What Does Recapitalization Mean?
Recapitalization is the fundamental restructuring of a company’s finances. The company may want to switch from debt-based funding to an equity funding agreement. Or it could go the other way, where a company issues new debt and uses the money to buy up all of its current outstanding shares.
This type of restructuring is often done during periods of financial turbulence, but it can be done whenever the Board of Directors dictates that it is necessary. If a company has a high debt to equity ratio, it can buy back some of its shares in the open market in order to drive the price up and improve its ratio. Companies that want to make themselves unappealing to hostile buyers will often issue large amounts of debt, because this reduces their attractiveness in the open market.
Other times recapitalizations occur are when a company wants to reduce its financial obligations. In this case, the company could pay off its debt obligations and lower its debt-to-equity ratio. This reduces the amount of financial obligations of the company and allows the company to pass through more of its profits to shareholders. This can also allow a company to buy back a block of its shares in the open market and shore up the share price. The opposite can also happen, where a highly leveraged company pays off all of its debt-based obligations and issues new shares of stock to raise capital. A recapitalization can help a company to increase its liquidity in some cases.
Two other major instances where recapitalizations occur is when a company is facing bankruptcy. A recapitalization may be required by the bankruptcy court in order to help the company settle its affairs. Or a company may want to provide its venture capital or private equity partners with an exit strategy.
Divestopedia Explains Recapitalization
Recapitalization can substantially affect both the price and the overall volatility of a company’s stock. Therefore, this action is usually carefully monitored by majority shareholders, who may or may not be in favor of a radical change in the company’s financial structure. In fact, most recapitalizations require shareholder approval before they can be done. But even reluctant shareholders may realize that a recapitalization is the company’s only viable alternative to bankruptcy.
While there are many reasons why a company may decide to recapitalize, the capital structure irrelevance principle mandates that a company’s capital structure bears no relation to its profitability. But a debt-financed company may better its position by paying off its debts and issuing stock when interest rates are high, and vice-versa when rates are low.
When a company converts at least a portion of its debt obligations into equity, it reduces the company’s overall amount of leverage. Earnings-per-share (EPS) will also decline proportionately, but the company’s stock will then pose less risk to investors because the company’s financial obligations have decreased. The lower debt ratio ultimately means that the company can now pass more of its earnings and profits along to shareholders going forward.
Both debt and equity recapitalizations can be done for many reasons. A company can do a leveraged recapitalization, where it issues a large amount of new debt securities and uses the money from this issue to buy back a portion of the company’s outstanding shares of stock. This can push up the share price and also improve the stock’s earnings per share (EPS). It can also allow current shareholders to sell their shares at a higher price and thus exit the investment. A leveraged recapitalization can also “discipline” a company that has a large amount of cash or rebalance its debt and equity positions within a holding company.