What Does Leveraged Recapitalization Mean?
Leveraged recapitalization is a strategy where an organization takes on additional debt in order to pay out large dividends or repurchase shares. The amount of debt that a company can raise (in the form of either senior or mezzanine financing) would depend on the qualitative and quantitative characteristics of the business.
Divestopedia Explains Leveraged Recapitalization
Leverage recapitalization is a strategy that is commonly used in family succession transactions. In contrast to a private equity recapitalization, no other equity partners or sources of capital are introduction into the transaction. All of the capital used to fund the dividend pay out or share repurchase would be in the form of either senior or mezzanine debt (not equity). The advantages and disadvantages of a leveraged recapitalization are as follows:
- A business owner (or their family members) will retain 100 percent ownership of the company.
- The process is relatively quick - typically three to four months - because owners need only negotiate with the bank.
- This type of financing can be done confidentially, with minimal disruption to the operations of the business.
- Personal guarantees will very likely be required by the bank as secondary security for the additional debt obtained. So, even though the business owner has taken cash out of the business, risk still remains with the personal guarantees. Owners need to assess whether they can stomach this extra debt.
- There will be increased financial reporting required by mezzanine and senior debt providers.
- Additional debt on a business will increase the stress on cash flows, since lenders will require sufficient cash to cover the debt servicing requirements. This can affect a company’s ability to grow.
In the public markets, leveraged recapitalization can be used in many ways for a variety of reasons that are beneficial to the organization. For example:
- This technique is widely used to prevent a hostile takeover of an organization. When the target company increases its debt and uses it to pay large dividends to its shareholders, the amount of assets goes down. This position can make the target company unattractive to potential companies that are looking to make a bid on it. This strategy of using leveraged recapitalization to make a company unattractive is called "shark repellent."
- This technique can be used to give a company a tax shield as the amount of free cash flows that come by way of a debt increase is in excess of its current needs. The existing Modigliani-Miller theorem calculates the present value of the tax shield by multiplying the amount of debt with the prevailing tax rate. So, a higher debt means lower taxation for the company. This strategy is used when the company has seen big profits or is sitting on a huge pile of cash.
- Another use for leveraged recapitalization is to give the company financial leverage. When the amount of cash inflow is higher than the operating expenses of the company then its financial leverage increases. When a large dividend has been paid by the company, it causes the price of shares to drop. A share is called a "stub" when it has lost 25 percent of its price value. If a recapitalization is successful then the value of the dividend plus the price of the stub should exceed the share price that was prevalent before the leveraged recapitalization was completed.