The Dodd-Frank Act was enacted on July 21, 2010 after intense debate within the investment banking industry and the political realm in Washington D.C. to address the consequences of the “Lehman Shock” and other lessons learned from the 2008 financial crisis that affected the world economy.1 One area that congress did not consider in depth…
Tag: Private Equity
Investment Plus What? Sun Capital and the “Investment Plus” Standard
Earlier this year, the First Circuit Court of Appeals delivered its opinion in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund1, overturning a lower court’s decision and sending lawyers in the private equity industry scrambling to make sense of it.2 In short, Chief Judge Lynch’s opinion held that, in…
Double Bottom-Line Investing, In Brief
The first bottom-line in any investment is obvious: market-rates of return for banks, pension funds, foundations, and other financial investors.1 The second bottom-line consists of social or environmental returns.2 This can be realized in the form of job creation, community revitalization, or energy conservation, among others.3 As a growing number of investors express a desire…
What is in a Name? Private Equity Industry Considers Label Change
Entering 2012, expectations were high for the private equity industry. Firms were finally recovering from the 2008 financial meltdown and private equity executives were confident that transactions would only continue to increase.[1] To top it off, one of the field’s very own had a legitimate chance to become our nation’s next president. Despite this favorable outlook, 2012 resulted in such damage to private equity’s image that some are now insisting the industry needs a complete rebranding.[2]
While the private equity industry has shouldered the blame for economic problems in the past, public criticism rose to unprecedented levels in the past year. The most widespread vilification occurred during the presidential election, when both Democrat and Republican rivals of candidate Mitt Romney spent millions attacking his private equity background.[3] Around the same time, a federal class action was filed accusing some of the nation’s largest private equity firms of a wide conspiracy to rig deal prices.[4] Considering the very negative popular conception of private equity following these events, it was not surprising when the Security and Exchange Commission’s enforcement division continued the assault by announcing that a regulatory heavy-hand would soon be coming down on the industry.[5]
Historically, private equity firms have not found this type of publicity overly concerning. They have had little need or incentive to uphold their image because they have operated completely in the private sector.[6] However, with many of the big firms going public in recent years, high-level private equity executives now believe that the industry must be “widely trusted” and maintain a “pristine reputation.” [7]
Looking to save face, some private equity practitioners have proposed rethinking the name “private equity.”[8] Blackstone Group President Tony James dislikes the label’s clandestine connotation and feels that it “subliminally sends the wrong message.”[9] Others argue for change by citing the fact that the industry is no longer truly “private,” as it is now regulated by government agencies.[10]
The corporate world has seen this type of makeover before. In the 1980s, “corporate raiders” became symbols of Wall Street greed for their tendency to conduct hostile takeovers of large companies. When legal countermeasures were put into place to thwart these attacks, corporate raiders revised their approach and adopted a more politically correct name: “activist shareholders.”[11] Since the re-characterization, activist shareholders have enjoyed success despite continuing to shake up companies like the corporate raiders before them.[12]
But still, in order for a name change to work, the industry must settle on an appropriate moniker. Noting how Blackstone provides its limited partners with widespread access to its portfolio companies’ financials, James suggests that the name should be changed to “clarity equity.”[13] Other ideas such as “ long term capital providers” and “opportunity capital” suggest positivity and communicate an actual function of these firms.[14]
While altering a label has helped groups repair their image in the past, it is a difficult process that is by no means guaranteed to succeed. An effective approach would supplement the name change with an effort to better educate the public on the benefits of the industry. Regardless of what these investors call themselves, their increasingly important reputation is unlikely to improve significantly unless they first make some attempt to eliminate the negativity surrounding the term “private equity.”
____________________________________________________________
[1] Hillary Canada, Survey Says: Glass-Half-Full Outlook For 1H 2012, Wall Street Journal Private Equity Beat (May 1, 2012, 7:08 PM), http://blogs.wsj.com/privateequity/2012/05/01/survey-says-glass-half-full-outlook-for-1h-2012/.
[2] William Alden, Rethinking the Term ‘Private Equity’, New York Times Dealbook (Jan. 31, 2013, 1:41 PM), http://dealbook.nytimes.com/2013/01/31/rethinking-the-term-private-equity/; Shasha Dai, Should Private Equity Industry Change Its Name?, Wall Street Journal Private Equity Beat (Feb. 1, 2013, 3:35 PM), http://blogs.wsj.com/privateequity/2013/02/01/should-private-equity-industry-change-its-name/.
[3] Tomio Geron, The Mitt Romney Effect on Private Equity and Venture Capital, Forbes (Sept. 21, 2012), http://www.forbes.com/sites/tomiogeron/2012/09/21/the-mitt-romney-effect-on-private-equity-and-venture-capital/.
[4] Don Jeffrey & Devin Banerjee, Blackstone, KKR, Bain, Accused of Agreeing Not to Compete, Bloomberg (Oct. 11, 2012), http://www.bloomberg.com/news/2012-10-10/investors-claim-kkr-told-equity-firms-not-to-bid-for-hca.html.
[5] See Bruce Karpati, Chief, SEC Enforcement Division’s Asset Management Unit, Private Equity Enforcement Concerns at Private Equity International Conference (Jan. 23, 2013) (transcript available at http://www.sec.gov/news/speech/2013/spch012313bk.htm).
[6] D.M. Levine, Carlyle and Oaktree Are Latest Private Equity Firms Expected to Go Public, The Huffington Post (Apr. 11, 2012), http://www.huffingtonpost.com/2012/04/11/private-equity-firms-go-public_n_1417734.html public_n_1417734.html.
[7] Alden, supra note 2.
[8] Id.; Dai, supra note 2.
[9] Dai, supra note 2.
[10] See id.
[11] Bob Moon, Corporate Raiders Morph Into Nice(r) Guys, American Public Media Marketplace (Nov. 26, 2012), http://www.marketplace.org/topics/business/corporate-raiders-morph-nicer-guys.
[12] See id.
[13] Dai, supra note 2.
[14] See id.
Private Equity and the Leveraged Buyout: Taking a Public Company Private
What is a Leveraged buyout?
A leveraged buyout (LBO) is a form of a business acquisition. However, it differs from an ordinary merger and acquisition (M&A) deal in many ways. First, the acquirer in an LBO is not a traditional corporation as in other acquisitions. Instead, the acquirer is a newly formed non-operating company, made up of the private equity firm and often the party who will manage the daily activities of the business.
Additionally, LBO’s are heavily debt financed, often with as little as 10 to 20% of the purchase price coming from equity investment.[1] In order to secure the large amount of debt necessary to complete the deal, the non-operating company is forced to borrow against the physical assets of the acquired business.[2]
Once the terms of the LBO are agreed to, current shareholders will be compensated with an agreed upon per share price and the ownership will be transferred to the non-operating company (the private equity firm and all other investors).
Why take a company private through an LBO?
Private equity firms are motivated to take the targeted company private in order to unlock potential synergy gains[3]. These synergy gains might come from financial restructuring, change in control, or increased coordination in decision-making.[4]
Firms often create synergy gains through financial restructuring. As discussed before, leveraged buyouts involve heavy debt financing. Debt has a tax benefit not available from equity investment, in that the interest owed on current outstanding debt decreases taxable income, resulting in higher cash flow available to all stakeholders.[5] In other words, debt creates a tax-shield equal to current interest expense multiplied by the effective tax rate.[6] Therefore, increasing the amount of debt within the financial structure of the firm can create value.
Additionally, Private equity firms often look to unlock synergy gains by eliminating the waste associated with inefficient management. By taking the company private, the firm no longer has to seek shareholder approval of management, but instead, can self select the new leadership team.[7] The idea is that the new management team will make better business decisions, increasing revenues and decreasing the associated costs.
Moreover, even if current management is efficiently running the company, there are coordination advantages from taking a company private. Public companies face a folly A/folly B problem. The company wants long-term success. In other words, it wants to make investments that result in the greatest net present value in the long run. However, companies have to respond to shareholders, who reward short-term performance, which results in increased stock price, over long term performance.
By taking the company private, management has flexibility in its decision-making and can focus on long-term performance without having to worry about shareholder repercussions. Also, public companies are often slow to act because there is a shareholder coordination problem. The company must provide information on major changes to all shareholders and must convince owners of a majority of the shares to vote collectively. By taking the company private, ownership is concentrated in a few individuals/entities who can act swiftly.
The potential downside of an LBO
While there are certainly numerous potential sources of synergy gains associated with an LBO, the form of acquisition is not without its risks. When levering a company to such a high debt to equity (D/E) ratio, the company must be able to produce enough cash flow to make its periodic interest payments on the outstanding debt. As a result, the risk of bankruptcy increases and the possibility of receiving the tax shield decreases. Additionally, banks will require higher returns to compensate for the risk associated with the debt. Therefore, private equity firms partaking in LBOs are continuously confronting the issue of how much leverage to implement in the deal.
Additionally, in an LBO, there is a constant conflict between shareholders and bondholders. Shareholders are incentivized to take risk, whereas bondholders prefer sound investments that will allow the company to pay back its debt. Therefore, when securing debt, private equity firms might lose some financial flexibility due to bank-imposed constraints on spending. If not managed properly this can counteract some of the benefits associated with making the move to a private company.
Lastly, by taking a company private, the investors lose access to a liquid market. As a result, it may take longer to recoup the investment. Research has indicated that the median LBO is still in private equity ownership around 9 years after the initial buyout transaction.[8]
Who is a good LBO target?
Given the potential risks associated with an LBO transaction, private equity firms must be careful when deciding whom to target. Private equity firms should look at targets from a three-value driver perspective: leverage, change in control and private-public.[9] The ideal target should be underlevered, inefficiently managed, and should be incurring large costs from staying public.[10] Additionally, companies with large assets and stable free cash-flows (cash cows) can support more debt, making them an attractive target. At the same time, private equity firms want to avoid using an LBO to purchase companies in highly cyclical industries and industries with rapid product obsolescence.[11] Companies in these industries are prone to periods of low to negative free cash-flows, which in turn increases the probability that they will be unable to meet their debts as they come due.
Summary
LBO’s are a form of private equity acquisition, in which the investors form a non-operating company and purchase a public company by implementing primarily debt financing. Taking a public company private can create gains in a multitude of ways, including increased tax shield free cash flows, elimination of inefficient management, and increased coordination of decision making. At the same time, there are many risks associated with an LBO. The risk of bankruptcy increases immensely, resulting in higher lending rates and loss of some financial flexibility. Consequently, private equity firms must be strategic about when to implement an LBO acquisition and realize that it is not always the proper tool.
__________________________________________________________
[1] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013); Note on Leveraged Buyouts. Center For Private Equity and Entrepreneurship at 1, available at http://pages.stern.nyu.edu/~igiddy/LBO_Note.pdf.
[2] Steven N. Kaplan & Per Stromberg, Leveraged Buyouts and Private Equity, Journal of Economic Perspectives, American Economic Association 23(1), 2009.
[3] Here, synergy gain is a proxy for a long term financial benefit
[4] See Note on Leveraged Buyouts at 2.
[5] Grant Houston, Tax Advantages of a Leveraged Buyout, Chron, http://smallbusiness.chron.com/tax-advantages-leveraged-buyout-24006.html
[6] See id.
[7] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013).
[8] See Kaplan, supra note 2, at 130.
[9] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013).
[10] Id.
[11] Id..
Private Equity Firms Accused of Misleading Buyer
Japanese beer and beverage maker Asahi Group has filed a lawsuit in Australia against two private equity firms who sold Asahi a liquor company for $1.3 billion USD. The suit claims that Australian-based Pacific Equity Partners and Hong Kong-based Unitas Capital—the previous owners of New Zealand’s Independent Liquor—presented inflated earnings figures during the sales process.[1] As a result of this “misleading and deceptive conduct,” Asahi feels that it grossly overpaid for the premixed cocktail distributor and that it deserves compensation.[2]
At the heart of Asahi’s complaint is the allegation that Independent Liquor’s earnings before interest, tax, depreciation, and amortization (EBITDA) figures were embellished.[3] EBITDA is often used to value a company for purposes of buying it, and has been called the “single most important financial contributor to buyout performance.”[4] The complaint alleges that Independent used creative accounting techniques such as ‘channel stuffing’—“a practice where a supplier forward sells stock on extended terms to retailers in order to account for significant ‘one off’ sales in a particular period”—to wrongfully include income and exclude expenses.[5] Asahi claims that these practices inflated Independent’s EBITDA by $NZ42 million,[6] and made it appear as if Independent was growing at the time of the sale when normalized calculations show that it was actually declining.[7] These inconsistencies likely had a significant impact on the negotiated purchase price, as Asahi claims it “conducted due diligence thoroughly and in good faith and relied on [the EBITDA figures] provided.”[8]
Although this dispute will be resolved in an Australian court, it is factually similar to a case arising out of Delaware a few years ago. In ABRY Partners v. Providence Equity,[9] the buyer, ABRY Partners, accused the private equity seller, Providence Equity Partners, of knowingly presenting a portfolio company’s misstated financials in connection with a sale.[10] The purchase agreement contained provisions designed to insulate Providence from liability for representations made by its portfolio company.[11] Specifically, the warranty that ABRY claimed was breached was “by its plain terms . . . [a warranty] made only by the [portfolio company] and not by [Providence].”[12] The agreement also contained a $20 million indemnification cap.[13] The Delaware Court of Chancery ultimately found that the indemnification cap would be honored if Providence did not lie.[14] However, it found that ABRY could collect damages in excess of the cap if it could prove that Providence knew its portfolio company made false representations or if Providence itself made such representations.[15]
If the Australian court takes a similar approach, the purchase agreement will be crucial in determining the level of culpability Asahi must prove and the amount of damages that they can recover. ABRY suggests that a properly drafted agreement can insulate PE firms from fraud committed by their portfolio companies in connection with the sale as long as the firm was not aware of it. If such a term were contained in this agreement, it would force Asahi to prove that these companies knew Independent was manipulating the EBITDA figures. While this is a seemingly heavy burden, the Asahi complaint suggests that they would be able to prove knowledge through email correspondence they have obtained.
Regardless of the outcome, this case evidences the importance of (1) conducting thorough due diligence; (2) understanding ways in which EBITDA can be manipulated; and (3) thinking carefully about future liability when drafting purchase agreements.
_________________________________________________________________
[1] Neil Gough, Asahi Sues 2 Private Equity Firms Over $1.3 Billion Deal, N.Y. Times (Feb. 14, 2013, 5:13 AM), http://dealbook.nytimes.com/2013/02/14/asahi-sues-2-private-equity-firms-over-1-3-billion-deal/.
[2] Id.
[3] Asahi Alleges ‘Channel Stuffing’ At Beer Firm, The New Zealand Herald (Feb. 18, 2013, 11:45 AM), http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10866101.
[4] Nicolaus Loos, Value Creation in Leveraged Buyouts 229 (2006).
[5] Adele Ferguson, Japanese Brewer Up in Arms Over Purchase Price, Newcastle Herald (Feb. 26, 2013, 5:00 AM), http://www.theherald.com.au/story/1326151/japanese-brewer-up-in-arms-over-purchase-price/?cs=9.
[6] See id.
[7] Asahi Alleges ‘Channel Stuffing’ At Beer Firm, supra note 3.
[8] Gough, supra note 1.
[9] ABRY Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006).
[10] See Ruling in ABRY Partners v. Providence Equity Case Has Lessons for Buyers and Sellers, Goodwin Proctor LLP (Mar. 14, 2006), http://www.goodwinprocter.com/~/media/Files/Publications/Newsletters/Private%20Equity%20Update/2006/Ruling_in_ABRY_Partners_v_Providence_Equity_Case_Has_Lessons_for_Buyers_and_Sellers.pdf.
[11] See id.
[12] ABRY Partners, 891 A.2d at 1042.
[13] See Ruling in ABRY Partners v. Providence Equity Case Has Lessons for Buyers and Sellers, supra note 10.
[14] See id.
[15] See id.
Is the 2013 Private Equity Boom Sustainable?
2013 has seen an early resurgence in the volume of mergers and acquisitions conducted globally. Since January, there have been in excess of 1000 deals with an aggregate value of over $160 billion,1 the fastest start since 2005.2 This boom has been anchored by several large, and sometimes unprecedented, buyouts, including the $23 billion takeover of…
Private Equity Shares the Spotlight with Tax Reform
Post-2012 Presidential Election, the private equity industry is in the public spotlight simultaneously with the tax reform proposals. Throughout the election, private equity was a constant topic of conversation – especially Bain Capital. Acknowledging the media attention received from the election, Bain Capital addressed its investors in a formal letter thanking them for their support despite the increased scrutiny.[1] In this letter, Bain Capital attempted to portray the positive aspects of the business outside of its profits by asserting its creation of hundreds of thousands of jobs and support of hundreds of charities in its 28-year history. [2] These reassurances acknowledge the added scrutiny to the private equity industry that may not disappear post-election.
Tax reform is one topic that has emerged in response to the perceived inequities in the tax code and the need to reduce the national deficit. Earlier this year, President Obama proposed changes to the tax code to end corporate tax breaks and decrease the corporate tax rate from 35% to 28%. [3] Similarly, the top House Republican tax writer, Dave Camp, has vowed to pass tax reform legislation in 2013.[4]
With the private equity industry comprising a significant amount of the U.S.’s economic activity, this industry is not likely to avoid the effects of tax reform. Venture capital, one subset of private equity, alone provides 21% of the U.S. GDP.[5] If these efforts to close the gaps in the tax code are successful, private equity’s increased media attention comes at an inopportune time in light of the industry’s favorable “carried interest” rates.
Under the “carried interest” rule, private equity firms, alongside real estate and mining partnership structures, could lose its favorable tax treatment. In this provision, private equity firms are able to pay the capital gains tax rate, 15%, on a third of its profits rather than the income tax rate, 35%, paid on the remaining two-thirds of payments made on the guaranteed annual management fees. [6] Supporters of the favorable tax treatment argue that the private equity firms should be viewed as entrepreneurs whose risk-taking should be encouraged by this favorable tax rate.[7] Yet, some critics of the favorable tax rate state argue that private equity funds should be treated like investment bankers who use individual investor funds in these risky investments and retain approximately a 2% management fee and a 20% profit if they reach their target.[8]
Congress estimates that eliminating this favorable tax rate could generate up to $2 billion in tax revenues, increasing the attraction to close this provision. [9] Despite objections from the industry that investors would not receive adequate returns on their investments in this risky industry, there are admissions of some industry members that the “carried interest” provisions are generous.[10]
As the public and Congress continue to look more closely into the private equity industry, the favorable tax provision in private equity will not likely avoid review following the election. Consequently, as the support for tax reforms increases in the upcoming year, the media attention provided to the private equity industry makes the industry a prime candidate for tax reform in 2013, decreasing or eliminating the “carried interest provision”.
_____________________________________________
[1] Greg Roumeliotis, Bruised by Romney criticism, Bain Capital thanks investors, Reuters (Nov. 8, 2012, 8:31PM), http://www.reuters.com/article/2012/11/09/us-usa-campaign-bain-idUSBRE8A804220121109.
[2] Id.
[3] See, Kevin Drawbaugh & Patrick Temple-West, Top U.S. House tax writer vows tax reform in 2013, Reuters (Nov. 15, 2012, 8:26 PM), http://www.reuters.com/article/2012/11/16/us-usa-tax-camp-idUSBRE8AF00620121116; Zachary A. Goldfarb, Obama proposes lowering corporate tax rate to 28 percent, The Wash. Post (Feb. 22, 2012), http://www.washingtonpost.com/business/economy/obama-to-propose-lowering-corporate-tax-rate-to-28-percent/2012/02/22/gIQA1sjdSR_story.html.
[4] Id.
[5] Brian McCann, Private Equity Searches for its Public Identity After the US Election, Opalesque (Nov. 15, 2012), http://www.opalesque.com/private-equity-strategies/2/private-equity-searches-for-identity-after-the.html .
[6] An end to the carry on, Buy-out firms face the prospect of a bigger tax bill, The Economist (Nov. 17, 2012), available at http://www.economist.com/news/finance-and-economics/21566647-buy-out-firms-face-prospect-bigger-tax-bill-end-carry.
[7] Id.
[8] Id.
[9] Id.
[10] Id.
Should the Carried Interest Tax Loophole be Eliminated?
With the “fiscal cliff”[1] fast approaching and the federal budget taking center stage in national politics, legislators are under intense pressure to find politically feasible changes to the tax code that can be used to raise revenue. One feature of the tax code in particular – its treatment of the “carried interest” income earned by most private equity and hedge fund managers – has fallen squarely within these legislators’ crosshairs. It seems likely that this “loophole” will soon be eliminated, but current proposals for doing so miss the mark.
Most private equity firms’ fees are structured on the “2 and 20” model. The “2” refers to a baseline fee fixed at 2% of assets under management, which is taxed as ordinary income. The “20,” on the other hand, is the famous “carried interest:” fund managers also keep 20% of all gains realized by the fund. Because private equity funds typically enter relatively long-term investments, private equity fund managers can characterize their carried-interest income as long-term capital gains, which are taxed at 15%.[2] Thus, successful private equity fund managers – whose incomes routinely exceed seven figures – often have the bulk of their income taxed at the low rate of 15%.
Not surprisingly, this practice has drawn scrutiny from legislators in Washington. Congressman Sandler Levin has introduced a “Carried Interest Fairness Act” in the House of Representatives,[3] and President Obama’s 2013 budget specifically targets the loophole.[4] Both simply propose that carried interest be taxed as ordinary income. This is an enticing solution: it singles out these wealthy fund managers, a group many people find unsympathetic,[5] and it raises much-needed revenue.
However, resolving this issue may not be quite so simple. Whatever justifications exist for taxing other kinds of capital gains at rates lower than ordinary income may apply for carried interest income as well. For example, some argue that lowering capital gains taxes incentivizes risk-taking and investment; these incentives are certainly in play in the private equity world. The same is true of the “lock-in” rationale: some say lowering capital gains taxes prevents people from holding on to subpar investments simply for tax purposes, and the same considerations could affect the decision-making process of private equity fund managers deciding when to realize their gains.
A simpler solution would be to eliminate the distinction between capital gains and ordinary income altogether. Economic research has found little, if any, empirical evidence supporting the rationales described above.[6] More direct and effective methods can be used to achieve the purported benefits of low capital gains tax. Worst of all, this distinction encourages people to engage in inefficient rent-seeking. The time spent by accountants and tax lawyers thinking of ways to re-characterize income, and indeed the hours spent writing this very article, could be used for other pursuits. The most sensible solution, then, is to do away with this distinction and tax income of all types at one simple rate.
_______________________________________________
[1] I.e., the large number of scheduled tax increases and spending cuts set to go into effect in early 2013. See Jonathan Weisman, Q&A: Understanding the Fiscal Cliff, N.Y. Times Economix Blog (Oct. 9, 2012, 6:28 PM), http://economix.blogs.nytimes.com/2012/10/09/qa-understanding-the-fiscal-cliff/.
[2] Janet Novack, Romney’s Taxes: It’s the Carried Interest, Stupid, Forbes (Aug. 24, 2012, 6:03 PM), http://www.forbes.com/sites/janetnovack/2012/08/24/romneys-taxes-its-the-carried-interest-stupid/.
[3] H.R. 4016, 112th Cong. (2012).
[4] Cutting Waste, Reducing The Deficit, And Asking All To Pay Their Fair Share (2012), available at http://www.whitehouse.gov/sites/default/files/omb/budget/fy2013/assets/cutting.pdf.
[5] (just ask Mitt Romney)
[6] See, e.g., Capital Gains and Dividends: What is the effect of a lower tax rate?, Tax Policy Center, available at http://www.taxpolicycenter.org/briefing-book/key-elements/capital-gains/lower-rate.cfm; Brendan Greeley, Study Finds Benefit is Elusive for Low Capital Gains Rate, Bloomberg (Oct. 4, 2012, 10:17 AM), http://www.bloomberg.com/news/2012-10-04/study-finds-benefit-is-elusive-for-low-capital-gains-rate.html
Dividend Recapitalization: A Controversial Trend
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.[1] The resurgence is due to investors’ desires of achieving high yielding debt at a time of historically low interest rates.[2] 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.[3] Between 2003 and 2008, companies borrowed $69 billion primarily to pay dividends to private-equity owners, according to Standard & Poor’s Corp.[4] That compares with $10 billion in the previous six years.[5]
“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.[6] 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.[7] 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.[8] 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.[9] 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.
______________________________
[1] 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)
[2] Id.
[3] Id.
[4] Louis S. Freeman, General Overview And Strategies In Representing Sellers, 825 PLI/Tax 7
[5] Id.
[6] Dezember & Wirst, supra note 1.
[7] Alan S. Gutterman, et al., Review of Major Developments Affecting Mergers, Acquisitions and Divestitures, 28 No. 12 Corp Acq Ideas 1
[8] Louis S. Freeman, General Overview And Strategies In Representing Sellers, 825 PLI/Tax 7
[9] Id.