Uptick in Dividend Recaps – Reduce the Risk
Current interest rates remain at historically low levels, even for already leveraged companies and firms with higher-risk credit profiles. This has led to record amounts of recent debt financing activity. An increasing number of borrowers are feeding off investor demand for higher yields, as the Fed keeps its benchmark interest rates at near zero for a fifth straight year. Many of these financings are being completed to pay a special dividend to equity owners, often referred to as a dividend recapitalization (or “Dividend Recap”). Simply stated, Dividend Recaps provide immediate cash to equity-holders by adding leverage to a company’s capital structure. Most Dividend Recaps are also achieving reduced interest rates on refinanced debt and relaxed lender covenants.
There has been a substantial uptick this year in debt capital raises and Dividend Recap activityas companies take advantage of low interest rates, as well as aggressive funding source availability. For example, private-equity firms have been financing loans through their portfolio companies to pay dividends at a pace trumping even periods prior to the recent financial crisis. According to S&P Capital IQ Leveraged Commentary & Data, majority PE-owned borrowers are estimated to have raised a record $11.5 billion in May through Dividend Recaps, compared to $3.6 billion in April. Roughly $33 billion in Dividend Recaps have been completed in 2014 year to date, per S&P Capital IQ estimates.
Leverage, or the ratio of debt to EBITDA, for speculative-grade U.S. borrowers tracked by S&P Capital IQ LC&D increased to 4.8x in May, up from 4.1x in April and from a post-crisis low of 3.5x observed in February of 2009. “Demand for loans has been very strong this year and hence the ability to get dividend deals done,” said Adam Richmond, a credit strategist at Morgan Stanley, in an interview with Bloomberg. “The cost of debt is cheap making it an optimal time for companies to issue debt.” Richmond went on to state that, “from a timing perspective, there may be incentives to get debt deals done now…ahead of any tapering of bond purchases by the Fed, which could lead to rising rates.”
However, with increased leverage comes risk. If a company cannot pay its debts and becomes insolvent, on top of the obvious financial risks stemming from default and bankruptcy, creditors’ interests can be challenged as a fraudulent conveyance. A finding of fraudulent conveyance can result in the reversal, or unwinding, of an entire deal, potentially causing significant losses to the parties and at a minimum, extensive litigation. By their structure, leveraged transactions extend the opportunity for creditors to present a legal challenge to the solvency of the borrower years after a deal closes. However, for a fraudulent conveyance claim to succeed, the courts must rule that the transaction was not consummated at “reasonably equivalent value.” Requirements for this finding include insolvency of the borrower, inability to pay debts as they mature, or inadequate capital to fund operations.
A debt financing or leveraged transaction challenges the ability of the post-transaction firm to generate sufficient cash flow to service debts and continue operations as a going-concern. Any leveraged transaction, such as a Dividend Recap, burdens the surviving entity with financial obligations that could threaten the viability of the company. However, tests of solvency have been developed to assess a firm’s ability to fulfill proposed financial obligations, service its debts, and maintain its operations post-transaction.
Due to fraudulent conveyance concerns in a leveraged transaction, such as a Dividend Recap, best practice calls for stakeholders, such as new lenders, selling parties, and/or directors, to seek anindependent solvency opinion with respect to the impact of new debt on a potential borrower’s projected cash flows, proposed covenants, as well as estimated equity value.
Analyses that Delaware and other courts consistently rely upon to assess issues of solvency include:
- Balance Sheet Test
- Cash Flow Test
- Capital Adequacy Test
- Capital Surplus Analysis
Houlihan Capital can provide critical valuation information to interested parties in a leveraged transaction by rendering an independent solvency opinion, which can reduce risk and uncertainty by providing guidance and potential safeguards to a borrower’s Board, investors, and other stakeholders. Houlihan Capital provides clients with independent valuations and has a history of working closely with its clients’ management, investors, legal counsel, regulators, and auditors on matters of borrower solvency. For further information regarding independent valuation services, including solvency opinions, please visit www.houlihancapital.com or contact Paul Clark (pclark@houlihancapital.com) at 312-450-8656.
Houlihan Capital is a leading, solutions-driven valuation, financial advisory, and boutique investment banking firm committed to delivering superior client value and thought leadership in an ever-changing landscape. The firm has extensive experience in providing fairness and solvency opinions, and objective, independent, and defensible opinions of value that meet accounting and regulatory requirements. Our clients include some of the largest asset managers, private equity funds, hedge funds, fund administrators, and both public and private operating companies, who benefit from our comprehensive valuation and financial advisory services. Houlihan Capital is a Financial Industry Regulatory Authority (FINRA) and SIPC member, and is SOC-compliant. In short: Value. Added.
