the big music company paid its investors $700 million, part of which came from $450 million in PIK and discount notes that mature 10 years after the deal. We originally assigned WMG a stable outlook after its LBO in March 2004—an outlook that withstood a $300 million special dividend in October 2004. However, the bumper dividend of roughly $700 million in December 2004 and its accompanying debt prompted us to revise the outlook to negative. Now, even after an IPO in 2005, after which we reinstated a stable outlook, we remain concerned about management's financial policies as well as its on-and-off merger discussions with EMI Group PLC.

This type of uncertainty is a fear that hangs over many companies that have done dividend recaps with PIK financing. "What's going to happen when the bell tolls?" asked Christopher Donnelly, vice president of Standard & Poor's Leveraged Commentary & Data Group (LCD). "A certain amount of PIK debt used for dividend recap deals is going to flip to cash pay or become callable in the next few years. This is something to keep an eye on."

Since late last year and into 2006, the vast majority of dividend recap deals have been financed with bank loans. According to LCD, there were 63 bank loan recap financings totaling $24.1 billion in bank debt, compared to bond issues totaling $1.3 billion from the beginning of 2006 through June 9. Because the banks that write these loans profit from the fees but rarely hold onto all the debt, the risk is dispersed. Thus, we think it's unlikely that massive defaults on these loans would affect the banking sector the way they might have years ago, before bankers routinely syndicated many loans.

"Increasingly, equity firms have resorted to bank loans rather than bonds for their dividend recapitalizations," said Mr. Bavaria. The market for bank loans has been strong in recent months, and bankers are happy to make loans because the fee income is an important source of revenue. These bankers can then offset the risk by quickly selling off the loans. In Europe approximately half of those loans are sold to institutional investors, while the remaining half are kept by banks, though not necessarily the banks that originated the loans.

Why are loans preferred for these deals?

• Better rates: Loans in these deals will generally have floating interest rates instead of the fixed interest rates of high-yield bonds. Typically, they reset every three months. If companies believe, as many now do, that interest rates are near a peak, they'll prefer floating rates instead of bonds that might lock in higher rates for as long as 10 years.
• Few prepayment penalties: Most bonds have some call provision. If the debt is retired early, then there is an additional payment. Bank loans for these deals, however, are generally written with negligible prepayment penalties.
• Easier terms: Loans can and often are renegotiated. It's significantly more difficult to rewrite the terms and covenants of a bond issue.

"The thing to remember about bank loans is that they are free payable debt at par," said Mr. Donnelly. "That means a sponsor can structure a bigger transaction to supercede what they have already done and pay off the first loan and issue a dividend to themselves," he added. "The only cost to the issuer sponsor is the amount of fees that they will pay to arrange a new deal."

Because bank loans can be arranged quickly, some companies can do multiple dividend recaps, with equity owners taking out several dividends within the space of less than a year—all funded by banks eager to lend and then sell off the loans. "It is all a sign of how frothy the market is right now," said Mr. Bavaria. "They are definitely pushing the envelope. We'll have to see if and when the market will push back."

So far investors still have an appetite for the loans that finance these deals, and their default rate so far appears relatively low. Between 1995 and 2003, LCD tracked 52 recap deals for private-equity-backed sponsors that were financed with institutional loans. Of these, three of them, or 6%, defaulted. During the same period, LCD tracked 158 LBO loans with institutional tranches. Of these, 18 of them, or 11%, defaulted. Standard & Poor's expects that by mid-2007, more data will be available on how well loans connected with dividend recaps are performing.

Private equity sponsors are having increasing influence on credit quality as the allure of quick money paves the way for more dividend recaps. "While a particular corporate sector may not be ripe now for buyouts and subsequent dividend recaps, private equity sponsors will always have an eye out for the next target," says Mr. Gupte. "The predominance of private equity money is raising the stakes in this game because these firms' strategies can lead to deteriorating credit quality."

Writers: Robert McNatt and Frank Benassi