Private equity is loading up companies with debt to juice dividends and delay their pain

I have written, a few times now, about private equity’s cash flow problem: namely, PE as an industry is now raising more funding than they are distributing back to investors, so a lot of investor capital is tied up in portfolio companies that funds haven’t been able to sell.

The life cycle of a typical PE fund might be 10-12 years, in which capital is invested over the first half of the fund’s life, and investments are sold to return capital to limited partners over the second half. However, when funds find themselves unable to exit those positions, they have a problem: where do they get the money to pay investors?

The answer: junk bonds.

PE funds use a practice known as a “dividend recapitalization” to raise new debt in order to pay their investors a cash dividend (one example is 1-800 Contacts, a KKR portfolio company, taking out a $565 million loan earlier this year), and, according to The Wall Street Journal, dividend recaps through early August 2024 have hit $43 billion, up from $7.4 billion in the same period last year. 

Dividend recaps aren’t new, and the use of leveraged loans to distribute cash to investors exploded in 2020 and 2021 (according to the Journal piece, this year’s dividend recap payouts still lag behind 2021). However, in 2020 and 2021, debt was much cheaper as the Fed funds rate was close to 0%. With benchmark interest rates now sitting at 5%, the loans funding dividend recaps are more expensive to service, pressuring the portfolio companies. Additionally, despite the recent uptick in dividend recaps, capital is still being distributed to investors at an anemic rate of around 12%, down from 31.3% in 2021.

Personally, I don’t think this practice bodes well for private equity. As noted in my venture capital piece, “down rounds” are growing more popular in the venture space as startups can no longer justify their 2021 valuations, and, if they want to raise more capital, they’re going to have to take a haircut on their valuations. The same dynamic is in play in the more liquid stock market: you have to transact at market price, even if that price is below what you perceive to be the fair value.

Private equity valuations, however, tend to be subjective, and funds don’t want to mark down the value of their investments. Dividend recaps allow funds to maintain current valuations and avoid taking losses, but they’re just kicking the can down the road. Sooner or later, they will need to exit their positions, and when you do have to sell, your investment is only worth what someone else will pay for it. Loading that investment with pricey debt doesn’t make it a more attractive asset.