Private equity is a type of investment capital where a firm or group of high-net-worth individuals invest in a company in return for an equity stake. This allows them to own part of the company and make decisions about the future of the company in many cases.
Private equity is limited to private companies as the name implies. It doesn’t apply to publicly traded companies whose stock is listed on an exchange. Those companies have already raised investment capital by going public and listing their shares.
Key Takeaways
- The term private equity refers to firms or individuals who invest in a company in return for a stake in its equity.
- The company may be a public company that’s then taken private.
- Private equity investors receive dividends.
- Companies may have to take on debt to pay these dividends.
How Private Equity Works
Private equity also refers to firms or individuals that purchase large amounts of a public company’s shares to achieve majority ownership. They then take that public company private. It’s delisted from a stock exchange when a public company becomes private.
The goal is always to gain influence and control over a company and make adjustments whether they’re managerial or operational to improve the company’s performance. This potentially results in stronger profits and high returns for the investors.
How Dividends Work
The receipt of dividends is part of the returns for private equity investors much as it is for shareholders of a public company. This process is referred to as dividend recapitalization.
Dividend recapitalization involves raising debt to pay private equity shareholders a dividend. It’s a way for investors to receive a return without having to sell their shares but it can often be detrimental to the firm. Taking on more debt is a risky maneuver if the company doesn’t have a strategy to pay it back.
Petco was taken private for the first time by Texas Pacific Group for $600 million in 2000. It previously had $89 million in long-term debt. It was saddled with about $360 million in long-term debt two years later when it went public again. The company then went private again in 2006. It all begged the question of how its debt level could have grown so significantly in only two years.
Dividend Recapitalization
Dividend recapitalizations are very popular. The problem is that they only benefit a select few while adding debt to a company. This can lead to dangerous territory because capital is being used to pay this special dividend rather than to grow the business.
The increased debt will be nearly impossible to pay off if the economy goes into recession or worse. This could potentially lead a company to bankruptcy. A company would have to lay off employees, cut pay, close underperforming locations, or find other ways to free up cash to pay off the debt if creditors must be repaid and rampant growth isn’t a factor. The company would be headed in the wrong direction even if it wasn’t faced with bankruptcy.
Unfortunately, there’s no way of knowing which private companies are overleveraged. Bankruptcies can come out of nowhere. It’s easy to see which public companies are overleveraged, however, due to required transparency by the Securities and Exchange Commission (SEC). You can also see which companies are likely to have a sustainable dividend or dividend capable of growing.
Important
Petco acted for dividend recapitalization purposes so private equity sponsors and management teams could recoup their investments. There are many other examples of this occurring in private equity firms.
Real World Examples
BJ’s Wholesale Club was taken private by Leonard Green and CVC Capital for $2.8 billion in 2011. Leonard Green and CVC Capital demanded $643 million for a dividend payment. BJ’s didn’t have $643 million available so it had to take out a loan.
Bankrate was taken private by Apax Partners for $570 million in 2009. Bankrate had no long-term debt before this event. It reportedly had more than $290 million in long-term debt one year after going private.
What Is a High Net Worth Individual?
A high net worth individual is someone who holds at least $1 million in net assets. The assets must be liquid. They’re either cash or they can easily be converted to cash.
What Is a Public Company?
Shares of these companies trade on public markets and are made available in public offerings. Many investment funds hold a significant portion of stock in public companies. These companies are subject to government oversight and are obligated to be transparent about their business and financial information. This information must be accessible to the public.
What Is Dividend Recapitalization?
Dividend recapitalization is the process of a company assuming debt to pay dividends to its private equity shareholders. These investors can profit without selling their holdings. It can be a risky endeavor if the company doesn’t have funds available to make these payments and must borrow to meet the obligations.
The Bottom Line
Private equity isn’t always what it’s cracked up to be unless you’re one of the select few who’s being rewarded. There’s sometimes a moral issue related to what’s best for the company even if you fit into that category.
Dividend recapitalizations are a form of private equity dividend that’s achieved by taking on additional loans just to pay select shareholders so they can earn a pre-sale profit. This can lead to an overleveraged situation and increased potential for bankruptcy.