In a slow economy, with low interest rates, private equity firms are adding debt to the companies they own in order to create returns for investors. This controversial practice is now reaching record pace. The resurgence is due to investors’ desires of achieving high yielding debt at a time of historically low interest rates. Some of the most prominent private equity firms, such as Leonard Green & Partners LP, Bain Capital LLC, and the Carlyle Group LP are a few of the firms using this tactic, which became popular before the financial crisis. Between 2003 and 2008, companies borrowed $69 billion primarily to pay dividends to private-equity owners, according to Standard & Poor’s Corp. That compares with $10 billion in the previous six years.
“In these deals, known as ‘dividend recapitalizations,’ private-equity-owned companies raise cash by issuing debt. The proceeds are distributed in the form of dividends to buyout groups. In other words, private equity firms are creating returns for their shareholders by leveraging the companies that they own. This financing method allows the private equity fund to recoup part, if not all, of the fund’s initial investment and leaves open the possibility of benefiting from any future increase in value, since no sale transaction occurs. Despite the creation of high returns for shareholders, this trend of dividend recapitalization may prove to be extremely costly to a recovering economy.
First, many private equity funds, especially the mid-sized and smaller funds, are likely to feel pressure to sell off portfolio companies to create liquidity for their investors and build a track record that will support future fund raising efforts. Although the main goal for private equity firms is to create returns for investors, this is not the way that private equity firms traditionally went about fulfilling that goal. In the traditional sense, multiple parties with diverging interest potentially benefited from private equity firms taking over a struggling company. A struggling company would be made profitable through changes made by the private equity firm, and the private equity firm would sell the company once they thought they could get a return on their investment. With “dividend recapitalization,” the only party that benefits is the stockholders. They are getting paid, but the companies that the private equity firm owns are not any better off. In many cases they are worse off, as private equity firms may be unwisely leveraging the companies they own.
Second, through dividend recapitalizations, private equity funds maintain high leverage on portfolio companies capable of paying down their debt, thereby maintaining risk of insolvency. In times of economic uncertainty, it does not seem like a wise move to create unnecessary debt. One has to wonder what would be the consequence if some of these companies started going bankrupt. It all probably depends on how greedy the private equity firms are. There is one thing that will probably keep them in check, their public image. Leonard Green & Partners LP, Bain Capital LLC, and the Carlyle Group LP do not want to be known as the people who shut down American companies.
______________________________ Ryan Dezember & Matt Wirz, Debt Fuels a Dividend Boom, Wall St. J., Oct. 18, 2012, (http://online.wsj.com/article/SB10000872396390444592704578064672995070116.html?mod=WSJ_Markets_LEFTTopStories)  Id.  Id.  Louis S. Freeman, General Overview And Strategies In Representing Sellers, 825 PLI/Tax 7  Id.  Dezember & Wirst, supra note 1.  Alan S. Gutterman, et al., Review of Major Developments Affecting Mergers, Acquisitions and Divestitures, 28 No. 12 Corp Acq Ideas 1  Louis S. Freeman, General Overview And Strategies In Representing Sellers, 825 PLI/Tax 7  Id.