The recap rebound

Dividend recapitalization activity plunged in the immediate aftermath of COVID-19 but, as markets recovered, investor appetite for recap deals swelled

Leveraged loan and high yield bond issuance specifically intended for dividend recapitalization soared in North America and Western and Southern Europe in the third quarter of the year as investors returned to market, eager to deploy capital.

Dividend recaps from high yield bonds and leveraged loans for North America and Western and Southern Europe totaled US$14.6 billion in Q3 2020, up from a meager US$150 million in Q2.

Baltic telecommunications business Bite, backed by Providence Equity Partners, and US software company Epicore, a software provider owned by KKR, are among the companies accessing the market to finance dividend recaps in recent months.

Apax-backed ECi Software, broadband provider Radiate Holdco and Shearer’s Foods, which is owned by Wind Point Partners and the Ontario Teachers’ Pension Plan, have also come to market seeking dividend recaps.

An unusual cycle

The spike in dividend recaps comes despite ongoing volatility in capital markets. Dividend recap issuance is cyclical and typically viewed as peaking at the top of the credit cycle rather than through periods of uncertainty. Many leveraged finance stakeholders have expressed surprise at how quickly dividend recap activity rebounded in Q3—especially when Q2 2020 was comparably so weak.

Owners of assets went into portfolio management mode when COVID-19 lockdowns first landed. Their priorities were clear: Assess the liquidity needs of their portfolio companies, determine the impact of the pandemic on trading and ensure covenant compliance (or obtain covenant relief). Any plans to pursue dividend recaps were put firmly on the backburner. The return to a degree of normalcy in Q3—short-lived as it may have been—freed up borrower bandwidth to consider dividend recap options again.

COVID-19 fallout also created a unique set of circumstances that have supported dividend recap activity. For example, even though markets remain unpredictable, central banks around the world have kept interest rates low to kick-start economies through market dislocations wrought by COVID-19. This has driven investor demand for higher-yielding assets, including leveraged loans and high yield bonds. New CLO issuance in the US, for example, climbed from US$17.8 billion in Q2 2020 to US$24.5 billion in Q3 2020, according to Debtwire Par, reflecting the recovery in investor appetite.

Dearth of M&A

Many lenders have also been funneled toward dividend recap deals due to a lack of other options.

In normal circumstances, M&A activity is an important source of new money deals for investors, but with fewer M&A deals closing, lenders have been starved of opportunities. Global M&A deal value this year is down from US$2.6 trillion in the first nine months of 2019 to US$1.9 trillion over the corresponding period this year.

Leveraged finance issuance for M&A (excluding buyouts) in North America and Western and Southern Europe is down by just under a third (31%) year on year when compared to 2019, from US$197.6 billion to US$136.4 billion. Issuance for buyouts is down by a similar margin.

With M&A-related issuance down, dividend recaps have been the next best option for lenders in many cases.

For the owners of assets seeking value, meanwhile, dividend recaps have provided an alternative route to liquidity.

Vendors have been reluctant to sell assets at potentially reduced valuations. Dividend recaps allow financial sponsors to take money off the table and distribute capital to their investors without having to risk an auction process where the outcome is uncertain.

Underwriters have noted these dynamics and offered vendors dividend recap deals that include portability provisions, which allow owners to transfer any borrowings to new owners in the future. This has been particularly attractive for private equity firms that may have deferred exit plans, but do not want to be encumbered with excess leverage if and when sales restart in 2021.

Dividend recaps have also been done on a “best efforts” basis. This means arrangers do not need to guarantee the success of an issue or put their capital at risk to underwrite deals. They can test the market with aggressive terms and, after seeing if lenders are interested, adjust terms accordingly.

Noting this, vendors have increasingly been running dual-track processes. If an M&A process can deliver a deal at the right valuation, vendors will take this route, but running a dividend recap process in parallel offers a fallback option.

Favorable terms

Dividend recaps may sometimes be perceived to dilute alignment between equity sponsors and lenders if they allow sponsors to realize all their capital and de-risk entirely. There is no evidence, however, that lenders have demanded tighter terms or documentation for dividend recaps relative to other uses of proceeds. The investor community is almost willing to put as much debt on a business for a dividend recap as it would for a fresh transaction where new equity is going into the business.

Poor performing credits are unlikely to secure dividend recaps but, for strong performing credits, lenders have been agnostic toward use of proceeds as a risk factor. A focus on credit quality and the capacity of the business to carry additional debt are the main drivers of investor decisions.

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