Dividend Recaps: Currently Questionable, Soon to be Illegal

One of the biggest rages in the private equity world these days is the “dividend recap”.  In a dividend recap, a private equity firm takes over a company with a reasonably healthy balance sheet and then levers it up dramatically, not to invest in the business or support their original purchase price, but simply to generate a ton of excess cash. This excess cash is then quickly paid out as a "dividend" to the private equity firm.  While the tactic is a fantastic way for a private equity firm to improve its IRRs, it’s also highly likely to be illegal or at least financially impractical in the near future.

Private equity firms defend dividend recaps as simply a prudent use of capital and leverage however the truth is that they are really just a blatant tax dodge.  You see dividends in normally run companies come from retained earnings and retained earnings are subject to corporate taxes of roughly 35%-40%.  In addition, up until a few years ago, any taxable entity (such as, say, the GPs in a private equity firm) had to pay ordinary income taxes on those dividends once they received them. Thus, by the time a $1 of corporate pre-tax income made it into the pocket of an investor it was subject to somewhere between 75-80% in taxes.  Not the world’s easiest way to make a buck.

Good Things Come In Threes
Three things changed all of this though.  First, in 2001 Congress cut the tax rate on most corporate dividends to 15% in order to reduce the double taxation of corporate income.  Second, the credit markets dramatically loosened as both short and long term rates plummeted post the 2000 bubble.  Third, private equity firms were able, thanks to robust demand from LPs, to raise huge funds that were more than capable of doing many deals with little or no debt.

With their giant funds and the loose credit markets, private equity firms saw that it was now possible to raise much more cash than they actually needed to buy a given company.   However, rather than downsize their equity funds (and thus their fees and carry) to a more capitally efficient size, the funds instead figured out that they could have their cake and eat it too, i.e. they could invest “too much” equity into deals enabling them to justify their huge funds and then use loose credit to support dividend recaps as a way to restore the “proper” capital structure while magically turning the recently raised debt into profits subject to just 15% net taxes (and a 20% carry!).  One can just imagine all the former investment bankers at private equity firms looking over their spreadsheets and grinning while they whisper “God Bless America!”.

Too Much Of A Good Thing
The problem for private equity firms is that dividend recaps are such a great arbitrage in some respects that everyone and their grandmother is now rushing to do them.  As the size and volume of these recaps increases, the prices of the underlying assets are starting to inflate, making the incremental deals riskier and riskier.  Ultimately, the greater fool will push the edge of the envelope so far that he will set off a spectacular Enron-style collapse and the knives will then come out for everyone.  It is in many ways a classic Wall Street story that has been told again and again and always has the same ending.

Calling All Politicians
However, even before the long hand of market takes its inevitable toll, the government may beat them to the punch.  That’s because dividend recaps are basically exploiting a huge loophole in the tax code and subverting the original intention of the tax cuts.  All it may take is one enterprising politician (Elliot Spitzer anyone?) and one reasonably high profile dividend cap related failure, to bring about a Sarbanes-Oxley style backlash from Washington DC.  It might be a stretch to make dividend recaps illegal, but Congress can surely play with the tax code enough to make them financially impractical.

Until then, private equity firms will undoubtedly “pump up the volume” on dividend recaps in the false hope that their day of political reckoning might never come.   My one piece of advice them is to stand close to the exits and watch what they put in their e-mails.