Private-equity guys cash out while they can

Looming tax hikes, IPO scene spur debt buildup to pay big dividends

Nov 4, 2012 @ 12:01 am

By Aaron Elstein

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(Don Mason/Getty Images)

In 2010, The Carlyle Group acquired NBTY Inc., which sells vitamins under the Nature's Bounty label, in a $3.6 billion leveraged buyout.

The private-equity firm anted up $1.55 billion in cash to finance the deal and borrowed the rest.

In October, with the stroke of a pen, Carlyle recouped about half the money it invested in the LBO. It did so by having NBTY take on another $550 million in debt and dip into its cash reserves so the company could funnel a $672 million dividend to Carlyle.

Carlyle declined to comment on the cash extraction, but such moves — which the LBO world calls dividend recapitalizations or leveraged recaps — are all the rage these days. Companies this year have borrowed a record $62 billion through mid-October in order to pay for dividends to their private-equity owners, according to Standard & Poor's, and rare is the LBO shop that hasn't piled more debt onto its holdings and mined them for cash.

Blackstone Group LP, for in-stance, had SeaWorld Parks & Entertainment borrow about half a billion dollars this year so that it could pocket a dividend — the second such payout that it commanded in nine months.

Hospital operator Hospital Corp. of America borrowed $2.5 billion in October to help finance a $1.2 billion dividend payout, 40% of which went into the pockets of private-equity owners Bain Capital LLC and KKR & Co. LP.

Carlyle-owned management consulting firm Booz Allen Hamilton Inc. paid out a nearly $1 billion dividend in July after borrowing more than twice that amount.

“Anytime is a good time to take out millions' worth of dividends,” said Steve Miller, managing director at S&P Capital IQ's Leveraged Commentary and Data.

But several factors are also driving this year's surge in leveraged recaps.

Dealmakers said that they are hitting up their companies for cash because it is tough for LBO firms to fetch attractive prices for companies via initial public offerings — the traditional ticket to riches for private-equity players. What's more, plenty of fixed-income investors are eager to snap up the debt used to pay for dividends, as it often comes with hefty yields of 8% or more.

In addition, private-equity leaders fear that taxes on dividends and capital gains will rise next year as the Bush-era tax cuts expire and Washington looks for new sources of revenue.

Currently, dividend and capital gains are taxed at 15%, but President Barack Obama has suggested boosting tax rates on dividends to nearly 40% for the wealthiest investors and raising the capital gains rate to 20%. Republican presidential nominee Mitt Romney has proposed keeping existing rates for the wealthiest.

“Everyone is thinking about this,” Mr. Miller said.

But by far the most important driver of the borrowing binge is that the Bains and Blackstones of the world are under mounting pressure from pension funds and other institutional investors that entrusted billions with them in the past decade but haven't seen much in return.

To placate these increasingly impatient investors, LBO firms have taken out 91 cents in dividends for every dollar of capital that they have invested this year, according to S&P, compared with just 20 cents per dollar invested last year.

“The private-equity firms want to show their investors some money, and one way to do that is lever up their companies and take out dividends,” said Steve Siesser, chairman of the specialty finance group at law firm Lowenstein Sandler PC.

AND NOW, THE RISKS

The risk, of course, is that the LBO firms are saddling their companies with debt just as the economy is heading for a rough patch, much as they did in 2006 on the eve of the Great Recession.

What's more, risky types of debt instruments, such as PIK-toggle notes, which have been largely unseen for years, are resurfacing. PIK-toggles, which NBTY used to finance its dividend to Carlyle, are bonds that allow borrowers to delay payments to creditors in exchange for increasing their debt load.

The default rate for companies that use this form of financing is double the rate of similar companies, according to Moody's Investors Service.

Speaking privately, LBO executives insist they aren't unduly burdening their companies with debt so they can get a payout.

Indeed, a study by Fitch Ratings Ltd. recently showed that dividend recapitalizations are generally leaving European companies with debt equal to four and one-half or five times their cash flow, compared with 6.4 times in 2006.

In the case of NBTY, according to S&P, the hefty dividend payout doesn't significantly change the company's financial condition, and operating performance is im- proving.

CASE STUDY IN BORROWING

Still, it is clear that for some companies, the dividend payouts represent a real financial burden.

Consider Wall Street Systems Holdings Inc., a provider of trading technology acquired last year, reportedly for more than $500 million, by a company owned by private-equity firm TA Associates Management LP. In September, Wall Street Systems borrowed $570 million and forked over a $195 million dividend to its owner.

The new borrowings increased the company's debt load to 7.1 times cash flow from 5.3, according to S&P, and the rising debt load came after revenue fell in the 12-month period ended last June by $15 million, to $185 million.

Moody's responded to the growing debt burden Oct. 17 by downgrading Wall Street Systems' credit rating deeper into junk territory, to one notch above the rating that suggests obligations of “poor standing” and “very high credit risk.”

“Our expectation [is] that Wall Street Systems will periodically increase financial leverage to fund equity distributions,” said Moody's, which said it expects “low-single-digit” revenue growth annually.

In English: A slow-growing, heavily indebted company could be strained financially because it will need to borrow more in the future to pay additional dividends.

TA Associates and Wall Street Systems didn't respond to requests for comment.

Aaron Elstein is a senior reporter for sibling publication Crain's New York Business.

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