PE firms under pressure to pay investors are turning to risky debt

In a sign of mounting stress in the private markets, a growing number of private equity firms are turning to a potentially risky financial maneuver in an effort to return capital to their investors.

That tactic, known as dividend recapitalizations, is a way to extract cash from portfolio companies amid a slowdown in deal activity.

As explained by the Wall Street Journal, dividend recapitalizations involve loading portfolio companies with high-risk debt, enabling PE firms to pay out dividends to investors and themselves without having to sell off assets.

According to the Journal, PE firms’ junk-debt exposure from that type of borrowing has surged in 2024 as firms seek to navigate a challenging market environment.

Citing data from Pitchbook LCD, the financial news publication said debt issued for dividend recapitalizations reached $43 billion as of early August, more than five times the $7.4 billion posted during the same period in 2023. That figure also rivals the 2021 peak, when there was still plenty of cheap debt to fuel widespread dealmaking.

Dividend recaps provide private-equity firms with a means to extract value from portfolio companies without exiting their investments, but they don’t yield as much cash to return to investors compared to outright sales.

“It’s a way to return capital without selling the business,” J.W. Perry, head of the sponsor practice at Davis Polk told the Journal. Davis Polk advises known PE shops like Bain Capital, which is leading a $4.5 billion deal to acquire Envestnet, and Madison Dearborn Partners.

Despite the uptick in recapitalizations, the distribution rate of capital to investors remains low. From 11.5 percent at the end of 2022, it’s projected to hit 12 percent this year—still well below the 31.3 percent seen in 2021, according to Raymond James.

“The data isn’t showing any improvement as of the second quarter, that we hoped to see,” said Darius Craton, a director at Raymond James’s private capital advisory group, remarked to the Journal.

This isn’t the first time Raymond James has held a bearish outlook on PE. In a February interview with Bloomberg, Sunaina Sinha Haldea, global head of private capital advisory at Raymond James, noted that PE funds had returned historically low amounts of cash to investors, which kneecapped their ability to launch new investment vehicles.

“The cash flow math at the investor level is broken,” Haldea said at the time. “This is the worst-ever fundraising market, worse than even during the global financial crisis.”

The practice of dividend recapitalization has drawn no small amount of criticism, with many accusing PE firms of weakening companies to appease investors.

Still, there are signs the broader private-equity market could be on the path to recovery. According to Dealogic data, leveraged buyouts backed by PE, in part due to leveraged loans becoming more accessible to firms, have risen 37 percent this year, driven by more accessible leveraged loans from traditional banks.